Role of Thin Commodity Futures Markets in Physical Market Price Making: An Analysis of Wheat Futures in India in the Post-Ban Era

Abstract

There is a belief that even thin futures markets can act as a forum for reference pricing and create more volatility in the physical market prices. This article tests that hypothesis, given a few problems aflecting the efliciency of the wheat futures markets in India, after the resumption of wheat futures in May 2009 following a ban of more than two years. The article tries to answer three questions." D0 physical market players use the fixtures price of wheat as a reference price? Does the volatility in futures prices cause price volatility in the physical markets? What are the determinants of volume and volatility in the wheat futures markets, as also their interrelation? The article finds little evidence to suggest that futures price serves as reference price for transacting contracts in the physical market, and, as a natural corollary, futures market volatility cannot lead to volatility in the physical market. The level o/‘liquidity was low in the futures markets, as the markets were not only bereft ofspeculative volumes, it did not even seem to have served the purpose of hedgers. Hence, while rejecting the hypothesis set for testing, this article concludes that it is not possible for a thin market, bereft of adequate participation and liquidity, to provide a forum for discovering the reference price for the physical market, and thus it cannot destabilize the latter. These conclusions have been arrived with time series econometric analysis, consisting of Vector Auto regression (VAR) methods, Granger causality tests, Auto regression methods (AR), and seemingly unrelated regression equation methods.