Economic Benefits of Futures

REVIEW OF RURAL AFFAIRS

Economic Benefits of Futures
Do Speculators Play Spoilsport in Agricultural
Commodity Markets?
K G Sahadevan

This article examines the economic benefits of futures.
Theoretically, futures are expected to aid price discovery
and risk mitigation. But empirical analysis shows that
speculators drive the markets and, by virtue of their
domination, abduct the price discovery process in
certain commodities. The deceptive price discovery
leads to suboptimal forecast of future prices. So futures
markets fail to offer an effective hedge against price
risk. In addition, the current public-private partnership
regulation is a deterrent to the sustainable growth of
futures markets.

A version of this paper was presented at the Silver Jubilee Celebrations
Conference on “The State, the Market and the Agripreneurs” organised
by the Indira Gandhi Institute of Development Research, Mumbai during
3-5 April 2013.
K G Sahadevan ([email protected]) is with the Indian Institute of
Management, Lucknow.
Economic & Political Weekly

EPW

DECEMBER 27, 2014

vol xlIX no 52

1 Introduction

T

he debate on the utility of commodity futures in India
remains unsettled in academic and policy circles. The
reports of two government committees have raised concerns about the extent to which futures markets have served
the purpose for which they were promoted, particularly with
regard to agricultural commodities, and their role in promoting price stability in physical (spot) markets.1 Moreover, the
committees have pointed out that futures are inadequate as an
instrument for mitigating price risk. Nevertheless, the markets
for futures have grown in leaps and bounds with large volumes
of trade being generated by six online national and 16 regional
exchanges, which are permitted to offer futures in 113 commodities, including agricultural, metals, energy, and plastics.2
The annual turnover of trade in organised exchanges surpassed
the nominal gross domestic product (GDP) figure of the country
by March 2010. It rose from Rs 1.29 lakh crore in 2003-04 to
Rs 119 lakh crore in 2010-11 and further to Rs 181 lakh core in
2011-12.3 Futures markets face many challenges today. Apart
from the public perception that the market is “excessively speculation driven”, its narrow base restricts its benefits to only a
few players, that too in select commodities, and this raises serious doubts about its relevance to the national economy.
Futures markets play two key roles. They offer an efficient
market-driven mechanism for price discovery, and futures prices are seen as a clear indication of the collective expectations of
market participants on present and prospective demand and
supply conditions. It is often argued that excessive speculation
tends to mislead the price discovery process and reduces it to
“price determination”. The prices thus “discovered” will only
be a suboptimal predictor of future spot prices. The second important role is that futures markets have the ability to mitigate
price risk arising from stockholding through hedging. This is
possible because spot and futures prices tend to move together
under normal market conditions. Markets, however, have the
tendency to create a divergence between the two, although
effective hedging depends on convergence between spot and
futures prices as contracts approach maturity. This study is an
attempt to examine these two empirical issues that are pertinent to the agricultural commodity futures markets in India.
2 Growing Markets and Concerns

A major reason why the government permitted futures trading
was to develop a market-driven mechanism for hedging the
45

REVIEW OF RURAL AFFAIRS

price risk of farmers, and also to improve awareness among
them of the value of their marketable surplus through better
price discovery and its dissemination. With these objectives in
mind, various committees, including the Dantwala Committee
in 1966 and the Khusro Committee in 1980, recommended
steps to allow futures trading in more agricultural commodities.4 Subsequently, the Kabra Committee in 1994, while recommending the exclusion of certain commodities of mass consumption from futures trading, reiterated the usefulness of
futures to the farm sector. The current basket of commodities
open to futures trade comprises three commodity groups –
bullion and other metals; agricultural commodities; and
energy. With the growing interests in internationally traded
commodities, the futures market today is dominated by trade
in metals and energy. While the share of agricultural commodities in total value of trade declined sharply from 55% in
2005-06 to as low as 13% in 2012-13, the share of bullion and
other metals rose from 36% to 65% in the same period. The
share of energy products, on the other hand, more than
doubled during this period from less than 10% to 22%.
More importantly, there are concerns about the composition of the basket of agricultural commodities open to futures
trade. Although futures are permitted in as many as 90 agricultural commodities, leading exchanges now offer contracts
only in 32 of them. Most of these commodities, however, have
failed to generate a significant volume of trade. For instance,
the two leading agricultural commodity exchanges together
shared only less than 13% of the total value of trade in the
country in the last three years, including metals and energy.
Moreover, it is observed that major commodities with larger
production, marketable surpluses, and nationwide spot
markets are laggards in these exchanges. In the case of wheat,
maize, potato, chilli, cardamom, and rubber, the futures
multipliers are in fractions while commodities such as mentha
(mint) oil, guar (cluster bean) seed, and guar gum have
attracted large trade volumes compared to their total production in the country.5 For instance, the total volume of futures
trade in wheat in 2010-11 was only 2.68 million tonnes
compared to its physical production of 85.9 million tonnes
with a multiplier of 0.03 while the world market benchmark
multiplier was 28 (Johl 2007). At the same time, the volume
of trade in guar seed was more than 200 times its actual
annual production. If the futures multiplier is too high, as
the Abhijit Sen Committee pointed out, the divergence
between spot and futures widens, exposing futures markets
to “excessive speculation”.
A fundamental question that needs empirical verification is
the extent to which futures have helped farmers and other
stakeholders mitigate price risks and offered them reliable
price forecasts. There is a growing literature offering varied
empirical evidence on this subject.6 The consensus view, as
observed by the Abhijit Sen Committee, is that futures markets
have not succeeded as an effective instrument for risk
management in India. Lately, the Kolamkar Committee, which
examined the specific constraints on markets to achieve
price discovery and risk management, has supported the
46

observation of the Abhijit Sen Committee. This study seeks to
examine this empirical question.
3 Data and Methodology

