An Empirical Analysis on Long Term and Short Term Relationship between the Spot and Future Prices of India Crude Oil Market

By Purushothaman, S.; Velmurugan, P. S. | Advances in Management, August 2013 | Go to article overview

An Empirical Analysis on Long Term and Short Term Relationship between the Spot and Future Prices of India Crude Oil Market


Purushothaman, S., Velmurugan, P. S., Advances in Management


Abstract

The present study is to test for the existence long term and short term relationships between Spot and fiiture of crude oil prices from India (MCX). The crude oil spot and future price is collected. 2018 observations are collected from Multi Commodity Exchange (MCX) from 29th April 2005 to 31st December 2011. In the study we used Johansen co-integration and Vector error correction model (VECM) respectively. The first step in the analysis is stationarity of spot and fiiture prices of crude oil through unit root test ADF and PP test. Two variables are stationary at 1st difference. Based on the Johansen co-integration and Vector error correction model (VECM), the price discovery is achieved from the both the market and has long term and short term relationship between them at 1%, 5% level of significance.

Keywords: Indian Crude Oil Market, Spot and Future Prices, Short term, Long term, Relationship.

(ProQuest: ... denotes formulae omitted.)

Introduction

Crude oil futures and spot prices "reflect" the same aggregate value of the underlying asset and considering that instantaneous arbitrage is possible; futures should neither lead nor lag the spot price.1 However, the empirical evidence is diverse, although the majority of studies indicate that futures influence spot prices but not vice versa. The futures prices respond to new information more quickly than spot prices, due to lower transaction costs and flexibility of short selling.2 The hedgers and speculators will react to the new information by preferring futures rather than spot transactions.

Spot prices will react with a lag because spot transactions cannot be executed so quickly.3 A large number of empirical studies has shown that most economic variables exhibit an asymmetric adjustment process. Some recent literature suggested that the dynamic relationship between spot and futures prices may be characterized by a nonlinear equilibrium correction model due to factors such as non-zero transaction costs, infrequent trading etc.4

The dynamic interrelationship between spot and futures suggested a nonlinear relationship between spot and futures. Moreover, the co-integration and its corresponding error correction model assume that the tendency to move toward a long-run equilibrium is always present. However, it is possible that an adjustment towards equilibrium need not occur in every period.6

The price transmissions between spot and futures in Taiwan TECM clearly indicated a bidirectional feedback causality relationship between the spot and futures markets. Asymmetric price transmissions between these two markets are also found in the long run.6 The price discovery function of futures markets hinges on whether new information is actually reflected first in changes in futures prices or in spot prices. Identifying the direction of information flows between spot and futures prices, then, appears to be an empirical issue.

There exist many studies exploring the linkage of spot and futures prices for predictability, market efficiency and cointegration.7 Some works find that spot and futures price are not co-integrated, or they are co-integrated, but do not move together one-for-one in the long run. Recent studies focus on investigating the non-linear causality between spot and futures oil markets.1 However, our aim of the present study is to test for the existence relationships between Spot and future of crude oil prices from Multi commodity Exchange (MCX), which is used as an indicator of Indian oil market.

Review of Literature

1. Apostolos Serletis10 examined evidence concerning the number of common stochastic trends in a system of three petroleum futures prices (crude oil, heating oil and unleaded gasoline) using Johansen's maximum likelihood approach. The results indicate the presence of only one common trend.

2. Li-Hsueh Chen et al11 studied new supportive evidence for asymmetric adjustment in U.S. retail gasoline prices. …

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