Role of Indian Commodity Derivatives Market in Hedging Price Risk: Estimation of

Dynamic Hedge Ratio using Multivariate GARCH Model

GARP Delhi, India Chapter Meeting

Brajesh Kumar Jindal Global Business

School

Outline Of The Presentation

Futures market and Hedging Recent dynamics in Indian spot and

commodity derivatives market Research Questions Models Constant hedge models Dynamic hedge models

Findings and Conclusions

Futures and Commodity Futures Agreement to buy or sell an asset for a certain price at

a certain time

Commodity futures are different Storage cost and convenience yield Contango/Backwardation

Corn Farmer

Company

Contract to buy/sell fixed quantity of

Corn at fixed price

Settlement will take place

250

270

290

310

330

350

370

390

20-Oct-04 19-Nov-04 19-Dec-04 18-Jan-05 17-Feb-05 19-Mar-05 18-Apr-05 18-May-05 17-Jun-05 17-Jul-05 16-Aug-05 15-Sep-05 15-Oct-05 14-Nov-05 14-Dec-05

SPOT PRICEJAN FutureFEB FutureMAR FutureSEP FutureOCT FutureNOV FutureDEC Future

Futures Prices < Spot price(Backwardation)

Futures Prices >Spot price(Contango)

ARRIVAL LEAN Period PLANTATION

4

Illustration: Castor Spot And Futures Prices

Role of Commodity Futures Markets

Importance and management of Commodity Market Management through spot market intervention Management through Derivatives market

Management through derivatives market Price discovery Risk management Investment

Hedge Ratio and Hedging Effectiveness

Basic Idea To compensate loss/ profit in one market by profit/loss

in other market. In portfolio theory, hedging with futures can be

considered as a portfolio selection problem to minimize the overall risk.

The optimal hedge ratio is defined as the ratio of the size of position taken in the futures market to the size of the cash position which minimizes the total risk of portfolio

Hedge Ratio and Hedging Effectiveness

Return

Variance

Minimization of variance give OHR

Hedge Effectiveness

( ) ( )ttttH

ttU

FFHSSRSSR

−−−=−=

++

+

11

1

( )( ) FSFS

S

HHHVarUVar

,222

2

2 σσσ

σ

−+=

=

( ) ( ) ( )( )( )UVar

HVarUVarEessEffectiven −=

Commodity Derivatives Market In India

Year 1875 Derivatives market was started with the setting up of the Bombay Cotton

Trade Association

Year 1952 & 1953 Forward Contracts (Regulation) Act (FCRA) Forward Market Commission (FMC)

Year 1955 Free trade in many commodities was restricted

Year 2003 Removed the ban on futures trading Three national level multi commodity exchanges, National Multi

Commodity Exchange (NMCE), Multi Commodity Exchange (MCX) and National Commodities and Derivatives Exchange (NCDEX) were setup in 2004.

Recent Dynamics

Expansionary measures Planning to increase participation though Foreign Institutional

Investors (FIIs), Mutual Funds (MFs) and Banks Planning to introduce other derivatives products like futures

options, index, index, index futures & options etc Commodity transaction tax (CTT)

Critiques Govt. of India decided to suspend the futures trading in urad,

tur and wheat in early 2007. Abhijit Sen committee: to study the impact of futures trading

on agricultural commodity prices. In May 2008, Govt. of India banned futures trading on another

four commodities namely rubber, chana, soy oil and potato.

10

Some Facts About Indian Commodity Futures Markets

Reference settlement spot price of Industrial metals and Energy commodities are LME and NYMEX Spot price

Most of the non-agricultural commodities are cash settled contracts

Speculation ratio of non-agricultural commodities are very high compared to agricultural commodities

Overnight volatility of non-agricultural commodities are very high as compared to trading volatility.

Volume of near month futures is very high as compared to next to near month futures contracts for non-agricultural commodities

Motivation

Hedging effectiveness Found to be contingent on model used to estimate hedge ratio Few Studies in Indian commodity futures

Why it is important to look into? Would help in understanding effectiveness of commodity

futures contracts in managing risk may also help concerned exchanges and the government to

devise better risk management tools or support towards commodity-specific public policy objectives

Aggregation model Would help participants (farmers) in devising better hedging

strategies

Research Questions

To investigate optimal hedge ratio and hedging effectiveness of select futures contracts from Indian commodity markets.

