Price Discovery and Causality in the Indian Derivatives Market

-D G Praveen and A Sudhakar

The study articulates the price discovery mechanism in India's rapidly growing commodity futures market. The
paper highlights as to how the futures market influence the spot market and facilitates better price discovery in
the spot market. The spot and/or futures market dominates the price discovery, but it appears that a better price
discovery occurs when there is a mature futures market for the commodity. Granger Causality Test is used for
the study that focuses on the Indian stock and commodity market. A comparison is drawn for price discovery
between the grown stock market and the growing commodity market. Impact cost is considered for measuring
the liquidity and market efficiency, for Indian gold futures market.

The basic purposes of existence of the futures markets are that they provide the economic agents a place of price
discovery and risk management through hedging. The futures market reveals the market with information about
future spot prices and thus undertakes the process of price discovery. Hedging is a process where futures
contracts are being used in order to control their spot prices. Of course, the dual roles of price discovery and
price risk management undertaken by the futures markets, and are not offered by the spot market alone,
justifies the cause for the existence of such markets.

Considerable amount of research has been done on global benchmark markets as well as Indian market in
examining relationship between futures and the underlying spot prices particularly on the lead-lag relationship
between futures and the underlying spot returns. Stoll and Whaley (1990) reported existence of a two-way
relationship between futures and returns on the underlying S&P 500. Similar conclusions were drawn from the
empirical studies done on FTSE-100 and S&P 500 stock index futures by Wahab and Lashgari (1993) and Hung
and Zhang (1995). Tse (1995) reported that futures returns lead spot price returns with respect to Nikkei Stock
Index contract. In general, all these studies signify that causality between futures and the spot prices can be
one-sided (futures to spot) or both-sided (futures to spot and vice versa), depending on the market scrutinized.
Despite the plethora of studies directing towards price discovery, the rapidly expanding commodities and financial
futures Indian markets give leeway for continuous and further studies. Further, not much study has been done on
fledging commodity market in India. This paper inspects the causal relationship between futures and spot prices
in the Indian derivatives market, and for this, a simple Granger Causality test is chosen.

Indian Derivatives Market

The BSE Sensex tested a historic high of 7700 during a time when the rising oil prices ignited the growing worries
of ballooning inflation and fiscal debt going out of bounds. The benchmark WTI oil clocked an all-time high of
$62.3 a barrel. Amid this, the Indian derivatives market continued its growth path. The volumes of derivatives
market already surpassed that of stocks' however are far lower from its potential. The Bombay Stock Exchange
(BSE) first introduced the country's first stock derivative instrument-the BSE-Sensex index futures-on June 9,
2000. This is followed by the launch of index options, stock options and stock futures in June, July and November
2001 respectively. Now about 52 stock futures and options are being traded on the F & O segment of NSE. In just
four years, the NSE made its entry into the league of top 20 futures and options exchanges in the world.

Commodity markets offer perfect venue for alternative investments where investors can provide cushion against
abrupt fall in the value of the stocks they hold. The commodity derivatives markets provide a platform for
investors to derive all benefits of physical commodity markets without physically holding the commodities.

Basically, India is a commodity-based economy, having large consumer and producer base in a wide range of
commodities. However, commodity futures trading suffered serious set backs in the past due to reasons like ban
on commodity trading, illiquidity in the regional exchanges with participation of only few regional traders and
unavailability of reliable prices. In early half of 2003, the government mandated futures trading in commodities
and permitted constitution of national level commodity exchanges that trade in multiple commodities through
online trading platform. The national level commodity exchanges-National Commodity Derivatives Exchange
(NCDEX), Multi Commodity Exchange of India (MCX) and National Multi Commodity Exchange of India (NMCE)-
that commenced trading in later half of 2003 displayed a spectacular show. The daily average volumes at these
exchanges reached at Rs. 5000 cr per day.

About 55 commodities are being traded daily on these exchanges. However, interestingly 5-6 of the listed
commodities contributes about 70-80% of the total exchanges' volume. Each exchange has taken control of few
commodities, while other exchanges lagged on with few exceptions. The NCDEX exhibited the dominance in the
agriculture commodities with significant volumes in commodities like guarseed, chana, refined soy oil, urad,
wheat and sugar. Contrarily, the other dominant exchange MCX took control of commodities that have
international relevance such as gold, silver, crude oil and refined soy oil. The following shows important
commodities trading on these three exchanges that contribute a major chunk of exchanges' volume:
 Multi Commodity National Commodity National Multi
Exchange of India Derivatives Exchange Commodity Exchange
(MCX) (NCDEX) of India (NMCE)
(a) Crude Oil (a) Guarseed (a) Pepper
(b) Silver (b) Silver (b) Rubber

(c) Gold (c) Chana

(d) Ref. Soy Oil (d) Ref. Soy Oil

(e) Guarseed (e) Guargum

(f) Urad

The development of futures trading in agricultural commodities has increased the flow of agricultural credit to
rural areas. This is expected to further popularize the futures trading in commodities market.

