Future Trading and Spot Market Volatility Finance Essay

Published: 2021-06-27 08:10:05
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This study investigates the effect of the future trading activities trading volume : proxy of future liquidity on spot price volatility for crude palm oil by using GARCH model specifications. Specificlly, it examine whether the increase or decrease volatility level of spot price for crude palm oil affected by future market trading. In addition, it also show that volatility spot market in crude palm oil future is different from other spot market. The study of this research covers the period from 31 October 2006 until 31 October 2010. The expected result is the research will find that crude palm oil future trading is tend to drive spot market volatility. Generally believe that the existing of hedgers and speculators tends to drive spot market volatility and possible speculative trading in futures market may have destabilised spot prices of underlying commodities.

Palm oil is extracted from the fruit of the oil palm tree. The palm fruits yeilds both palm oil and palm kernel oil. Palm oil is extracted from the pulp of the fruit and is an edible oil used in food. It is the world biggest vegetable oil crop, which is 22% of the world’s oil compared to soybean oil. Malaysia is the world’s second largest crude palm oil producer and exporter and the first leading in the world is Indonesia. Over 90% of the world’s palm oil exports are produced in Malaysia and Indonesia. As we know, palm oil has been used in most daily product such us frying and cooking oil, cookies, butter, soap and many more, however, nowadays, they already found new technology in non – food used for palm oil such as biodiesel and it being expected be a increasingly demand in palm oil.
Futures market are developed as a means to accommodate the volatility of commodities prices, notably agricultural products. This is justified because the two feature of future markets are variability and unpredictable in prices. Malaysia Crude Palm Oil is currently the top futures contract by trading volume and open interest. Future Crude Palm Oil (FCPO) contract has been the global price benchmark. It has been launched by Bursa Malaysia Derivatives Bhd. (MDEX) or as known as Kuala Lumpur Commodity Exchange (KLCE) in September 2008. It is considered as a commodity derivatives instrument that use Ringgit denominated Crude Palm Oil Future contract which has been trading since 1980.
FCPO is derived from the actual priceof physical palm oil . On the other hand, physical palm oil is the underlying instrument which is traded in the local deliver market. FCPO is local investment product and being traded in Malaysian Ringgit. It is an investment product that offered by Bursa Malaysia which it being monitor their creadibility and transparency by Securities Commission Malaysia. It has been approved by The Adviser of Securities Commission Malaysia as one of investment product that has been declared as shariah compliance. The profit that being generated from FCPO is tax free. FCPO traded using matured palm oil and globally where hedgers involved actively and contributed to the real market based on demand and supply in palm oil market.
Commodities futures is introduced for two reasons. Firstly, it can be used to manage price risk. It is the main reason in derivative trading because trading derivative can reduce the risk goods by providing an additional way to invest the lesser trading cost. Its also provide extra liquidity in the stock market. Second reason is FCPO can be used as hedging vehicles. If we use commodities as one of the hedging vehicle, it is a very technical strategy that used almost by producer and processors to protect a position in commodities. For example, a grower would use commodity hedge to obtain price as high as possible for the he or she sells.
N. M. Naziman, A. Samad, Yusrina H. (2012) investigate the price of discovery of the Malaysian crude palm oil future market. They find there is a dynamic relationship between spot and future prices and it prove that the crude palm oil prices effect the price discovery function, therefore future prices will be used by producers and traders as the relevent price for they making decision. Their finding is very useful for anyone in agricultural commodities markets such as producers, traders, regulators and policy maker.
Rosalan, Shafinar (2006) said that as an agricultural product, palm oil prices are known for its unpredictability and variability. As such, the price movement of palm oil are very volatile in past few decades. For the past twenty five years palm oil prices had fallen to as low as RM400 per tonne in 1986 to as high as RM2 500 tonne in 1998. Therefore, at the peak of 1997-98 currency crisis, palm oil sector helped Malaysian economy from falling further and longer. In the beginning of 20th century, palm oil prices are remain floating between RM1,100 – RM 1,300 per tonne. For the first half of 2003, it is trading around RM1,400 to RM1,600 per tonne.
