Assessing Information Transmission of Commodity Futures Market through Information Share and Transfer Entropy

Abstract

Purpose: The study aims to assess the efficiency of the agriculture and non-agriculture futures market in India because, in situations where multiple trading venues exist for similar securities, it becomes crucial for traders and market participants to understand the price discovery process, including each market's contribution to the overall process. Motivation: Previous studies that examined how futures and spot markets interacted with each other used parametric models that assumed a linear relationship between the returns of the markets. Information flow between financial markets is actually nonlinear, and information theory provides a way to better understand these nonlinear dependencies (Osei & Adam, 2020). Transfer entropy is a nonparametric measure that can be used as an alternative. It quantifies the asymmetric transfer of information between time series and requires fewer assumptions about the underlying stochastic processes, making it a widely applicable tool (Behrendt et al., 2019). Other methods of causality like VECM requires the variables to be integrated at same order which makes it difficult to determine information flow of those variables. In such a scenario transfer entropy model will be most suitable as it does not consider stationarity or cointegration between the variables in order to determine the information share of a particular market. Methodology: Efficiency of 5 Agriculture commodities and 8 Non agriculture commodities which are being traded on Indian Commodity exchanges from 01.01.2010 to 31.08.2022 (3033 observations) has been studied by using Information share, Component Share, Shannon Transfer Entropy and Renyi Transfer Entropy. Findings: The study confirms the well-established higher relative impact of the futures market on the spot market and validates the transaction costs theory, which says that the futures market has a considerable influence on price discovery, and therefore, the futures market is likely to be the primary venue for this process due to lower transaction costs and high liquidity compared to the spot market. It also shows that the relationship between futures and spot does not hold if more weightage is being given to the tail events.