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The IUP Journal of Financial Risk Management
The Role of Commodity Futures in Risk Management: A Study of Select Agricultural Commodities
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This paper analyzes the efficiency of Indian futures market in discovering prices and mitigating risk for agricultural commodities consequential of significant price rise in recent times. Johansenís test of cointegration, Vector Error Correction Model (VECM) and Granger causality test are employed to understand the relationship between spot and futures prices. Optimal hedge ratio and hedging effectiveness are measured using VECM. The results indicate cointegration between spot and futures prices for all the four commodities studied in near month and next to near month contracts. For near month contracts, mostly, both the markets react simultaneously and contribute to price discovery, but for next to near month contracts, futures market plays a dominant role. Hedgers benefit by participating in the futures market for all the commodities, although variance reduction is relatively higher for the near month contracts and hedging effectiveness varies across commodities. After the merger of FMC with SEBI, the regulator has been encouraging increased participation of farmers and other hedgers on commodity exchanges. The findings of the study may have important implications for hedgers, risk managers and policy makers in utilizing and improving futures market as a tool in reducing price risk.

 
 
 

In todayís environment, every business is confronted by a wide variety of risks. To sustain and succeed in the business, it is a prerequisite to be aware of these risks, understand its magnitude and consequence along with the knowledge to manage these risks. Agriculture is vulnerable to a variety of risks. According to Sinha (2007), the major risk forms are: price risk resulting from volatility in prices and production risk resulting from uncertainty about the yield levels.

The price of agricultural commodities is not only influenced by forces of demand and supply but also by certain additional factors such as seasonality in production, vagaries of monsoon, availability of warehouse facilities, availability of inventory, seasonality in consumption, export-import policies of India and peer countries, government interventions such as minimum support prices, etc. In addition to the above constraints, in recent time, Indian agriculture has been staggering under the influence of El Nino (characterized by two consecutive years of drought and water scarcity, excessive rainfall, etc.) on the one hand, and skyrocketing commodity prices at the global level, on the other. These have resulted in significant rise in prices of agricultural commodities. The impact of price volatility in primary commodities is not only on the producers in the agricultural sector but also on the other sectors of the economy through backward and forward integration.

 
 
 

Financial Risk Management Journal, Agricultural commodities consequential, Vector Error Correction Model (VECM) , Granger causality test.