The study has examined the empirical issues in futures markets
for six agricultural commodities – cardamom, guar gum, guar
seed, mentha oil, pepper, and potato. These commodities were
chosen because their physical markets are free from government
intervention and price controls. Moreover, their production is
concentrated in certain geographical locations and they are
traded in at least one of the two leading exchanges – the Multi
Commodity Exchange of India (MCX) and the National Commodity and Derivatives Exchange (NCDEX), which jointly share
almost 97% of the markets in agricultural commodities. While
mentha oil and potato futures are offered by both exchanges,
cardamom futures are traded in the MCX, and pepper, guar seed
and guar gum futures are traded in the NCDEX.
The study has used non-overlapping time series observations for mean variance analysis (ANOVA) and ordinary least
squares regression estimations. The data set for these commodities covers an adequate number of non-overlapping
observations on spot and futures prices extracted from all the
individual contracts from the launch of futures trade in all the
sample commodities to the end of 2012. Independent and nonoverlapping spot and futures prices data are extracted from 90
contracts in potato; 153 contracts in mentha oil; 102 contracts
in pepper; 93 contracts in guar seed; 90 contracts in guar
gum; and 82 contracts in cardamom traded during the sample
period. Accordingly, there are as many observations on futures
and spot prices as the number of contracts initiated in the exchanges.7 The variables used in the study are spot and futures
prices on the opening and closing days of the contracts. The
futures prices are represented by the closing price of the day.
4 Price Discovery vs Price Determination

Conceptually, price discovery and price determination differ
from each other. Price discovery is a market-driven process by
which all buyers and sellers arrive at a consensus forecast of
prices in the light of present and prospective supply and demand of the commodities traded in futures markets. The prices thus discovered would be a consensus forecast when all of
them have depended on the same set of information on the
determinants of prices of the underlying commodities. On the
other hand, there is a possibility of markets being influenced
by buyers and sellers with incomplete and asymmetric information and “excessive speculation” motives, which potentially
abduct their primary function of price discovery. The prices
thus determined would not truly reflect the actual supply and
demand of commodities, leading, instead, to price discovery
metamorphosing into price determination (Majumdar 2007).
A standard futures pricing model as represented by equation
(1) implies that the price of a futures contract for a commodity
is equal to the discounted value of the expected spot price.
F(t,T) = e –ρ(T–t) Ef (t) [S(T)]
...(1)
where F(t,T) denotes the price of futures contract in period t
that matures in period T, E f (t) [S(T)] is the expectation in the
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REVIEW OF RURAL AFFAIRS

futures market in period t of the spot price in period T, and ρ is
the continuously compounded risk premium (Reichsfeld and
Roache 2011).
The following expression of equation (1) in its log form,
with the current log spot price st subtracted from it, shows
that the futures market premium is equal to the spot market
premium minus the risk premium with contract length
of k=T-t.
ft, t+k –st = –ρk + Eft (st+k) – st)

...(2)

An empirical test of the ability of futures markets to “discover”
future spot prices is based on the estimates of the following
regression derived from equation (2).
st+k –st = α + β (ft, t+k –st) + et+k

...(3)

The underlying assumption of equation (3) holds that the
k-period futures price is a consensus discovery of the future
spot price. It is a testable hypothesis. The accuracy and reliability of price discovery depends on the estimated value of β
(as denoted by βˆ ) in the above equation. The futures prices are
reliable forecasts of the expected spot prices if βˆ = 1. If the test
proves that αˆ = 0, βˆ + 1, and the residuals, et+k, which represent futures price error, are normally distributed and free of
serial correlation, then the futures market has optimally discovered future spot prices.
The estimates of equation (3) presented in Table 1 (p 49)
show that the soundness of the price discovery process varies
across markets. Only the cardamom and potato futures
markets pass the test of spot-futures price convergence as contracts reach maturity. In both cases, the test of null hypothesis
carried out individually as well as jointly is not rejected. However, it may be observed that while the βˆ coefficient is very
close to unity in potato markets, it is only 0.70 in cardamom
markets, signifying a relatively weaker price discovery process
in the latter. A perfect integration of spot and futures markets,
as implied by βˆ = 1, leaves no opportunity for arbitrage
between spot and futures markets, which implies that futures
prices are the optimal forecast of future spot prices.
Further, the results show that the futures markets in guar
gum, guar seed, mentha oil, and pepper, which generate relatively larger trade volumes, have failed to optimally discover
future spot prices. This raises serious concerns about the effect
of futures markets as a reliable mechanism that guides the discovery of future spot prices. It is expected that a larger trade
volume will promote the wider participation of various stakeholders in a commodity’s ecosystem, which, in turn, will
strengthen the price discovery process. Rather, the evidence
shows that commodities with large trade multiples are targets
of speculators. If the futures multiplier is too high, as observed
by the Abhijit Sen Committee, the divergence between spot
and futures is likely to widen, thereby exposing the futures
markets to speculation. While the futures trade multiple of potato was less than the 1 in 2009-10 and 2010-11, it was 1.78 and
4.91 respectively for cardamom. At the same time, commodities such as mentha oil, guar seed, guar gum, and pepper have
generated very large trade volumes compared to their total
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DECEMBER 27, 2014

vol xlIX no 52

production in the country. For instance, the total volume of
futures trade in pepper in 2010-11 was 4.2 million tonnes compared to its physical production of 52,000 tonnes with a multiple of around 80, while the world market benchmark multiplier was considered to be around 20. Similarly, the volume of
trade in guar seeds and guar gum was more than 200 times
and 50 times their actual yearly production, respectively
(Sahadevan 2012). The lack of organised spot markets in these
commodities, coupled with the distorted price discovery
caused by excessive speculative interests in futures markets in
them, are likely to have distorted their market prices.8
The suboptimal forecast of spot prices that transmits wrong
price signals can potentially distort demand and supply forces
in markets. An efficient price discovery implies spot-futures
price convergence as contracts reach maturity. The rejection of
the joint hypothesis that αˆ = 0 and βˆ = 1 implies that futures
markets are not able to incorporate all the relevant information on the future demand and supply of the underlying
commodity. The prices thus discovered could turn out to be a
biased estimate (upward or downward) of future spot prices.
The lack of integration between spot and futures markets
undermines the utility of the latter as an efficient hedge
against the price volatility of the former. The evidence suggests that futures markets in guar gum, guar seed, mentha oil,
and pepper are not a reliable hedge against price risk in their
spot markets. Rather, these markets serve the speculative
interests of traders.
Downward Biased Predictors