To examine performance of constant hedge

ratio models (VECM) and dynamic hedge ratio models (CCC-Multivariate GARCH) in emerging market context

Models: Constant Hedge Models

OLS

VAR

VECM

tFtSt HRR εα ++=

Ft

l

jjStSj

k

iiFtFiFFt

St

l

jjFtFj

k

iiStSiSSt

RRR

RRR

εγβα

εγβα

+++=

+++=

∑∑

∑∑

=−

=−

=−

=−

11

11

Ft

l

jjStSj

k

iiFtFitStFFFt

St

l

jjFtFj

k

iiStSitFtSSSt

RRSFR

RRFSR

εγβγβα

εγβγβα

+++++=

+++++=

∑∑

∑∑

=−

=−−−

=−

=−−−

22111

2211

Models: Dynamic hedge models CCC-MGARCH

( ) 21

,,,

1,1,2

1,1,,

1,1,2

1,1,,

tfftsstsf

tffftffftff

tssstssstss

hhh

hh

hh

×=

++=

++=

−−

−−

ρ

βεαω

βεαω

Constant conditional correlation (CCC) model Bollerslev et al.(1990)

fft

sftt h

hH =Dynamic Hedge Ratio

Details of Commodity, Data Period and Source

Commodity Data-Period Futures Market

Spot Market

Agricultural

Soybean 09/01/2004 to 10/20/2008 NCDEX Indore

Maize 01/05/2005 to 10/20/2008 NCDEX Nizamabad

Castor Seed 09/21/2004 to 10/20/2008 NCDEX Disa

Guar Seed 04/12/2004 to 09/19/2008 NCDEX Jodhapur

Precious Metals

Gold 05/02/2005 to 09/30/2008 MCX Ahmedabad

Silver 05/02/2005 to 09/30/2008 MCX Ahmedabad

Industrial Metals

Aluminium 02/01/2006 to 09/30/2008 MCX LME

Copper 07/04/2005 to 11/20/2008 MCX LME

Zinc 04/03/2006 to 09/30/2008 MCX LME

Energy Crude Oil 05/02/2005 to 09/30/2008 MCX NYMEX

Natural Gas 07/21/2006 to 09/30/2008 MCX NYMEX

Unit Root and Johansen Co-integration Tests

ADF Test Prices are Non-stationary Returns are stationary

Co-integration Spot-Futures prices are co-integrated Exceptions

Guar seed: Near month (second sub-period) Natural gas: Next to near month (Entire and both the sub-

periods) Maize, Aluminium, and Copper : next to near month (first sub-

period) Castor, and Crude : next to near month (Second sub-period)

