An empirical investigation into casual relation of spot and future markets and hedging effectiveness with reference to NSE futures

Abstract

The investigation of the Co-integration and causal relationship between futures and spot prices is very significant especially in an emerging market economy like India. Indian capital market has witnessed significant transformations and structural changes due to implementation of financial sector. This paper examines the relation and impact of Spot prices on Futures prices of NSE Futures contracts and also investigates the optimal hedge ratio and hedging effectiveness of the contracts traded on CNX NIFTY INDEX in India using OLS Model, VAR Model and VECM Model. The Johansen-Juselius Co-integration test used in the study finds two Co-integrating equations indicating long run relationship between Futures and Spot prices of all Future contracts. The Vector Error Correction Model stated that apart from having a long run relationship the prices of Futures are influenced by the prices of Spot in short run in most of the cases whereas in few cases it is vice versa. From Impulse Response graph in case of Spot prices and all the contracts it was found that Spot and Futures markets are highly sensitive to each other’s shocks. From the Granger Causality test it was found that there is unidirectional Granger Causality running from Futures prices to the Spot prices for all contracts. This means that Futures plays an important role in explaining the movements in Spot prices. Also Ordinary Least Square Model which was used to study the impact of Spot prices on Futures prices showed a significance which means Futures is impacted by the Spot prices in all the contracts. The indication presented in this study strongly suggests that the Nifty Index Futures contracts are an effective tool for hedging risk.