Futures prices are downward biased predictors in markets
under backwardation, if βˆ is larger than unity, and upwardly
biased in contango markets if βˆ is lower than unity. The price
discovery function can continue to operate even when the
unity condition is not fulfilled provided that the size of the
bias is predictable. However, the price of a futures contract in
time period t that matures in period T, that is, F(t,T), must
equal the actual realised spot price S(T) on maturity of the
contract whether the market was in backwardation or contango. There are three important reasons for the divergence,
if any, between S(T) and F(t,T). First, it is an indication of
the variation in the quality and grade of the underlying
commodity that is due for delivery as per the terms of the contract. The deliverable is at a premium if the basis on maturity
[that is, S(T) – F(t,T)] is negative, otherwise, at a discount.
Second, the divergence can occur if the market offers gains to
those who hold open positions, either short or long in futures.
A negative maturity basis offers a profit opportunity to short
position holders while investors with long positions in futures
gain when the basis is positive. Third, it shows imperfections
in the transmission of information from futures markets to
spot markets.
Figures 1(a) to 1(h) (pp 48-49) demonstrate the magnitude
and trend of price divergence between spot and futures. A value of
unity for the futures price bias as measured by the ratio of S(T)
and F(f,T) implies that the futures price is an optimal forecast of
the future spot price, which is an essential condition for making
47

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48

Figure 1(a): The Futures Price Bias in Cardamom Market
S(T)/F(t,T)

2
1.6
1.2
0.8
14-Mar-06
15-May-06
15-Jul-06
15-Sep-06
15-Nov-06
15-Jan-07
15-Mar-07
15-May-07
14-Jul-07
14-Sep-07
15-Nov-07
15-Jan-08
15-Mar-08
15-May-08
15-Jul-08
15-Sep-08
15-Nov-08
13-Jan-09
14-Mar-09
15-May-09
15-Jul-09
15-Sep-09
14-Nov-09
15-Jan-10
15-Mar-10
15-May-10
15-Jul-10
15-Sep-10
15-Nov-10
15-Jan-11
15-Mar-11
14-May-11
15-Jul-11
15-Sep-11
15-Nov-11
14-Jan-12
15-Mar-12
15-May-12
14-Jul-12
15-Sep-12
15-Nov-12

0.4

Maturity date of contracts

Figure 1(b): The Futures Price Bias in Guar Gum Market

S(T)/F(t,T)

8
6
4
2

20-Sep-04
19-Nov-04
20-Jan-05
18-Mar-05
20-May-05
20-Jul-05
20-Sep-05
18-Nov-05
20-Jan-06
20-Mar-06
19-May-06
20-Jul-06
20-Sep-06
20-Nov-06
19-Jan-07
20-Mar-07
18-May-07
20-Jul-07
20-Sep-07
20-Nov-07
18-Jan-08
17-Apr-08
20-Jun-08
19-Sep-08
20-Jan-09
20-Apr-09
19-Jun-09
20-Aug-09
20-Oct-09
18-Dec-09
19-Feb-10
20-Apr-10
18-Jun-10
20-Aug-10
20-Oct-10
20-Dec-10
18-Feb-11
20-Apr-11
20-Jun-11
19-Aug-11
20-Oct-11
20-Dec-11
17-Feb-12
28-Mar-12
28-Mar-12

0

Maturity date of contracts

Figure 1(c): The Futures Price Bias in Guar Seed Market
S(T)/F(t,T)

8
6
4
2

18-Jun-04
20-Aug-04
20-Oct-04
20-Dec-04
18-Feb-05
20-Apr-05
20-Jun-05
18-Aug-05
20-Oct-05
20-Dec-05
20-Feb-06
20-Apr-06
20-Jun-06
18-Aug-06
17-Oct-06
20-Dec-06
20-Feb-07
20-Apr-07
20-Jun-07
20-Aug-07
19-Oct-07
20-Dec-07
20-Mar-08
20-May-08
18-Jul-08
20-Nov-08
20-Mar-09
20-May-09
20-Jul-09
18-Sep-09
20-Nov-09
20-Jan-10
19-Mar-10
20-May-10
20-Jul-10
20-Sep-10
19-Nov-10
20-Jan-11
18-Mar-11
20-May-11
20-Jul-11
20-Sep-11
18-Nov-11
20-Jan-12
20-Mar-12
28-Mar-12
28-Mar-12

0

Maturity date of contracts

Figure 1(d): The Futures Price Bias in Mentha Oil Market (NCDEX)
S(T)/F(t,T)

2
1.5
1

31-Jan-11

31-Mar-11

30-Nov-10

30-Jun-10

30-Sep-10

30-Apr-10

26-Feb-10

31-Dec-09

20-Jul-09

18-Sep-09

20-Feb-09

20-Oct-08

19-Dec-08

20-Jun-08

20-Aug-08

17-Apr-08

20-Feb-08

19-Oct-07

20-Dec-07

20-Jun-07

20-Aug-07

20-Apr-07

20-Feb-07

17-Oct-06

20-Dec-06

20-Jun-06

18-Aug-06

20-Apr-06

20-Feb-06

20-Dec-05

20-Oct-05

0.5

Maturity date of contracts

Figure 1(e): The Futures Price Bias in Mentha Oil Market (MCX)
S(T)/F(t,T)

2.25
1.75
1.25
0.75
30-Jun-05
31-Aug-05
31-Oct-05
31-Dec-05
28-Feb-06
29-Apr-06
30-Jun-06
31-Aug-06
31-Oct-06
30-Dec-06
28-Feb-07
30-Apr-07
30-Jun-07
31-Aug-07
31-Oct-07
31-Dec-07
29-Feb-08
30-Apr-08
30-Jun-08
30-Aug-08
31-Oct-08
31-Dec-08
28-Feb-09
29-Apr-09
30-Jun-09
31-Aug-09
31-Oct-09
31-Dec-09
26-Feb-10
30-Apr-10
30-Jun-10
31-Aug-10
30-Oct-10
31-Dec-10
28-Feb-11
30-Apr-11
30-Jun-11
30-Aug-11
31-Oct-11
31-Dec-11
29-Feb-12
30-Apr-12
30-Jun-12
31-Aug-12
31-Oct-12
31-Dec-12

