Effect of Futures Trading on Spot Market Volatility: Evidence from Indian Commodity Derivatives Markets

Abstract

This study investigates the relationship between futures trading activity and spot market volatility for agricultural, metal, precious metals and energy commodities in Indian commodity derivatives market. This article contributes to the debate whether the futures trading in Indian commodity futures market stabilizes or destabilizes spot market. We explore this issue by modeling contemporaneous as well as dynamic relationship between spot volatility and futures trading activity including trading volume (speculative/day trading) and open interest (hedging). Following Bessembinder and Senguin (1992), we examine contemporaneous relationship through augmented GARCH model in which spot volatility is modeled as GARCH (1,1) process and trading activity is used as explanatory variable. We also decompose futures trading volume and open interest series into expected and unexpected component. The lead-lag relationship between spot price volatility and futures trading volume and open interest is investigated through VAR model. Granger causality tests, forecast error variance decompositions and impulse response function are used to understand the dynamic relationship between these variables. We found that both expected and unexpected futures trading volume affects contemporaneous spot volatility positively. However, in case of agricultural commodities only unexpected volume affects the contemporaneous spot volatility. Granger causality tests, forecast error variance decompositions and impulse response function confirm that the lagged unexpected volatility causes spot price volatility for all commodities. The effect of speculative/day trading activity measured by trading volume on spot market volatility is positive. However, hedging activity measured by open interest does not show significant effect on spot market volatility. We do not find any effect of spot volatility on futures trading activity for most of the commodities.