Hedge Ratio and Hedging Effectiveness: VECM

2004-2008 2004-2006 2007-2008

Commodity Hedge Ratio

Hedging Effectiveness

Hedge Ratio

Hedging Effectiveness

Hedge Ratio

Hedging Effectiveness

Soy Bean 0.739833 0.692946 0.731624 0.702977 0.735484 0.689706

Maize 0.317607 0.237123 0.333731 0.183017 0.315907 0.338375

Castor Seed 0.584379 0.486313 0.516682 0.398208 0.670206 0.598378

Guar Seed 0.477391 0.437719 0.496459 0.454555 0.395943 0.398083

Gold 0.316849 0.236243 0.32528 0.225757 0.313358 0.24966

Silver 0.232021 0.146975 0.237217 0.138 0.242272 0.180167

Aluminium 0.262816 0.096287 0.1625 0.045788 0.38085 0.225528

Copper 0.097611 0.027994 0.111726 0.024454 0.114104 0.061162

Zinc 0.295546 0.197039 0.200687 0.092126 0.344876 0.270389

Crude Oil 0.349902 0.189441 0.432523 0.234767 0.276419 0.122934

Natural Gas 0.409389 0.189156 0.397671 0.222604 0.414326 0.198484

Near Month Futures

Hedge Ratio and Hedging Effectiveness: VECM

Next To near month Near Month Futures

2004-2008 2004-2006 2007-2008

Commodity Hedge Ratio

Hedging Effectiveness

Hedge Ratio

Hedging Effectiveness

Hedge Ratio

Hedging Effectiveness

Soy Bean 0.577326 0.311315 0.694536 0.393548 0.496836 0.267845

Maize 0.242724 0.133362 0.233463 0.062189 0.286811 0.287731

Castor Seed 0.542966 0.452535 0.496621 0.370665 0.271338 0.096645

Guar Seed 0.438871 0.430664 0.452964 0.443269 0.327935 0.31789

Gold 0.342242 0.246231 0.375518 0.256074 0.333604 0.240686

Silver 0.245991 0.150156 0.244549 0.137873 0.269838 0.19757

Aluminium 0.273305 0.09171 0.01866 0.000515 0.434189 0.24516

Copper 0.120029 0.032746 0.102194 0.016025 0.116117 0.05452

Zinc 0.299099 0.170797 0.167391 0.054529 0.365703 0.266877

Crude Oil 0.379611 0.185514 0.48726 0.231297 0.161897 -0.024979

Natural Gas 0.354383 0.08307 0.028244 0.012088 0.21348 0.027981

Dynamic Hedge Ratios: CCC

Commodity Hedge Ratio

Hedging Effectiveness, E

Hedge Ratio

Hedging Effectiveness, E

Near Month

Futures Next to Near

Months Futures

Soy Bean 0.4276 0.6335 0.4521 0.4707

Maize 0.892 0.2418 0.4046 0.1514

Castor Seed 0.7126 0.4917 0.5329 0.4577

Guar Seed 0.5022 0.4367 0.4063 0.4316

Gold 0.2723 0.2407 0.2698 0.2492

Silver 0.2681 0.1385 0.229 0.1459

Aluminium 0.5048 0.1481 0.4518 0.1449

Copper 0.1072 0.0402 0.1103 0.0468

Zinc 0.2795 0.1972 0.363 0.178

Crude Oil 0.3951 0.1978 0.3869 0.192

Natural Gas 0.3849 0.2486 0.4472 0.1446

Empirical Findings

Agricultural commodities and precious metals, futures contracts provide higher hedging effectiveness as compared to other non-agricultural commodities

Hedging effectiveness provided by the near month futures is

higher than the next to near month futures for most of the commodities.

For most of the commodities hedging effectiveness has

improved in the recent sub-period. Hedge ratios and hedging effectiveness estimated from CCC-

GARCH model are not very different

Further Investigation: Industrial Metals and Energy Commodities

Indian futures markets of industrial metals and energy commodities may aggregate global price information from LME/NYMEX futures markets than spot prices.

Most of the futures contracts of non-agricultural commodities are cash settled contracts than actual delivery

LME/NYMEX futures also provide similar hedging effectiveness with their spot prices

Further Investigation: Industrial Metals and Energy Commodities

India Futures and Int Futures Int Futures and Spot

Commodity Hedge Ratio

Hedging Effectiveness

Hedge Ratio

Hedging Effectiveness

Aluminium 0.552 0.29829 0.60376 0.54981

Copper 0.56684 0.41952 0.68964 0.56625

Zinc 0.64848 0.51193 0.62216 0.63114

Crude Oil 0.81525 0.45 0.34978 0.19862

Natural Gas 0.79289 0.71676 0.43591 0.25234

Conclusions Differences between agricultural and non-agricultural commodities

with regard to the hedging performance

Agricultural commodities: hedging effectiveness (30-70%) industrial metals and energy commodities (less than 20%) LME futures are providing good hedging effectiveness with spot prices

Indian commodity futures markets with the LME/NYMEX futures prices: hedging effectiveness of Indian futures contracts increases dramatically.

Similar Hedging effectiveness with constant hedge ratio or dynamic hedge ratios.

The near month futures provide higher hedging effectiveness than next to near month futures.

The hedging role of Indian commodity futures markets has increased in the recent period with increased activity in the market.

Thank you!! Questions?