0.25

Maturity date of contracts

Figure 1(f): The Futures Price Bias in Pepper Market
1.75
1.5
1.25
1
0.75
0.5
20-Jul-04
20-Oct-04
20-Jan-05
20-Apr-05
20-Jul-05
20-Oct-05
20-Jan-06
20-Apr-06
20-Jul-06
17-Oct-06
19-Jan-07
20-Apr-07
20-Jul-07
19-Oct-07
18-Jan-08
17-Apr-08
18-Jul-08
20-Oct-08
20-Jan-09
20-Apr-09
20-Jul-09
20-Oct-09
20-Jan-10
20-Apr-10
20-Jul-10
20-Oct-10
20-Jan-11
20-Apr-11
20-Jul-11
20-Oct-11
20-Jan-12
20-Apr-12
20-Jul-12
19-Oct-12

S(T)/F(t,T)

the market efficient with transmission of information. As the
figures show, the movement of
price bias has neither been consistently upward nor downward.
However, the linear trend line
fitted to the data (see the dotted
line in all the figures) shows a
stable trend only in the cardamom and mentha oil markets,
while the others show an upward trend, particularly of guar
gum and guar seed. As seen in
Figures 1(b) and 1(c), there was
consistent and significant downward bias in futures prices in
these two markets after December 2010. This is an indicator
that the unprecedented increase
in the spot prices of guar gum
and guar seed, particularly after
December 2011, were obviously
not because of futures trade in
them.9 Rather, they were driven
by demand-supply forces and/or
speculative stockholding in spot
markets. The following section
has a detailed statistical analysis of the futures price bias.
The results in Table 1 also
show that futures prices are
biased. The upward price bias in
the cardamom and potato markets signifies that the futures
price premium compensates for
their storage cost, while mentha
oil futures retain abnormally
higher premiums as shown by
very low value of βˆ. The three
highly liquid markets – that of
guar gum, guar seed, and pepper – show a contrarian price
behaviour. The negative sign of
βˆ signifies that their futures and
spot markets are independent
from one another without any
transmission of information between them. While futures markets do factor in carrying cost
with a premium, the spot markets adjust prices with a discount to them. This is obviously
abnormal market behaviour,
which leads to larger deviation
between expected spot prices
and futures prices.

Maturity date of contracts

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Figure 1(g): The Futures Price Bias in Potato Market (NCDEX)
S(T)/F(t,T)

2
1.5
1

18-Aug-06
20-Sep-06
17-Oct-06
20-Nov-06
20-Mar-07
20-Apr-07
18-May-07
20-Jun-07
20-Jul-07
20-Aug-07
20-Sep-07
20-Mar-08
17-Apr-08
9-May-08
9-May-08
9-May-08
9-May-08
20-Mar-09
20-Apr-09
20-May-09
19-Jun-09
20-Jul-09
20-Aug-09
18-Sep-09
19-Mar-10
20-Apr-10
20-May-10
18-Jun-10
20-Jul-10
20-Aug-10
20-Sep-10
18-Mar-11
20-Apr-11
20-May-11
20-Jun-11
20-Jul-11
19-Aug-11
20-Sep-11
20-Mar-12
20-Apr-12
18-May-12
20-Jun-12
20-Jul-12
17-Aug-12
21-Sep-12

0.5

tool if the basis that measures
the deviation of futures prices
from spot prices is predictable.
The magnitude of basis risk as
measured by the standard deviation of the basis is an important parameter by which the
risk management potential of
futures markets can be judged.
While a low basis risk makes futures a good hedge, a larger basis risk makes futures markets
more speculation oriented.
The ability of futures markets
to offer an effective price risk
management depends on their
built-in mechanism for stabilising physical market prices, which
tend to fluctuate in response to
unpredictable shifts in supply and demand. The theory of
futures markets implies that continuous auctions ensure uninterrupted supply of commodities throughout the year against
seasonal supply and consequent price variations in spot markets.
Therefore, futures markets are considered to be a market-driven
mechanism for price stabilisation, particularly in seasonal
agricultural commodities with a higher geographical concentration of production.
As the market offers continuous auctions of contracts, futures
are ideal instruments to iron out seasonal price fluctuations in
spot markets. A comparative analysis of certain statistical
measures presented in Table 2, however, fails to give any
evidence of the price stabilisation role of futures. Three important findings emerge from the comparison. First, the standard
deviation of prices, which measures their variability, is far
higher in spot markets compared to that in futures. Particularly, the spot price margins (defined as St+k – St) of guar
gum and guar seed are excessively volatile compared to their
futures price premium/discount (defined as Ft, t+k – St). A larger
holding period margin in spot markets offers better profit
opportunities to long position holders in futures markets, thereby
exposing short hedgers, who are mainly producers, to larger

Maturity date of contracts

Figure 1(h): The Futures Price Bias in Potato Market (MCX)
S(T)/F(t,T)

2
1.6
1.2
0.8

15-Apr-06
15-May-06
15-Jun-06
15-Jul-06
14-Aug-06
15-Sep-06
14-Oct-06
15-Mar-07
15-Jun-07
14-Jul-07
14-Aug-07
14-Sep-07
15-Oct-07
15-Mar-08
15-Apr-08
7-May-08
7-May-08
7-May-08
14-Mar-09
15-Jun-09
15-Jul-09
14-Aug-09
15-Sep-09
15-Oct-09
15-Jun-10
15-Jul-10
14-Aug-10
15-Sep-10
15-Oct-10
15-Mar-11
15-Apr-11
14-May-11
15-Jun-11
15-Jul-11
12-Aug-11
15-Sep-11
15-Oct-11
15-Mar-12
13-Apr-12
15-May-12
15-Jun-12
14-Jul-12
14-Aug-12
15-Sep-12
15-Oct-12

