Dynamics of Indian commodity markets with regard to price discovery and volatility an empirical examination

Abstract

newline Commodities are considered as a separate asset class in the domain of all assets. In order to attain the economic exposure associated with commodities by the use of commodity derivatives, futures contracts are considered as one of the most important hedging instruments. Price discovery and risk transfer are the two major two functions performed by the futures market towards the organization of economic activity. The quintessence of price discovery is to create a competitive reference price from which the future spot price can be derived. An efficient futures market should not only have a close relation with the spot market and thereby helps hedging through a process of arbitrage between both the markets, but it should also acts as a forum whose prices should be taken as a reference price for the future spot prices by the market functionaries. This service of reference pricing is popularly known as price discovery . In a perfectly efficient and frictionless market, futures price should move concurrently with the underlying spot price without any lead or lag in price movements across markets. However, due to institutional factors associated with futures market such as high liquidity, inherent leverage, and lower transaction costs etc. futures market processes information faster than the spot market. This results in an empirical lead-lag relationship between price changes in the two markets. If the information is reflected first in futures price and subsequently in spot price, futures price leads spot price, indicating that the futures market performs the price discovery function and it is usually regarded as the leading indicator of judging the efficiency of the futures market. The extent to which futures market performs this function well can be measured from the inter-temporal causal relationship between futures and spot prices. Although a number of studies have examined the inter-temporal relationship between spot and futures markets, they analyse the data at their original level