EXAMINING THE RELATIONSHIP BETWEEN SPOT AND FUTURE PRICE OF CRUDE OIL

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1 KAAV INTERNATIONAL JOURNAL OF ECONOMICS,COMMERCE & BUSINESS MANAGEMENT EXAMINING THE RELATIONSHIP BETWEEN SPOT AND FUTURE PRICE OF CRUDE OIL Dr. K.NIRMALA Faculty department of commerce Bangalore university Bangalore SWARNA.C Research scholar Department of commerce Bangalore university Bangalore (560001) ABSTRACT This study examines the dynamic relationship between spot and futures prices crude oil we first briefly discuss what the and GANGER CAUSALITY AND COINTEGRATION to say about the relationship between spot and futures markets. Next, using recent price data for for crude oil, we perform Granger causality tests to empirically uncover the direction of information flows between spot and futures prices. The results indicate that spot prices are generally discovered in futures markets. In particular, we find that changes in futures prices lead changes in spot prices more often than the reverse. Key words: Spot prices, Futures prices, Granger causality INTRODUCTION Crude oil is a global commodity which is sold on an international market, India is in 3 rd place in the world in oil demand Compared to last year, India's oil demand has risen 300, 000 b/d, putting the country on track to surpass China in incremental growth for India s Crude Oil Demand Growth is at Its Highest in 10 Years and the prices of crude oil have been increasing enormously. There are many factors which are leading spot prices one of the factor is futures. Considering that the futures price is the price specified in an agreement (futures contract) to deliver a specified 309

2 quantity of a commodity at a specific future date, whereas the spot price is the cash price for immediate purchase and sale of the commodity, Knowing the relationship of spot and future price of crude oil is the key objective of this study. The dynamic relationships between spot and futures have been comprehensively examined and analysed by researchers and practitioners over the past three decades. We should expect a close relationship between the prices of futures contracts and spot prices Futures markets are generally considered to perform two major roles in commodity markets a risktransfer role and, in particular, an informative or price discovery role we might be tempted to assume that futures markets dominate spot markets. The risk-transfer role results from the fact that a futures market is a place where risks are reallocated between hedgers (producers) and speculators. Producers are then willing to compensate speculators for sharing the risks inherent in their productive activity. Futures prices also transmit information to all economic agents, especially to uninformed producers who, in turn, may base their supply decisions on the futures price. It can also be argued that physical traders use futures prices as a reference to price their commodities due to the greater transparency and (often) greater liquidity of commodity futures over physical commodities. Review of Literature Extensive Research has been undertaken in the context to know about the relationship between spot price and future price Bopp and Sitzer (1987) tested the hypothesis that futures prices are good predictors of spot prices in the heating oil market. that spot prices are generally discovered in futures markets and the changes in future prices lead changes in spot prices more often than the reverse. Manuel Hernandez Maximo Torero (2010) discuss that in general, futures markets dominate cash market with about 75% of new information incorporated first in futures prices and then flowing to cash price Kenneth D. Garbade and William L. Silber*( 1983) the presence of bidirectional nonlinear causality. Linear causality testing reveals that futures prices lead spot prices, but nonlinear causality testing reveals a bidirectional effect. PARAM SILVAPULLEIMAD A. MOOSA*(1999) futures market stabilizes the spot price, as well as lowering its long-run mean STEPHEN J. TURNOVSKYI(1983) Bwo-Nung Huang, C.W. Yang, M.J. Hwang (2009)With respect to the short-run dynamic interaction between spot price change (Δst) and futures price change (Δft), our results indicate that when the spot priceis higher than futures price, and the basis is less than certain 310

3 threshold value (regime 3), there exists at least one causal relationship between Δst and Δft. Conversely, when the futures price is higher than spot price and the basis is higher than certain threshold value (regime 1), there exists at least one causal relationship between Δst and Δft. (Abhyankar, 1996; Chen and Lin, 2004; Silvapulle and Moosa, 1999 Recent work has revealed that nonlinear structure indeed exists in spot and futures returns. These nonlinearities are normally attributed to nonlinear transaction cost functions, the role of noise traders, and to market microstructure effects), Dr.K.Nirmala, Munilakshmi R. The results support with empirical evidence that futures prices appear to play a dominant and significant role in the spot market Stelios D. Bekis s Cees G.H. Diks (2008). The study contributed to the literature on the lead lag relationships between the spot and futures markets in several ways. In particular, it was shown that the pairwise VECM modelling suggested a strong bi-directional Granger causality between spot and futures prices in both periods. Data Analysis and Discussions Augmented Dickey Fuller Results of Augmented Dickey Fuller test and Phillip-Perron tests are done to check the stationarity of the data series. The absolute values of and PP test statistic are more than the critical value at 5% level (Refer Table 1). Therefore, the first differenced log of data series can be taken to be stationary. The hypothesis that near month futures prices and spot close prices having unit root can be rejected. Therefore, the necessary condition for testing co-integration is satisfied. Unit Rot Critical Value Calculated Table:1 Results of Augmented Dickey Fuller test and Phillip-Perron tests: Spot At Level Stati stic PP Spot at 1 st Differencing PP Futures At Level PP Futures at 1 st Differencing PP P Value * * * 311

