Performance and impact of national multi-commodity exchanges on the marketing and price-risk management of agricultural commodities

Abstract

This research undertakes a detailed examination of the performance and impact of recently started National Multi Commodity Exchanges on the marketing and price risk management of agricultural commodities in India. With the permission given by the government, three National Multi Commodity Exchanges came into existence in 2004: (1) National Commodity and Derivatives Exchange, Mumbai (NCDEX) (2) Multi Commodity Exchange, Mumbai (MCX) and (3) National Multi Commodity Exchange, Ahmedabad (NMCE). The performance of these multi commodity exchanges towards the important roles of price discovery, price stabilization and price risk management of agricultural commodities has not yet been comprehensively studied. The performance has major implications for India’s agriculture sector, food security and the national economy. This research undertakes such an examination focusing on the major agricultural commodity of wheat. Before 2004, the bulk marketing of agricultural commodities in India was undertaken primarily through a huge number of spot markets around the country, and a few regional and commodity specific exchanges. There were significant apprehensions about allowing large scale national commodity futures exchanges since it could unleash speculation and lead to the nation loosing control over the prices of essential commodities. However, marketing remained traditional and stabilization depended heavily on government action. In order to modernize the marketing, improve efficiency and bring more liquidity and broad base participation in the markets, the Government approved three National Multi Commodity Exchanges (NMEs). Since their inception in 2004, the trade volume at these national commodity exchanges has seen exponential growth at about 300 percent per year. NCDEX has become world’s third largest agricultural commodity exchange. Multi Commodity Exchanges (or commodity futures markets) have been developed in many countries of the world primarily with the objective of enhancing marketing efficiency by improving the process of price discovery, and assisting in the price risk management of commodities. For agricultural commodities this includes price risks associated with production, storage, quality, and trading in domestic and international markets. Commodity futures market may be used by producers, traders, stockists, processors, financers, exporters as well as other intermediaries. The main role of these futures markets is to provide various instruments for hedging, price risk transfer,and price stabilization in an organized manner. This research undertakes investigation through three main objectives (1) To examine the market efficiency of Indian spot and futures market, (2) To explore the nature of price discovery process in the commodity futures market, and (3) To investigate the influence of the time dimension on the liquidity, hedge performance, and convenience yield (CY)of commodity futures market.

To address the three objectives, following investigations were carried out (1) Impact assessment on spatial market integration of wheat spot markets (2) Impact assessment on wheat spot market volatility (3) Integration between spot and futures market (4) Market liquidity assessment and examination of seasonality in the liquidity (5) Estimation of bias and risk premium (6) Study of causality between futures and spot market (7) Estimation of hedging performance of futures market (8) Convenience yield and forward rate surface estimation (9) Linkage between hedge effectiveness and convenience yield on the common time dimension of crop calendar. Though enough data is available for the period before the national multicommodity exchanges, the research is constrained somewhat by the short data history since the start of the exchanges. The results are subject to this limitation. The research results indicate that wheat spot markets seem to show better spatial market integration since the start of national exchanges/ futures trading. However, it finds that the spot market volatility has increased - the coefficient of variation increases from 7 percent to 10 percent. Though, lower stocks and production could have contributed to this, futures trading could not help in reducing the spot price volatility. However, inter-seasonal volatility has been slightly reduced.

Granger Cointegration test indicates that the short run integration between spot and futures markets was poor during 2004-05 but has improved and is present later. Trade volume, effective spread and market liquidity are important indicators, and it is found that the trade volume has risen rapidly at 300 percent per annum but with high seasonality. Roll’s estimate of effective spread based on intra day trading data indicates the presence of considerable seasonality in liquidity with high liquidity for contracts maturing in the arrival period of wheat.

Unbiasedness in price and zero risk premium in the futures markets indicate efficient price discovery. The research finds a downward bias in the futures price, though Keynes (1930) indicates that futures markets generally have a downside bias. The information content in the basis for forecasting the spot market price is also not statistically significant. On the joint hypothesis of unbiasedness and forecastability, regarded as necessary and sufficient for efficient price discovery, the hypothesis is rejected by the research and indicates underperformance on price discovery. Tests based on Garbade Sliber methodology to examine causality between spot and futures prices performed for each contract indicates that the direction of causality is not consistent. Thus, it is not possible to conclude on the direction of causality: whether it is from the spot market to the futures market or vice versa.

The research finds that the convenience yield varies with an inverse parabolic relationship with stocks. During the lean period (August to March) the market shows backwardation with a positive convenience yield. By the last month of March it goes up to 15 percent. However, during the flush/arrival period (April to July), contango is observed with negative convenience yield up to -5% in the peak arrival months of April- May. This crop cycle based variation in the convenience yield supports the “theory of storage”. There is a negative relationship between stocks and volatility in the spot price Increase in stocks reduces market volatility.

The Minimum Variance Hedge Ratio (MVHR), a standard method of measuring hedging effectiveness, indicates that wheat future contracts provide a maximum hedge effectiveness of only 25 percent. In 2005, the performance was around 20 to 25 percent, but in 2006 this was only 10 to 12 percent and in some cases only 5 percent. The poor hedge performance despite increasing trade volume/ liquidity in the market is related to high basis variance indicative of market imperfections. Poor liquidity can lead to high basis variance and poor hedge performance. This is supported by the results. It is found that contracts maturing during the arrival period exhibit poor hedge effectiveness. Thus, wheat futures market would be of limited usefulness for hedging purpose during the arrival period.

International comparison of the convenience yield spread as an indicator of the effectiveness of futures shows that NCDEX does not fare very badly. Results for wheat futures contracts show that the spread for NCDEX is lower than that for CBOT (Chicago Board of Trade) but higher than that for LIFFE (London International Financial Futures and Option Exchange). Further, the hedging effectiveness of wheat futures contracts of NCDEX in 2005 was around 16 percent for NCDEX as compared to around 14 percent for WINNIPEG (North American Canadian Grain Exchange).

In methodological contribution, the study has developed a framework for examining the performance of futures markets for agricultural commodities in countries such as India. Key objective measures such as market integration, causality, hedging effectiveness, convenience yield, liquidity and basis variance have been estimated and related. These facilitate an objective assessment of the performance of the futures markets and their impact on marketing efficiency, commodity prices and the economy, within the limits of the available data. Important implications emerge for policy at the commodity exchange, sector and the national levels.