0.4

Maturity date of contracts

Table 1: Results of the Test of Price Discovery

Cardamom
Guar gum
Guar seed
Mentha oil
Mentha oil NCDEX contracts
Mentha oil MCX contracts
Pepper
Potato
Potato NCDEX contracts
Potato MCX contracts

^
α

^

β

D-W

R2

0.007
(0.13)
0.34
(1.54)
0.36
(1.42)
0.04
(1.95)*
0.03
(0.73)
0.05
(1.80)
0.17
(2.69)*
0.02
(0.27)
0.09
(0.72)
-0.01
(-0.18)

0.70
(3.33)*
-0.90
(-1.73)
-1.13
(-2.51)*
0.25
(1.41)
0.15
(0.44)
0.30
(1.51)
-0.94
(-2.64)*
0.96
(10.42)*
0.85
(7.99)*
1.10
(5.64)*

2.08

0.71

2.02

0.89

1.84

0.87

2.14

0.51

1.82

0.31

1.85

0.63

1.89

0.67

1.66

0.74

1.75

0.79

1.79

0.64

H 0: b ^
β =1
Test Value

-0.30
(-1.46)
-1.90
(-3.65)*
-2.13
(-4.73)*
-0.75
(-4.27)*
-0.85
(-2.57)*
-0.70
(-3.60)*
-1.94
(-5.47)*
-0.04
(-0.41)
-0.15
(-1.39)
0.09
(0.51)

^ = 0, ^
H0 : α
β =1
F-statistic,
P-value

1.14
0.15
7.22
0.00
11.57
0.00
14.05
0.00
3.65
0.03
11.88
0.00
14.98
0.00
0.10
0.90
1.05
0.36
0.13
(0.88)

The equation estimated using the OLS method is st+k – St = α + β (ƒt,t+k – St) + et+k.
Values in parentheses represent t-statistics of the respective parameter estimates;
* Indicates the level of significance at 5%; D-W stands for Durbin-Watson statistic; all
regressions are corrected for serial correlation.

Table 2: Statistical Measures of Futures Premium and Spot Price Changes

5 Risk Mitigation

The markets for futures offer the opportunity to lock in a price
in advance so that hedgers are insulated from the risk arising
out of price variability of the underlying commodity. While
farmers go for a “short” hedge to cover the risk of fall in
price when their crop is ready, traders and processors take a
“long” hedge to cover the risk of a possible rise in price due to
unanticipated supply shocks during the harvest season. Both
long and short hedgers are able to reduce the future price risk
because spot and futures prices are expected to move together
so that losses in one market are offset by gains in the other.
However, complete elimination of risk is possible only if spot
and futures prices move perfectly in tandem, and eventually
converge on maturity. Futures can still be a risk management
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vol xlIX no 52

Statistical
Measures

Markets

Cardamom Guar Gum

Guar Seed

Mentha
Oil

Pepper

Potato

Stdev

Spot
273.75 16,972.00 5,042.70 231.46 3,256.80 254.90
Futures 122.69
257.07 123.52 104.57 809.33 142.70
Futures-spot ratio**
0.45
0.015
0.025
0.45
0.25
0.56
CV
Spot
7.69
3.14
3.19 10.67
1.56
2.02
Futures
2.50
0.86
0.76 -2.98
0.68
1.48
Ratio of relative
price variation***
0.33
0.27
0.24 -0.28
0.43
0.73
Test of equal variance
F-statistic 4.98 4,358.50 1,666.60
4.90
16.19
3.19
p-value
0.00
0.00
0.00
0.00
0.00
0.00
The spot price change at levels in this context is defined as (St+k – St) and futures premium
as (Ft,t+k – St), with t and t+k as they are defined in equation (2); Stdev and CV stand for
standard deviation and coefficient of variation respectively; ** is the ratio of standard
deviation of futures price premium and spot price change; *** is the ratio of the coefficient
of variation of futures premium and spot price change.

49

REVIEW OF RURAL AFFAIRS

basis risk. Therefore, genuine hedgers are at a disadvantage
while speculators who take long futures positions stand to gain.
Further, the comparative figures show a larger spot-futures
price divergence as contracts reach maturity. The larger the
divergence, the weaker the ability of futures markets to forecast future spot prices. Only futures in cardamom, mentha oil,
and potato show relatively lower divergence of the two prices.
Moreover, a low ratio of standard deviations of futures and spot
prices indicate the inefficiency of futures prices to incorporate
information. A unitary ratio signifies complete integration
of markets, while closer to zero ratio indicates that they are
insulated from each other. The ratios for guar gum and guar
seed are as low as zero, while the cardamom, mentha oil, and
potato markets show relatively higher ratios.
Second, the relative variability as measured by the coefficient
of variation (CV) and its comparison between spot and futures
markets reaffirms the inefficiency of the latter to lead the
former. The ratio of CV of a perfectly integrated market would
ideally be one. A low ratio of CV of futures and spot in guar
gum and guar seed, however, shows that the relative variability
in spot markets is larger than that in futures markets. Once
again, potato markets show a better level of integration
between spot and futures markets with a relatively higher
value (0.73) of the ratio of relative price variation. The divergence
of spot and futures prices at maturity, as observed above,
signifies that the futures markets in all the six commodities
fail to serve the purpose of producers while they offer profit
opportunities to speculators. One possible reason for such a
divergence could be the higher geographical concentration of
production of these commodities.10 The spot market in commodities with high concentration of production is more likely
to face uncertainties in supply, leading to higher price fluctuations, and hence shorter price expectations.
Third, the results of the test of equality of variance show
that futures prices failed to guide future spot prices. If futures
and spot markets are perfectly integrated, their prices would
tend to move in tandem. This makes the variances of the two
price series equal. The results of the test of equality of variance
show that the null hypothesis of equal variances is rejected for
all the six commodities. However, it may be observed from the
results that the spot and futures markets in guar gum and guar
seed move apart from each other in a greater magnitude, as
shown by the high value of F-statistics in comparison to the
other four commodities.
6 Market Orientation: Speculation vs Hedging