4 3 Conclusion Non-Stationary Stationary Non-Stationary Stationary Causality relationship The causal relationship between the spot and future prices for crude oil is presented below. Here two regression analyses are done, firstly from spot prices to future prices and secondly from future prices to spot prices. In the present study the Granger causality test involves estimating the following pairs of regressions. = + +. (1) = (2) Table 2: Results of Granger Causality test of Spot and Future Prices of crude oil Null Hypothesis: Obs F- Probability Decision SPOT does not Granger Cause FUTURE Reject FUTURE does not Granger Cause SPOT E-153 Reject Granger causality test primarily indicates that whether there is a causal relationship between the futures and spot close prices. Granger causality tests in Table 2 shows that there exists a bi-directional causality relationship between the spot and futures prices of Copper. The test results indicate that future prices influence spot prices and vice versa. The rationalization of the result is that futures and spot markets for copper respond to new information more quickly due to lower transaction costs and flexibility of short selling (Cees G.H Diks and Stelios D. Bekiros). Moreover, hedgers with storage constraints will buy future contracts. Therefore, both hedgers and speculators will react to the new information by preferring futures transactions for decision making. So we accept the hypothesis that future prices cause spot prices and vice-versa. Johansen co-integration : This test explains the long term relationship between spot and future prices of Cotton. By using trace statistic and maximum Eigen value statistic, we have identified that there exists 312

5 one co-integration equation between the futures and spot cotton price (Shown in Table 3), The null hypothesis of zero cointegrating vectors is rejected, whilst the null of two cointegrating vector cannot be rejected at the 5% level. Thus, the spot and futures prices are I(1), with linear combinations being I(0), so the two price series are CI(1,1). The existence of co-integration between the crude oil spot prices and the near month futures prices, using both the Engle- Granger and Johansen tests, confirms the first necessary condition for long-term market efficiency. Table 3: Results of Co-integration between Spot and Future prices of Guar Seed Critical Max- Critical Hypothesized No. Eigen Trace value at 5% Prob.** Eigen Value at of CE(s) Value level) 5% level) Prob.** None * At most 1 * 2.23E Note: Trace test indicates 1 cointegrating eqn(s) at the 0.05 level, Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level, * denotes rejection of the hypothesis at the 0.05 level, **MacKinnon-Haug-Michelis (1999) p-values Conclusion: The present study has been undertaken to investigate the dynamic relationship between future price and spot price in order to ascertain which series provides an indication of the other in the future, that is, if futures prices lead cash prices or vice-versa. Hence, this paper attempts to investigate the statistical relationship that exists between the price movements in the cash market and futures market with reference to selected crude oil Commodity. Augmented Dickey Fuller () test and Phillipperron tests conducted on the daily spot and futures data series indicate that both the data series are 313

6 non-stationary at level but become stationary at first difference, which validates the suitability of data for further analysis. Granger Causality test and Co-integration test shows that there exists bidirectional causality relationship and significant long-term relationship between the spot and futures prices of crude oil traded at MCX India. To conclude we can say that there exists bi-directional relationship and long term relationship between future and spot prices of crude oil traded at MCX India. Bibliography: 1. Bekiros, S. D., & Diks, C. G. (2008). The relationship between crude oil spot and futures prices: Cointegration, linear and nonlinear causality. Energy Economics, 30(5), Huang, B. N., Yang, C. W., & Hwang, M. J. (2009). The dynamics of a nonlinear relationship between crude oil spot and futures prices: A multivariate threshold regression approach. Energy Economics, 31(1), Turnovsky, S. J. (1983). The determination of spot and futures prices with storable commodities. Econometrica: Journal of the Econometric Society, Garbade, K. D., & Silber, W. L. (1983). Price movements and price discovery in futures and cash markets. The Review of Economics and s, Hernandez, M., & Torero, M. (2010). Examining the dynamic relationship between spot and future prices of agricultural commodities (No. 988). International Food Policy Research Institute (IFPRI). 6. Pindyck, R. S. (2001). The dynamics of commodity spot and futures markets: a primer. The Energy Journal, Silvapulle, P., & Moose, I. A. (1999). The relationship between spot and futures prices: evidence from the crude oil market. Journal of Futures Markets, 19(2), Nirmala.K., & Munilakshmi. R. (2014) A study casual relationship between spot and future prices of cotton. Indian Journal of Commerce 314