Spot and futures prices relationship problems

spot and futures prices relationship problems

Request PDF on ResearchGate | Further evidence on the relationship between spot and futures prices | In this note, we show that Gulley and Tilton's findings. definitive conclusions on this issue, we find that in all cases considered the futures market given (arbitrarily specified) behavioral relationships for the agents in the market. short-run market clearing spot and futures prices are derived. A tutorial on the determination of futures prices, including the spot-futures parity theorem The parity relationship is also known as the cost-of-carry relationship.

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spot and futures prices relationship problems

View PDF Download PDF Abstract This study empirically examines the market which reacts first in India by assessing the relationship between spot and future prices of agricultural commodities such as Soya bean, Chana, Maize, Jeera and Turmeric for a period from January to March traded in NCDEX, Empirical results suggest the existence of long-run equilibrium relationships between futures and spot prices for all the 5 agricultural commodities that were taken for this study.

Regression model pertaining to Lead-Lag relationship between Spot and Future markets suggests that for the commodities Maize, Jeera and Turmeric, both the spot and future markets price plays the leading role in the price discovery process and said to be informationally efficient and reacts more quickly to each other. Keywords Agriculture; Price discovery; Regression model; Futures; Cointegration Introduction The agricultural production system in India has undergone profound changes over the decades due to adoption of green revolution technologies coupled with price support policy of the government [ 1 ].

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After independence, various policy initiatives undertaken for protecting agriculture sector affected the growth in agricultural commodities markets adversely. The Essential Commodities Act envisaged price and movement protection applicable to various agricultural commodities, particularly food grains such as paddy, wheat, coarse grains and pulses to protect the interests of producers as well as of consumers.

spot and futures prices relationship problems

During the process of economic liberalization, it was felt that there is a need to reorient policies and regulations in agricultural commodities. The Khusro Committee recommended reintroduction of futures trading in most of the major commodities [ 2 ].

The Government of India constituted another committee headed by Professor K. Kabra in June on Forward Markets [ 3 ], which also emphasized the need for introduction of futures trading in 17 commodity groups covering a wide range of agricultural commodities.

spot and futures prices relationship problems

It also recommended strengthening of the Forward Markets Commission FMC and various amendments in Forward Contracts Regulation Act to bring fairness and efficiency in futures trading operations.

As a result, the Government of India issued notifications on April 1, and permitted futures trading except options trading for a wide range of agricultural commodities. Futures contracts help in performing two important management functions, i.

Determination Of Futures Prices: Spot-Futures Parity

Price discovery is the process of revealing information about future spot prices through the future markets. It is useful for producers as they get a fair idea about the prices likely to prevail at a future point of time and hence, can allocate their limited available resources among various competing commodities for optimizing their profits. It also provides food processors and consumers an idea about prices at which the specific commodity would be available at a future point of time.

Although futures trading in a large number of agricultural commodities were re-introduced in India in the yeargovernment is always skeptical about its efficiency and likely impact on the price movement of agricultural commodities.

The ban on futures trading of some major agricultural commodities in February makes it imperative to explore whether the futures market has really been able to achieve its above-stated objectives of price discovery and risk management or not.

Determination of Futures Prices

Thus, understanding the influence of one market on the other and role of each market segment in price discovery is the central question in market microstructure design and has become an increasingly important research issue among academicians, regulators and practitioners alike as it provides an idea about the market efficiency, volatility, hedging effectiveness and arbitrage opportunities, if any.

The spot-futures parity equation can also be applied to other futures contracts with different underlying assets by making the appropriate modifications. For instance, for bonds, the coupon payment would be equal to the dividend payment. If the underlying asset pays no dividends, such as a commodity like silver, then the dividend is simply set equal to 0, so the price of the futures contract would be equal to asset price multiplied by the risk-free interest rate.

spot and futures prices relationship problems

By taking the long position in the futures contract, the trader can earn the risk-free rate of interest with the money that would otherwise be used to buy the asset; ergo, the long position must agree to a higher price to compensate the short position for holding an asset that pays no interest or dividends. Spreads Because the price of a futures contract is fixed relative to its underlying asset for any maturity, there must also be a relationship between futures contracts of the same underlying asset but with different maturities.

If this relationship does not hold, then arbitrage opportunities will arise that will cause prices to conform to parity. If the risk-free interest rate is greater than the dividend yield, then futures prices will be higher for contracts with a longer maturity. This is usually the case, but there are times when the risk-free interest rate is actually lower than the dividend yield, in which case futures contracts with longer maturities will be cheaper than futures contracts with shorter terms.

spot and futures prices relationship problems

Delaying delivery from t1 to t2 allows the earning of risk-free interest during that time interval, but it also entails the loss of the dividend yield during that time period, hence the equation. Since both the dividend yield and the interest rate are annual yields, the time difference between 2 contracts is generally calculated as the number of months between the delivery dates divided by the 12 months of the year.

Therefore, the futures price for April delivery, which is 3 months later, should be: In the spot-future parity theorem, an assumption is made that the futures contract would only pay on delivery.

However, futures are marked to market daily, which causes the futures price to deviate from parity and to deviate from the forward price. If interest rates are high, then marking to market will give an advantage to the long position causing the price of futures contracts to be greater than the corresponding forward contracts.

If interest rates are low, then the advantage accrues to the short positions, so that futures prices will be less than parity. Because higher interest rates favors the long position, futures traders are willing to accept a higher price on the futures contract, while a negative correlation between futures prices and interest rates will favor the short position, causing the futures price to be less than the corresponding forward price.