The magnitude and stability of maturity basis are important
indicators of the orientation of markets on speculation and
hedging.11 The basis falls to zero as the futures contract reaches
maturity. This means that the futures price converges to the
spot price of the underlying commodity on maturity. It may,
however, be noted that the value of basis moves down from
positive to zero during the period of the contract in a market
under normal backwardation, while in a contango market, it
moves up from a negative value to reach zero on expiry of the
contract.12 Deviation of basis, if any, from zero during the
50

delivery period opens up the opportunity for arbitrage. If the
basis is negative, the arbitragers can make profit by going
short in futures and delivering by buying the commodity
from the spot market. On the other hand, if the basis is positive,
the arbitrager is able to make a profit by taking a long position
in futures at a lower price and sell the commodity in the
spot market at a higher price. However, if all traders know
of this price anomaly, or if there is no asymmetry of information in the market, futures prices will change accordingly,
making them equal to the spot price, thereby eliminating
arbitraging opportunities.
The variability of basis as measured by its standard deviation indicates the magnitude of risk. The closer the basis is to
zero, the greater the risk reduction. However, if futures
contracts are considered as effective price insurance, there
must be some compensation for the risk assumed by the seller
of the insurance who buys futures contracts from hedgers.
Therefore, as Telser (1981) argues,
The futures price would be a downward biased estimate of the expected
spot price. The size of the bias represents the return to the seller of the
price insurance and equals the cost of price insurance to those who
buy it, the hedgers of inventories.

Given this, it is reasonable to expect a positive basis that
adequately compensates for the risk. The relevant measures of
mean variance analysis of the basis presented in Table 3 are
expected to throw some light on the orientation of markets.
Table 3: The Maturity Basis and the Measure of Market Orientation
Commodity

Cardamom
Guar gum
Guar seed
Mentha oil
Pepper
Potato

Statistical Measures of Maturity Basis*
Stdev
CV
Minimum
Maximum

10.84
1,361.4
272.82
29.95
417.48
32.82

4.76
3.23
6.47
2.07
40.32
-41.08

-50.0
-172.0
-151.35
-95.4
-1463.8
-65.8

51.6
7,770.0
1,619.3
112.0
671.85
134.45

CV of Spot Stdev of Spot
Prices at
Prices at
Maturity
Maturity

0.45
1.80
1.59
0.50
0.62
0.37

345.68
20,077
5,895.8
384.10
10610
256.27

The price units are Rs per 1 kg for cardamom and mentha oil while they are Rs per 100 kg for
guar gum, guar seed, pepper, and potato; * measures the difference between the spot and
futures prices on maturity of contracts.

The magnitude of basis risk as measured by the standard
deviation of basis is an important indicator of the risk management ability of futures markets. A higher basis risk is favourable to speculative interests in the market, while a low, stable,
and predictable basis makes the market more conducive for
hedging. Some of the important findings that emerge from the
mean-variance analysis of the maturity basis are as follows.
First, higher standard deviations of the basis, particularly that
of guar gum and guar seed futures along with their low sub-zero
minimum basis and substantially higher positive maximum
basis, indicate abnormal fluctuations in basis compared to a
relatively stable movement of the basis of cardamom, mentha
oil, and potato futures within a narrow band, particularly that
of cardamom and mentha oil. Given that a higher maturity basis
benefits the holders of long positions in futures, who are
typically speculators, guar gum, guar seed, and pepper futures
markets are favourably biased towards speculators.
Second, the relative variability of spot prices at maturity, as
measured by their CV, is an indicator of the usefulness of
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futures to risk-averse short hedgers, who are generally the producers. The larger the spot prices and basis at maturity with
higher variability, the greater the advantage for speculators in
futures markets. The guar gum and guar seed markets with
larger values of CV, 1.80 and 1.59 respectively, signify that they
are best suited to the interests of speculators, compared to
potato and cardamom futures with corresponding values of
0.37 and 0.45 respectively. Third, an abnormally higher standard deviation and high ratio of maximum and minimum values of the basis of guar gum and guar seed are indicative of
their excessive speculative orientation.
7 Speculation – A Double-edged Sword