A study which analyzes the relationship between future trading activities (trading volume) and spot market volatility on Crude Palm Oil Future (FCPO). Without better understanding from the relationship between variables define above will give negative impact and will end up will some loss. Price of FCPO is very volatile and unexpected. Some people said that, it because of the existence of speculators because they creating untrue news and keep speculate the market. They also one of the main reason why price of FCPO keep volatile and they take advantage from the volatile market. Investor should more sensetive regarding the price of crude palm oil and try to avoid speculator that will make our life miserable.
A model that is frequently used to link futures and spot contracts uses the concept of cost of storage. In this model, the difference between the spot and futures contracts is the cost of carrying the commodity into the future, specified by the maturity date of the futures contract. This difference, or the cost of storage, may either be negative or positive, depending on the trading volume of the underlying asset and spot price. Acording to Bakaert and Harvey (1997), emerging future market are characterized by low liquidity, small trading, and maybe the return produced higher sample average, better predictability, higher volatility and offer smaller sample for research.
The objective of this study is to examine the stabilizing or destabilizing effect of derivative market on spot market for crude palm oil, to understand the destabilization effect, the relationship of the unexpected liquidity of future market. This paper also empirically examine the effect of future trading activities on spot price volatility for crude palm oil. This study is differ from other studies of future trading because Malaysia is the number one producer and exporter of palm oil in the world market. Besides that, FCPO were the first derivative instrument being traded in Malaysia. Secondly, this study differ with other studies because we use the GARCH family of statistical models which are a superior technique for modelling volatility. GARCH is a model for forecasting volatility where the variance rate follows mean reverting process.
Future market is a form of derivative market. It developed as a means to accommodate the volatility of commodity prices, notably agricultural products. Rosalan Ali,(1998) and Shafinar I.(2006) said that this is justified because the two feature of futures markets are variability and and unpredictability in prices. The prices shows very fluctuate and always volatile. That’s why agricultural supplier and users concern in managing adverse price movements and hence, futures market being used as on of hedging mechanism. Basically, there are two type of group involved in future market that is hedgers and speculators. Rosalan Ali said hedgers can provide wider protection for from drastic move in commodities prices. They can remove the effect of price increase and decrease and stabilizing and give flexible management action. By creating counterbalancing position in future market, profit can compansated any loss in future market. And this can create a stable price which can be determined in advanced.
Spot price volatility behavior is very related and very close to the stabilization issue. If we used derivative trading efficiently and improved it, the volatility problem can be reduced. Speculators who are creating the speculative forces will be attracted to the lower transaction in derivative trading which is can affect also spot market volatility. This show the positive relation that the introduction of derivative will afffect the volatility underlying spot market. There are many past studied intensely debated about the future trading will affect de- stabilize the spot market by making volatile. Sbehal B., Saurabh G (2003) and Sanjay S. Namita (2012) said that derivative will attract speculator. If with the participant of speculators, this will allow high level of leverage which mean that will make the quality information lower in market. Speculators will make money when there are price movements and lose money when the price move against them. As a risk taker, the margin requirement and commision charges are considered and the effect of leverage. This means that once the contract is opened (open interest), his position will be marked daily according to market( closing) prices.
Sahadevan(2002) found that the the analysis of futures markets in agricultural commodities in the India on price discovery in a sample six commodities traded in four exchanged not efficient in sense that the futures prices are not unbiased predictor of the future ready rates. Sahadevan show that the different between the future prices and the future ready rates is an indication of inefficiency come from the underdeveloped nature of the market.
Lazaros, Marcel, Chris (2012) analayzes the fundamental role of inventory in explaining commodities futures prices and their volatilities in the economic framework. They using an extensive dataset of monthly inventories for 21 different commodities for the period from 1993 to 2011 and test two prediction. First they found negative relationship between inventories and forward. Second, they found that inventory is negatively related to commodity price volatility. Besides that, they also foundlow inventory more impact on volatility than high inventory.
