Price Volatility, Trading Volume and Open Interest: Evidence from Indian Commodity Futures Markets

Abstract:     
This paper empirically investigates the relationship between volatility and trading activity including trading volume and open interest, for agricultural, metals, precious metals and energy commodities in Indian commodity derivatives market. Trading volume and open interest are included in this paper to distinguish between speculators/day traders and hedgers. The relationship between volatility and trading activity is more important in emerging market context where derivatives markets are generally criticized for speculative activity and destabilizing effect on spot market. This study uses three different measures of volatility: (1) daily volatility measured by close-to-close returns, (2) non-trading volatility measured by close-to-open returns and (3) trading volatility measured by open-to-close returns. The contemporaneous as well as dynamic relationship between volatility and trading activity are investigated. Following Bessembinder and Senguin (1993), volume and open interest are divided into expected and unexpected components. The contemporaneous relationship between volatility and trading activity is investigated by augmented GARCH model where expected and unexpected components of trading activity (volume and open interest) are used as explanatory variables. This is also an empirical test of the Mixture of distribution hypothesis (MDH) in Indian commodity derivatives markets. The dynamic relationship across conditional volatility from GARCH (1,1), unexpected trading volume and unexpected open interest is examined by Granger Causality test in which trivariate VAR model is used. To obtain additional insights about the interaction between volatility, trading volume and open interest, variance decomposition and impulse response function are employed.

We find positive and significant correlation between volatility and trading volume for all commodities under consideration. It is found that although volume parameters are significant, volatility is mainly explained through its own lagged values. For most of the commodities we find insignificant relationship between volatility and open interest. In Indian commodity futures market trading activity does not proxy for information. The results of dynamic relationship between volatility and trading activity show that only overnight volatility drives the trading volume but not open interest. This result is more prominent in non-agricultural commodities. We also find asymmetric relationship between trading volume and open interest. The lagged open interest affects volume positively but lagged volume affects open interest negatively. This result is also more prominent in case of non-agricultural metals.

Keywords: Volatility, Volume, Open Interest, MDH, Emerging Market

JEL Classification: C32, C52, G12

working papers series