CHAPTER4CONCEPTUAL/THEORITICALFRAMEWORK4.1Relationship between Spot and Future Prices .Thereare certain theoretical frameworks which are available throughvarious literature’s which describes the relationship between spotand future prices. TheSamuelson’s (1965) preposition, the net hedging hypothesis etcwhich explains the relationship between spot and future prices. Basedon the recentdevelopments in these directions can be observed in Garbade&Silber (1983), Foster (1996) and Figuerolla – Ferretti &Gonzalo (2008) in which the authors tried to provide the context onthe impact of other activities like arbitrage on price behavior.4.
1.1The Relationship between Spot and Future Prices based on the ‘Basis’ Therelationship between spot price and futures price can be easilyunderstood by studying the ‘basis’ as the behavior. Basis is thedifference between the cash price and the futures price (or) itdefines the relationship between the cash/spot and the futurescontract. Positive basis is called backwardation and negative basisis called contango.
Spot prices are more volatile when the market isin backwardationWhere,Basis = Spot Price – Future Price So,If we rearrange the equation and solve for Spot price , it will beSpot price = Basis + Future Price4.1.2The Relationship between Spot and Future Prices based on the ‘costof carry model’Therelationship of futures price and spot price is the cost of carrymodel.
The cost of carry model states that under a perfect marketsituation the returns in the spot and the futures market signal oftight supply and demand condition should be perfectly correlated.Which the equation below statesFt= St e (r-y)*(T-t)/365 4.1.3The Relationship between Spot and Future Prices based on the ‘Theoryof Storage’Theoryof storage is an fundamental structure which is used in commodityprice modeling. The convenience yield, as introduced in Kaldor’s(1939) theory of storage is meant to represent the benefit of holdingthe physical commodity instead of a paper contract on that commodity,hence avoiding the cost of disruption in the production.
Convenienceyield is the implied yield or non- pecuniary return from holding acommodity. It is a measure of the degree of backwardation in market.Convenience yield is defined as the difference between the positivegains attached to the physical commodity less the cost of storage.Keeping inventory generates lot of advantages –the marginalconvenience yield varies inversely with the level of inventories. Therelationship between spot and future prices can be written as ft= st – (r-y) 4.1.4The Relationship between Spot and Future Prices, the ‘SamuelsonEffect’ Nethedging hypothesis tells that the spot price and the future pricewill converge at the end of the future contract or at expiration(Future price = Spot price). The arbitrages make sure thatconvergence happen at the expiration.
Arbitrage is the simultaneouspurchase (sale) of commodity and sale (purchase) of the correspondingfutures contract, in order to profit from price distortions. Thefutures price and spot price converges at expiration (on the expiryof the contract). Samuelson (1965) proposition states that thefutures price varies less in comparison to spot prices and thevariation of futures price reduces as maturity approaches. Thiseffect is called the Samuelson effect. 4.1.5The Relationship between Spot and Future Prices, Recent Developments Garbade& Silber (1983) establish an equilibrium price relationshipbetween the futures and cash market prices as Fk = Ck + r.?k (5) Where, Fk is the future price and Ck spot price of acommodity.
r is the continuously compounded yield per unit time,assumed not to vary with maturity. The authors observe that the cashand futures markets will be in partial equilibrium if the futuresprice will equal the cash price plus a premium which reflects thedeferred payment on a futures contractCHAPTER5DATAANALYSIS AND INTERPRETATIONDataCollectionThedata collectedhere are the price series of futures and spot closing prices of 8agricultural commodities i.e Chana ,Turmeric , Barley,Wheat, Pepper,Soya Bean, Coriander (Dhanya) and Castor Seed at a daily frequencywhichare available quarterly periodfrom January 2013 to December 2017. The price series data arecollected from the website like Multi-Commodity Exchange, NationalCommodity and Derivatives Exchange Limited (NCDEX) and otheragricultural commodity exchange in India were the percentage ofmarket share for these agricultural commodity is about 70 percentbased on Average Daily Traded Value (ADTV) and more than 85 percentbased on open interest. Therationale selection for these commodities can be because thesecommodities represent as the highly traded contracts in the commoditymarket so as for the selection goes the commodity are based on thefollowing for which Wheat is the most essential food grain in India.
. Barley comes in the category of cereals, and is used for makinghealth food, beer and soups. We also use barley as a cattle feed. Soyabean is the most widely grown oil seeds in the world and India isthe fifth largest soyabean producer worldwide. Coriander comes inthe category of spices. It has medical use also.
India is one of themajor exporter of coriander. In brief, these agricultural crops playan essential role in the Indian economy. Further,these are the commodities for which futures and spot price data areavailable from the national exchanges. Wehave to analyze the inter linkages among Chana maize, Turmeric ,Barley , Wheat , Pepper , Soyabean ,Coriander (Dhanya)and Castorseed.Inorder to construct the futures price series, the nearby futurescontracts are being used because these are highly liquid and the mostactive/regular contracts. So we observe these above variables for thefuture contracts based on the delivery month to the day of trading,which will be specified beThenbased on consistent and objective criteria, trading activity is takenas the parameter for splicing the price series. Whenevera contract approaches maturity, the market changes its attention awayfrom the nearby month contract to the next nearby contract before thenearby contract approaches its last trading day.
It is important tonotice that trading volume and open interest for a particularcontract peak three or four weeks prior to the last trading day andstart declining. The present method evades using observations nearthe maturity date of the contracts, which represent weakening andwobbly market interest. The criterion established to identify theshift from the nearby contract observations to the next nearbycontract is based on when both the daily trading volume and openinterest for the next nearby contract surpass those for the nearbycontract; it is considered as the evidence of shifting market’sattention from the nearby contract.
At this point we roll-over theseries to the next nearby contract. Sowe consider the selected 8 Major Agricultural Commodities are takenas Chana ,Turmeric , Barley,Wheat, Pepper, Soya Bean, Coriander(Dhanya) and Castor Seed. For the Study by adopting Phillip Perron and Augmented Dicky-fuller (ADF) to check for stationarity among thetime series data , Johansen’s Co-integrated model to examine thelead-lag between the 8 selected spot and future agriculturalcommodity prices and by using Error Correction Model (ECM) andGranger causality analysis to examine the linkages among theagricultural commodity futures and spot prices.