Effectiveness of Commodity Futures in Curbing Spot Volatility

Chepchirchir Rancy,Olukuru John

doi:10.12691/jfe-5-3-1

Abstract

This study examines the impact of introduction of futures trading on the spot price volatility in the commodity market. The paper considers the United States of America, South Africa and Ethiopian economies. Three commodities i.e. coffee, maize and wheat from New York Mercantile Exchange, South African Futures Exchange and Ethiopian Commodity Exchange are analyzed. ARCH LM test is used to check for heteroskedasticity and GARCH and EGARCH are used to check for the behavior of volatility for the pre- and post-futures periods. For all the three economies, the results indicate presence of the ARCH effect in the log returns. For conditional and unconditional variances; spot price volatility for coffee has decreased after futures trading across all the economies and the EGARCH has also shown reduction in persistence of volatility in the post-futures period in the three economies; while that of maize has reduced for the Ethiopian economy but increased in both the US and South African economies. For wheat, the conditional variance has been found to rise in the post-futures period in all the three economies. These results imply that more positive feedback from futures trading is bound to be seen for maize in the less developed economies as opposed to the developed economies as opposed to the other products. This paper has focused on the overlooked factor by earlier researchers, i.e. of economic-gap amongst countries, in looking at the impact of the futures trading on the spot price variation.

Highlights

Background of the Problem Agriculture is a sector facing large risks mainly from natural factors outside control of the farmers
While much research has been done on stabilization-destabilization question, there are problems associated with this work including the fact that most studies relate to developed and emerging economies at the expense of the less developed countries [1] and failure for empirical testing to recognize the relation between information and volatility incorrect policy implications; this study will address this issue by focusing on futures trading in a developed, emerging and a less developed economy and employ the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) and EGARCH models to capture this relation of information and volatility
The standard deviation has decreased for NYMEX and SAFEX except for ECX after the introduction of the futures trading for coffee implying a reduction in spot price volatility as expected from first null hypothesis

Summary

Introduction

Background of the Problem Agriculture is a sector facing large risks mainly from natural factors outside control of the farmers. Recent experience with volatility in this sector with major episodes of food price spikes of 2006-08 and 2010-11 has resulted in growing interest in risk management in agriculture. While agriculture faces a higher level of revenue risk, insurance could be the most suitable solution to manage yield risk from rare and extreme events. Recently index-based products have been introduced in these countries like India with no subsidized yield insurance though most schemes have not moved beyond the pilot stage. Index-based products overcome most of these problems but their effectiveness is limited to the extent to which the underlying indices on which they are based are correlated with the actual yield experienced on an individual farm.

Methods

Results

Conclusion