% of Commodity Turnover Prevailing Futures

in the Total Exchange Multiplier Against Spot
Turnover Market
Multi Commodity Exchange of India (MCX)
Crude Oil 28.16 1.5
Silver 31.88 20.37
Gold 21.12 1.21
Ref. Soy Oil 7.65 2.12

National Commodity Derivatives Exchange (NCDEX)

Guarseed 37.58 122.22
Silver 18.66 8.32
Chana 9.05 1.76
Ref. Soy Oil 5.56 3.17
Guargum 5.01 27.65

Data and Methodology

A question that often arises is that whether or not futures prices help to predict future underlying spot prices.
Can an economic variable enable us to forecast another economic variable? History says that most of the
economic recessions are preceded by the steep increase in crude oil prices. Does this mean oil shocks cause
recessions?

A popular causality test proposed by Granger (1969), well known as `Granger Causality Test' can be used to get
answer for these questions. Granger test involves examining whether lagged information of a variable, Y provides
any statistical clue about another variable, X given the lagged X under consideration. If not, then it implies that
"Y does not cause X". There are different ways to use Granger Causality Test. One simple approach that is used
for the study is explained below, where we need to conduct the F-test once for validating 1-m Nifty influence on
Nifty and one for Nifty's influence on 1-m Nifty futures. Similar test is done for MCX Gold futures for examining
the causality in the commodity market.

Nifty Futures traded on National Stock Exchange (NSE) and Gold Futures on Multi Commodity Exchange of India
(MCX) are considered for the study due to their good liquidity and popularity.

Granger Causality Test

Does 1-m Nifty futures influence on Nifty's daily returns? Say two variables that we are considering to test the
direction of causality are `Nifty Daily Returns (Nifty DR)' and `1-month Nifty Daily Returns (1-m Nifty DR)'.
Create a variable that is lag of Nifty DR (Nifty t-1) and another, which is the lag of 1-m Nifty DR (1-m Nifty t-1).

Run a regression analysis, where `Nifty DR' is the Dependent Variable, and lag Nifty DR (Nifty t _1) is the
Independent Variable. This we call it as restricted regression and the residual sum of squares from this analysis is
symbolized as RSS_r. Now run another regression analysis, `Nifty DR' is the Dependent Variable, and lag Nifty
DR (Nifty t _1) and lag 1-m Nifty DR (1-m Nifty t-1) are Independent Variables-this is the unrestricted analysis
and the residual sum of squares from this analysis is shown as RSS_ur.

Now, you need to calculate F:

F=((RSS_r-RSS_ur)/m)/(RSS_ur/(n-k))

Where m is the number of lagged terms-currently 1; n is the number of cases in the analysis, and k is the
number of parameters in the unrestricted regression (i.e., 2 in this case).

This F is distributed with m, n-k df.

The following would be the null hypothesis and alternative hypothesis for the proposed F-test.

Null Hypothesis (H0) and Alternative Hypothesis (H1)

Null hypothesis (H0) assume that estimated coefficients on the lagged 1-m Nifty are statistically not different
from zero. That means lagged 1-m Nifty terms does not belong in the regression and has no influence on Nifty.
Contrary to null hypothesis, alternative hypothesis confirms 1-m Nifty futures influence on Nifty. Hence, a
rejection of null hypothesis justifies existing influence of 1-m Nifty futures on Nifty. Similarly, the same F-test is
used for examining the Nifty's impact on the 1-m Nifty futures.

The test figures and results were given briefly at the end as appendix to this paper. The results empirically
confirm that the 1-m Nifty futures (roll-over contracts) does not have any influence on the spot Nifty, but does
get influenced by the Nifty.

A similar test is conducted to examine the casual relationship in commodity markets by assuming Spot Gold and
Gold Futures Prices of Multi Commodity Exchange of India Ltd. The results were quite contrary. That points out
that Gold Futures prices do influence the spot gold prices, but not the contrary. This implies that information is
first disseminated in the futures market and then later gets reflected in the spot market.

