Asymmetric Volatility of Net Convenience Yield: Empirical Evidence from Indian Commodity Futures Markets

Abstract

The theory of storage predicts asymmetric behavior of spread or net convenience yield (NCY). It asserts that the volatility of NCY increases as it become positive. Positive NCY arises when inventory is less and in the less supply condition any demand shock causes more volatility in spot prices than futures prices. The correlation between spot and futures prices also becomes weak because of less supply of storage. Hence, NCY becomes more volatile when it is positive. This paper investigates asymmetric volatility behavior of NCY in Indian commodity futures markets. We model NCY as EGARCH process which captures the asymmetry in volatility of the series. The mean equation of NCY is modeled as autoregressive process with month and period dummies. We also include volatility of the spot prices as explanatory variable.

Our results of the asymmetric behavior of NCY indicate that the theory of storage is not valid in Indian commodities market. In most of the agricultural commodities, we do not find asymmetric behavior of NCY except for crude oil where positive NCY has higher volatility than negative NCY. In the case of agricultural commodities, we find that any negative shock to NCY increases the volatility of NCY rather than decreasing it as suggested by the theory of storage. In other words, when the spot prices are higher than the futures prices (backwardation), the volatility of spread is higher than volatility of spread when spot prices are lower than the futures prices. It is found that the volatility of spot and futures prices are low when market is in backwardation (less volume of trade because of no supply) as compared to higher volatility in the contango period. Also, speculation ratio defined as ratio of trade volume to open interest is lesser for agricultural commodities. Less speculation and lower volume of trade in the spot and futures markets would be the probable reasons for less volatility of NCY in the backwardation period. Our results reveal an important characteristic of spread or NCY in Indian commodity markets which has both theoretical and practical implications.

Keywords: Convenience Yield, Asymmetric Volatility, EGARCH, The Theory Of Storage

JEL Classification: C22, G13