Academic journal article The International Journal of Business and Finance Research

Price Discovery and Volatility Spillover: Evidence from Indian Commodity Markets

Academic journal article The International Journal of Business and Finance Research

Price Discovery and Volatility Spillover: Evidence from Indian Commodity Markets

Article excerpt

ABSTRACT

This paper examines the price discovery and volatility spill-over relationship for Indian commodity markets. We cover twelve actively traded commodities including agriculture, metal and energy and four commodity indices. Price discovery is confirmed for eight commodities and three indices with a greater role for futures markets in the price discovery process. Price discovery results are encouraging given the nascent character of commodity markets in India. However the market does not seem to be competitive. Volatility spill-over is confirmed for only three commodities and none of the indices. This implies the Indian Commodity Market is yet to evolve an efficient risk transfer system for most commodities. The findings have implications for policy makers, hedgers and investors. The research contributes to alternative investment literature for emerging markets such as India.

JEL: G13; G14; G15; G18; C32

KEYWORDS: Price discovery, Granger Causality, VECM, EGARCH, Volatility, Spillover

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Commodities are regarded as separate assets in the realm of all assets classes. Commodity markets are volatile. This price volatility impels the demand for hedging the risk in the commodity market by producers and consumers. In response to this need, derivative markets for commodity risks trading arose. Their use has become extensive. There are many instruments traded in these markets including financial instruments such as futures and forward contracts, options, swaps, and physical instruments like inventories. Future contracts are among the most important of these instruments, and provide significant information about cash and storage markets. Price discovery, hedging, financing, liquidity, price stabilization, encouraging competition, increasing efficiency, inherent leverage, low transaction costs, and lack of short sale restrictions as well as fulfilling desires of speculators are some of the prime economic functions of the futures market.

Price discovery and risk transfer are two major contributions of futures market towards the organization of economic activity (Garbade and Silber, 1983). Price discovery refers to the use of future prices for pricing cash market transactions. This implies that future prices represent a market's expectations of the subsequent spot price. Understanding the influence of one market on the other and the role of each market segment in price discovery is the central question in market microstructure design and is very important to academia and regulators. In efficient markets, new information is impounded simultaneously into cash and futures markets (Zhong et al. 2004). In other words, financial market pricing theory states that market efficiency is a function of how fast and how much information is reflected in prices. The rate at which prices exhibit market information is the rate at which this information is disseminated to market participants (Zapata et al. 2005). In reality, institutional factors such as liquidity, transaction costs, and other market restrictions may produce an empirical lead-lag relationship between price changes in the two markets. Moreover, all markets do not trade simultaneously for many assets and commodities. Besides being of academic interest, understanding information flow across markets is important for hedge funds, portfolio managers and hedgers for hedging and devising cross-market investment strategies. The market that provides the greater liquidity and low trading cost as advocated by Fleming, Ostdiek and Whaley (1996) is likely to play a more important role in price discovery.

Volatility is another area of interest for regulators and market participants who prefer less volatility to more volatility. A meaningful interpretation of volatility gives significant information and acts as a measure of how far the current prices of an asset deviates from its average past prices. …

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