The traditional view on speculation, as Working (1953) says, is
that agricultural futures markets are primarily hedging markets and that speculation tends to follow hedging volume. On
the contrary, the modern view maintains that speculation increases market participation, which, in turn, drives markets
(Sanders et al 2010). Both the views tend to emphasise that
“excessive” or “inadequate” speculation relative to the level of
hedging activity is not in the best interests of markets. This is a
challenge to the agricultural commodity futures markets and
food prices because excessive speculation distorts the natural
price discovery process, causing disruption to spot-futures
convergence (Irwin et al 2009). On the other side, inadequate
speculation can make the markets gasp for liquidity. The
biased price discovery, coupled with underdeveloped spot
markets, including the organised markets operating under the
aegis of state-level agriculture produce market committees
(APMCs) and national-level electronic spot exchanges, can
distort prices of commodities in physical markets and harm
capital formation in the farm sector. Therefore, in view of the
evidence on the speculative bias of markets, what is important
for developing a sustainable market is attracting genuine
hedging interests, while retaining the speculators. To find a
reasonable justification for the lopsided orientation of markets, we explore the following three points.
First, it is a global experience that futures markets remain
directly inaccessible to many constituent players in the agricultural value chain. Futures markets in India are no exception for the reason that more than 80% of farmers are small
and marginal with landholdings less than one hectare. A
majority of them are not able to access futures markets directly
because they lack not only the knowledge to deal with futures,
but also fall short of the critical minimum production required
by exchange-prescribed contract specifications (Sahadevan
2007).13 An organised system for the indirect access of farmers
and small-scale processors and exporters through institutional
participants who operate as aggregators (pooled investors) on
behalf of them is yet to find a place in India. Therefore, agricultural commodity futures markets continue to be dominated
by speculators.
Second, an important factor that has a direct bearing on the
orientation of markets is the choice of candidates for futures
trade. The markets for commodities with larger geographical
concentration of production are likely to be more speculative
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compared to those with nationwide production, physical markets,
and intermediate and final demand. For instance, the total
volume of futures trade in wheat in 2012-13 was only 3.75 million
tonnes compared to a physical production of approximately 90
million tonnes with multiplier closer to zero. At the same time, as
indicated above, the volume of trade in guar seed recorded
more than 200 times its actual yearly production.
Finally, the institutional structure for futures trade and its
regulation raises concerns about the motives of exchanges to
maintain a healthy balance between their private commercial
aspirations and public regulatory obligations. The current
regulatory architecture has exposed marketplaces to the
adversities of agency problems.14 The relationship between the
government regulator (Forward Markets Commission; FMC)
and the recognised exchanges in the present regulatory structure is akin to the principal-agent relationship in which the
government and the commission (which is, in a way, an “agent”
of the former) as policymaker is positioned as a “principal”
and exchanges, which are private entities with commercial
interests, as “agents”. It is difficult to fully weed out the agency
problem and its threat to market integrity and client confidence as long as designated marketplaces are sponsored and
run by private bodies with commercial aspirations. The
commission has reported that exchanges often turn a blind
eye towards brokers who contribute a significant volume of
business and carry out large volumes of proprietary trade and
similar market abuses.15 The practice of proprietary trade is
not only in violation of rules and by-laws, but also carries the
danger of putting exchanges under systemic risk as the margin
payable for the client’s trade is avoided due to netting of the
positions at members’ end because all trades are done in a
single account (proprietary account).16
Although quantification of speculation, excessive or inadequate, is constrained by data limitations, the discussion on the
factors that directly promote it in futures markets and the findings of the statistical analysis do indicate that the presence of
speculators is strong enough to drive futures markets. Moreover, the excessive speculative orientation in certain markets
has been a major area of regulatory intervention. To counterbalance the speculative elements in price discovery, the FMC
has initiated various steps to facilitate the participation of
hedgers by allowing expanded delivery periods and direct
delivery; permitting exchange for physicals and alternate
futures settlement in a leading exchange; altering the duration
of contracts; and relaxing the near-month open interest limit
in certain commodities where the hedgers face difficulties in
delivering because of adverse price movements (Government
of India 2011). It has also introduced a staggered delivery
mechanism and a special margin,17 and prescribed lower open
positions limits and a higher minimum initial margin aimed at
curbing excessive speculation, particularly in the guar gum,
guar seed, mentha oil, and cardamom markets (Government
of India 2013). A FMC proposal to permit various government
entities that can act as aggregators of farmers and the
proposed Forward Contracts (Regulation) Amendment Bill,
2010, which aims to strengthen the regulatory powers of the
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REVIEW OF RURAL AFFAIRS

FMC, are expected to transform markets to more balanced and
broad-based ones.18
8 Concluding Observations

Futures markets, particularly in agricultural commodities, in
India need careful attention during policy formulation at the
macro level and active regulatory intervention in their operations at the micro level to ensure that they are broad-based
and able to serve the purpose for which they exist. This is all
the more important because India can hardly afford any crisis
in the agricultural sector, which is critical to the food security
of the nation and the livelihoods of a large share of the working population. The analysis and its findings lead to the following conclusions.
First, it is risky for a country with a dominant farm sector to
liberalise internal trade, particularly futures in commodities,
without putting sound institutional checks and balances in
place. Lack of vigorous micro-level prudential regulation and
diligent controls on exchanges that operate on commercial
lines, and the growth of futures in commodities in which spot
markets are not adequately developed seem to have led to unbridled speculation and a deceptive price discovery process.
There are fiscal implications to these market anomalies. Excessive speculation in futures markets often lead to strengthening
of spot market prices, and may eventually lead to increased
costs of holding stocks for food security.
Second, the choice of right candidates for futures trade is
critical to achieve broad-based markets and benefits. It is
Notes
1 The expert committee headed by Abhijit Sen
to study the impact of futures trading on
agricultural commodity prices was constituted
in March 2007, and it submitted its report in
May 2008. The government constituted yet
another committee headed by D S Kolamkar
to suggest steps for fulfilling the objectives
of price discovery and risk management in
December 2013, and it submitted its report in
April 2014.
2 Though the FMC has notified 113 commodities
under Section 15 of the Forward Contracts
(Regulation) Act (FCRA), 1952, exchanges
have not offered futures in all of them. For example, the MCX, which had 87% of the total
value of trade during 2012-13 offers contracts
in only 52 commodities, while regional exchanges continue to be specialised exchanges
offering futures in a limited number of commodities that are grown in their regions.
3 After the payment crisis in the National Spot
Exchange, and related developments in the
MCX, the volume of trade declined to Rs 170
lakh crore during 2012-13.
4 After Independence, futures trade flourished
in many commodities until it was banned in
the mid-1960s, except in pepper and turmeric.
Later, trading was permitted selectively in
potato, castorseed and gur in the 1980s and in
hessian and edible oil and oil seeds in the
1990s, followed by sugar futures in 2001 before
the entire ban was lifted in 2003.
5 This is the ratio of futures trade volume to total
production of any commodity. Internationally,
the benchmark trade multiplier varies from 15
upwards for agricultural commodities though
it depends on their respective spot markets. A

52

6

7

8

9

10

11

important to ensure that the commodities in which futures
trade is permitted are relevant to the national economy on
many counts. On the contrary, futures in commodities with
greater geographical concentration of production, such as
guar gum, guar seed, and mentha oil, restrict its benefits to a
relatively smaller number of players in their value chain, that
too limited to certain geographical regions.
Third, institutional participation is vital for the balanced
growth of markets as it offers an effective counterbalance
to excessive speculation and thus makes markets more broadbased. With the adoption of robust technology solutions
for trading, better transparency, and guarantee of trade in
futures more institutional players such as consumer and
marketing organisations, banks, mutual funds, and foreign
institutional investors should be allowed to trade in commodity markets. This will be the right step towards promoting commodities as a standard asset class in personal and
institutional portfolios.
Finally, a fast-growing futures market with dominant
private commercial interests needs a powerful regulator. An
independent regulator with adequate legislative powers to discipline the market and its intermediaries is an absolute necessity to achieve a prudent balance between the public regulatory
obligations of the government and the private commercial aspirations of the exchanges. This will ensure integrity and investor confidence in the marketplace. This calls for reconsidering the 2010 Forward Contracts (Regulation) Amendment Bill
and enacting it on a priority basis.

