Optimizing Hedging Effectiveness of Indian Agricultural Commodity Futures: A Simulation Approach

Indian agricultural commodity futures have seen declining volumes over the last ten years. Several studies in the literature have suggested that this may be due to their hedging effectiveness being, in general, low. To prevent manipulation, location options are embedded into such commodity futures allow for the short position holder at expiration to deliver several non-par assets in addition to the par asset. Choices of delivery specifications pertaining to the location option can impact hedging effectiveness of the futures contract. We use a Monte Carlo approach to guide the choice of these delivery specifications including the number of deliverable assets, their inter-se correlations, discounts incurred for delivery of non-par assets and contract life, with the goal of optimizing hedging effectiveness of futures. We also corroborate the results of simulations with empirical evidence. The simulations, while confirming some of the empirical results in the literature also suggest several additional insights for the optimal selection of contract delivery specifications and provide contract designers with comprehensive guidelines for making choices of contract delivery specifications. These results also confirm the necessity for regulators and exchanges to focus on and constantly optimize delivery specifications of such futures contract to make them more useful for hedgers by improving their hedging effectiveness.