Weather Shocks, Spot and Futures Agricultural Commodity Prices- An Analysis for India

We analyze the impact of climate shocks on price formation in spot and futures market for food in India where until the recent introduction of commodity futures markets in 2005, the transmission of these shocks on short-term (spot) price movements was unclear. The existence of a futures market is expected to reduce risk, a major component in agricultural production as well as in price formation. Hitherto, the price discovery mechanism was weak and end price was expected to be different (mostly higher unless if some product prices are administered) from equilibrium price. In addition, this weak mechanism was expected to result in higher price volatility. Though the commodity futures market in India is nascent, we model transmission of weather shocks to future and spot prices using monthly data. Based on cointegration analysis, our results suggest strong cointegration between futures prices (based on MCX AGRI-future index) and spot prices (MCX AGRI-spot index) for commodities traded in futures markets. Our causality and impulse response results show futures prices Granger cause spot prices--a shock in futures prices appears to have an impact on spot prices at least for a five month period with maximum impact with a lag of one month. Changes in rainfall affect both futures and spot prices with different lags. Although there could be other factors that affect the futures prices, after controlling for fuel prices our results clearly show the transmission mechanism of weather shocks to prices. Further, with the help of smooth transition models, the study finds that the bivariate relationship between rainfall and prices of rice, wheat and pulses show some non-linearity with the structural change happening after the introduction of futures market. Also, this relation is found to be much stronger with the introduction futures market.