Market Efficiency of Gold Futures in India

The yellow metal (gold) occupies a special place in India. India is the largest consumer of Gold with about 750
tons of annual consumption. Unfortunately, the gold mines in India produce a meager quantity that satiates the
Indian demand. A large quantity of gold is imported annually and the prices of gold in India more or less reflect
the global prices.

Particulars April ’02 to June ’05 Before MCX After MCX

Daily Volatility in Indian Spot (Vs. Global 0.84% (0.99) 0.67% (0.69)
Spot)
Correlation with Global Markets (Spot) 0.98 0.83

The study on spot prices of gold during the period of April '02 to June '05 signifies some interesting facts. It
shows that the volatility in the Indian gold spot prices witnessed fall relatively higher than global market after the
commencement of futures trading on a national level. Further, the correlation of global markets vis-à-vis Indian
spot declined during the period. This implies the increased influence of domestic factors on the Indian spot
market and greater domestic price discovery in the gold market.

One method of measuring the liquidity and efficiency of the futures market is done by the computation of impact
cost on the exchange. A lower impact cost signifies better liquidity in the system that encourages greater
efficiency in the market.

Impact refers to the percentage price movement caused by an order of say 3 kgs of gold from the average of
best bid and ask price in the order book. For the study, 3 kgs is considered as that matches with the contract size
of gold in global benchmark exchange, COMEX. For the purpose of computation of impact cost, the snapshots of
order book are taken at different internals and on different days. The impact cost is computed separated for the
buy side and the sell side in each of the order book snapshot. The mean of the impact cost is taken for further
considerations and comparisons.
 Impact Cost (for 3 kgs of Gold)
Asset Contract MCX COMEX
Gold October ‘05 0.01% 0.06%
Gold December ‘05 0.06% 0.06%

The contract size of gold contract on MCX is 1 kg, while on COMEX is 100 ounce (approximately 3 kgs). Hence,
for the computation of impact cost execution of 3 contracts is taken. The impact cost at 0.0079% on the near
month contracts put the domestic exchange on the higher liquidity side against COMEX. The far month contract is
lesser liquid and efficient than the near month contracts. However, the domestic exchange is at par with the
global benchmark exchange.

Another tool for the measurement of liquidity and efficiency is futures multiplier. The futures multiplier shows the
number of times the size of the futures market with that of the spot market. The futures multiplier studied during
the period, December '04 to June '05 recorded 1.68, implying that the futures market for gold stands 1.68 times
of physical spot market of Gold. For the same period, the delivery on the futures exchange is recorded 1.6 tons
against a total turnover of 630 tons, which means the delivery in the futures market accounts for just 0.25% of
total turnover on the futures exchange. This is very common scenario in the futures market, as futures contracts
are used mainly for surrogate hedging and speculation.

Conclusion

It is well-known that stock market enjoys the benefit of having a well-developed spot market due to presence of
popular national wide exchanges-National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). The strong
presence of these exchanges provides the stock market a perfect platform for price discovery and the place for
initial information to reflect on prices, followed later in the futures market. Converse is the case for commodity
market in India. And, the reason looks similar. Probably, we may give reasons that the Spot Gold market in India
is not confined to one place, and has no single market as in for the futures market. Thus, we can expect a better
price discovery platform in the Gold futures market.

References

1. "Cointegration and Error Correction: Representation, Estimation, and Testing", Engle, R F and Granger, C W
(1987), Econometrica, 55, 251-276.

2. "Cointegration and Error Correction Models: Intertemporal Causality between Index and Futures Prices",
Ghosh, A (1993), The Journal of Futures Markets, 13, 193-198.

3. "Lead-Lag Relationship between Spot Index and Futures Price of the Nikkei Stock Average", Tse, Y (1995), The
Journal of Forecasting, 14, 553-563.

4. "A Further Analysis of the Lead-Lag Relationship between the Cash Market and Stock Index Futures Market",
Kalok Chan, The Review of Financial Studies 1992, Volume 5, Number 1, pp. 123-152.

5. "Information in the Cash Market and Stock Index Futures Market", Chan, K, 1990, Unpublished Ph.D.
dissertation, Ohio State University, Columbus.

6. "The Temporal Price Relationship between S&P 500 Futures and S&P 500 Index", Kawaller, I G, P D Koch, and
T W Koch, 1987, Journal of Finance, 42, 1309-1329.

7. "Intraday Price Changes and Trading Volume Relations in the Stock and Stock Option Markets", Stephan, J A,
and R E Whaley, 1990, Journal of Finance, 45, 191-220.