In commodity future markets, few studies have addressed this issue. Noriza, Noraini (2012) said that commodity price instrument relatively very volatile which is reflected to their trading mechanism performance.This statement proved using relation between price with open interest, volume of trading and cash settlement and test using regression. The volatility of the commodity price instrument can be evaluate based on analyzing pattern movement fron high to low level. The result is increasing in price of FCPO and FPKO will increase their trading volume, cash settlement and open interest. For recommendation , the trader or investor in Malaysia can invest in FCPO contract compared to FPKO since the contracts can maximize the trader profit.
The data consist of crude palm oil which is most actively traded on Malaysia Derivative Exchange (MDEX). The selection of crude palm oil commodities because FCPO is in investment instrument that have inflation sheild and mostly other investment influence also because of the characteristics is two way market. It aslo proved future market that have the most stable product among other product offered by Bursa Malaysia. It also offered high leverage compared with other instrument offered in Malaysia where the potential return is very high.
The period of study is from October 2006 to October 2012 and data being extracted from Bursa Malaysia website. The data comprises of daily closing spot and future prices of the crude palm oil. To minimize the heteroscedasticity in data, we take the natural logarithm of daily prices. The daily spot return are constructed from the spot price data as log (/), where is the spot price at time t. These commodities are applied to examine the aggregate behavior of commodities with regards to destabilisation effects.
The paper uses HP filter to decompose the study series into expected and unexpected components. Like
The GARCH (1,1) Model
We begin with the simplest GARCH (1,1) specification :
n which the mean equation given in (a) is written as a function of exogenous with an error term. Since is the one-period ahead forecast variance based on past information, it is called the conditional variance. The conditional variance equation specified in (b) is a function of three terms :
A constant term
News about volatility from the previous, measured as the lag of the squared residual from the mean equation (the ARCH term).
Last period’s forecast variance (the GARCH term).
The (1,1) in GARCH (1,1) refers to the presence of a first- order autoregressive GARCH term (the first term in the parentheses) and a first- order moving average ARCH term ( the second term in parentheses). An ordinary ARCH model is a special case of a GARCH specification in which there are no lagged forecast variances in the conditional variance equation, a GARCH (0,1).
There are two equivalent representation of the variance equation that may aid you in the interpreting model :
If we recursively substitute for the lagged variance on the right-hand side of Equation (b), we can express the conditional variance as a weighted average of all of the lagged squared residuals:
We see that the GARCH (1,1) variance specification is analogous to the sample variance, but that it down- weights more distant lagged squared errors.
The error in the squared returns is given by . Substituting for the variances in the variance equation and rearranging terms we can write our model in terms of the errors:
Thus the squared errors follow a heteroscedasitic ARMA (1,1) process. The autoregressive root which governs the persistence of volatility shocks is the sum of and . In many applied setting, this root is very close to unity so that shocks die out rather slowly. The GARCH (q,p) model and the GARCH-M model are other versions of GARCH model. We take the residuals of GARCH model to take this as a measure of spot market volatility. GARCH 1 1 P Q model hence our paper model hence our paper model has used this model.
Using GARCH methodology, this article evaluated the effect of future trading on spot market volatility of FCPO. The expected result is FCPO trading in future market have destabilized spot prices of underlying commodities. Based on previous studies, most of future trading have impact on spot price volatility whether increase in volatility or decrease in volatility.
Using GARCH methodology, this paper evaluated the impact of introduction of future on spot market volatility in Malaysian commodity market or more likely about Crude Palm Oil Future that being traded in the Malaysian Derivatives Exchange. The effect of future trading activities on spot price volatility for crude palm oil which is the most liquid future contracts traded in the Bursa Malaysian derivative market have attracted interest from many researchers. Empirical studies carried out so far does not have any solution on the debate of the effect future trading on spot price volatility on CPO. In particular, the effort is targeted towards estimating the convenience yield implicit in the prices of futures contracts using historical return variances. This parameter is then included in the cost-of-carry model for determining whether or not any improvement in forecasting ability can be achieved. The results, based on 15-year from 1988 to 2002, support the claim that the model provides a better prediction than the simple cost-of-carry model, both for in-sample and out-ofsample
data. This strengthens the view that historical return variances play a role in the pricing of futures contracts for commodities, and can be used to provide a relatively good
forecast of futures prices

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