larger ratio is considered to be an indicator of
higher speculative interests in the market.
See the Appendix (p 53)for a brief review of
studies on futures markets in India. A comprehensive review of earlier studies on the subject can
be found in the Abhijit Sen Committee report.
These sample observations are independent
observations on spot and futures prices. For
example, if the first observation is a threemonth futures price on 10 January paired with
a spot price on 10 April, the next independent
observation is the three-month futures price
of 10 February along with the spot price of
10 May.
Commodities in which open positions are excessively larger than their actual physical production are considered to be speculative. For
example, open positions in mentha oil, guar
gum, and guar seed futures sometimes show
more than 40 times their actual production.
Spot prices of guar gum increased from
Rs 6,310 per quintal on 20 December 2010 to
Rs 21,960 on 20 December 2011 and further to
Rs 88,740 by the end of March 2012. Similarly,
the price of guar seed shot up from Rs 2,350 per
quintal to Rs 6,577 and further to Rs 26,700
during the same period.
While Kerala shares almost the entire production of pepper and cardamom, Gujarat, Haryana and Rajasthan together share the entire production of guar seed and guar gum. Similarly,
80% of potato production is from Uttar
Pradesh, West Bengal and Bihar, while Uttar
Pradesh alone contributes close to 80% of mentha cultivation.
The maturity basis measures the price difference between spot and futures on expiry of the
contract. If Ft, t+k is the futures price at time t
DECEMBER 27, 2014

12

13

14

15

16

for k period maturity and St+k is the spot price
at maturity of the futures contract, the basis is
denoted by (St+k – Ft, t+k). Ideally, futures price
is the optimal forecast of the future spot price
when the basis turns to zero, whereby the
f utures and spot prices converge on maturity.
The traditional theory of futures price known
as normal backwardation says that, at any
time, the futures price must be a downward
biased estimate of the future spot price,
that is, as per the notations in equation (1),
F(t,T) < Ef(t)[S(T)] and the futures price must
rise as the contract moves to maturity, making
futures price at time T, that is, F(T,T) equals
the actual realised spot price S(T). It assumes
that S(T) = Ef(t)[S(T)]. In a contango market,
on the other hand, the futures price overestimates the future spot price and futures prices
decline as the contract reaches maturity.
For example, according to the mentha oil
futures contract specifications of the MCX, the
standard trading and delivery units are 360 kg
and 720 kg respectively. Considering average
productivity per acre to be approximately 45 kg,
only farmers who hold at least 8 acres of land
under mentha cultivation will only be able to
directly access futures markets.
A detailed review of the existing regulatory
framework and the proposed changes to it in
the form of a new bill, the Forward Contract
(Regulation) Amendment Bill, 2010 can be
found in Sahadevan (2012).
Clients reportedly route their trade through
the proprietary accounts of brokers to escape
from depositing margin money with the exchanges.
Memo, Forward Markets Commission, Mumbai,
19 May 2006.

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17 The FMC introduced the staggered delivery
system to limit excessive speculation, especially
in near month contracts, and to ensure delivery.
Under this, sellers can indicate their delivery
intentions on any day during the last 15 days of
the contract, which is allocated to buyers in a
random manner. The FMC in its Annual Report
2012-13 claims that this system has already
yielded good results in terms of reducing the
excess speculation and price volatility in the
near month and showing a more mature trading pattern in the commodity contracts concerned. This has also led to greater liquidity in
far month contracts.
18 See Berg (2008) for a case study of the aggregator model in wheat futures markets in India.
The study reported that before the ban on
wheat futures in early 2007, the Haryana State
Cooperative Supply and Marketing Federation
(HAFED) has effectively hedged its wheat by
using the NCDEX wheat futures contract. The
HAFED, which acts as a wheat procurer under
the minimum support price scheme, positioned
itself as a standard “short hedger,” that is, it
sold futures contracts (short) on the NCDEX
against its cash (long) purchases from a large
number of farmers in Haryana.

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Appendix
The literature on futures markets in the Indian
context can be classified under four broad
themes. First, a large part of the literature is
constituted by studies on price discovery, market efficiency, and hedging effectiveness. They
include Naik and Jain (2002); Karande (2006);
Lokare (2007); IIMB (2008); Kumar and Pandey
(2008); Singh et al (2009); Elumalai et al (2009);
Ali and Gupta (2011); Dey and Maitra (2012);
Arora and Kumar (2013); Agarwal et al (2014).
These studies have primarily tested market
efficiency hypothesis and the lead-lag relationship between futures and spot markets using
continuous time series data on near month
futures and spot prices of different sets of commodities. They have carried out the standard
unit root test based on the Augmented DickeyFuller and/or Phillips-Perron methods, followed
by the test of cointegration and causality based
on the error correction model, to examine the
stable long-run equilibrium relationship between spot and futures prices. The results vary
across studies on market efficiency in transmitting information and spot price stability.
Second, the studies that have investigated
the information transmission and volatility
spillover between futures and spot markets in
India and between Indian and world markets
include Sahi (2006); Bose (2008); Kumar and
Pandey (2011a, 2011b); Sehgal et al (2012, 2013);
Srinivasan and Ibrahim (2011). A third set of
studies, including Raizada and Sahi (2006);
Abhijit Sen Committee (2008), and Nath and
Lingareddy (2008), have specifically examined
the effects of futures trade on inflation. Most
of them, including the Abhijit Sen Committee,
have failed to find any supporting evidence of
either reduced or increased volatility of spot
prices because of futures trading. Finally, studies on market microstructure and regulation,
including Nair (2011) and Sahadevan (2012),
have examined the present public-private partnership model of regulation in the principalagent model framework.

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