Overall Performance of Malaysian Futures Market: Evidence Using Crude Palm Oil and Stock Index Futures Contract

Abstract

This research analysed four important issues relating to the efficiency of futures market, namely pricing characteristics, informational role, arbitrage efficiency and hedging performance of two important derivative products namely crude palm oil futures (CPO) and stock index futures contracts (SIF). Daily data on CPO contracts for the calendar years 1987 through 1998 and 1996 through 1999 for stock index contracts were used. Several hypotheses concerning the pricing behaviour of futures contracts (CPO and SIF) were tested to ascertain whether the pricing behaviour is consistent with theory in the context of an emerging market. The fmding suggests that the pricing behaviour of CPO futures is consistent with theory over the whole period of analysis. And the liquidity increased with volume for the CPO futures. Delivery month does not have any significant impact on price volatility. For stock index futures, the pricing behaviour is not stable over time possibly due to the financial crisis (July 1997 to September 1998) and/or more importantly, due to the learning period effect. The liquidity of this contract did not increase with the increase in volume probably due to the lack of speculators. Excepting in a sub-period (1993-1995), the findings suggest that information is a major determinant of cash price movement of CPO contracts. For stock index futures, significant informational linkages between cash and futures prices is observed only after the financial crisis. There was no informational link between cash and futures markets before the crisis. In terms of arbitrage efficiency, the CPO futures show weak arbitrage activity. Spot volatility reduces the spread between cash and futures though it was not simultaneous while futures volatility does not have an important role in reducing the spread. For stock index futures, spot volatility as well as futures volatility simultaneously reduces the spread in the post crisis period. In the pre crisis period, these contracts showed 􀜿 weak-form arbitrage efficiency with expected sign. Holders of spot positions are expected to hedge the risk of unexpected price changes. The traditional hedging theory regards the risk reduction as the motive for establishing a futures position, whereas portfolio approach to this theory incorporates the return (loss or gain) together with risk reduction concepts. The empirical results demonstrate the risk reduction effectiveness of stock index futures contracts. Incorporating the influence of hedging on return, it was found that risk reduction in most cases is higher than that of return reduction. But it is not meaningful for the initial years (1996 and 1997) because of thin trading (in terms of volume) compared to the underlying market. The evidence suggests that the index futures contracts can be used as a risk reduction instrument.The fmdings also demonstrate the risk reduction ineffectiveness of CPO futw'es contracts despite high informational efficiency. The hedging did not improve the risk-return performance probably due to the low level of arbitrage efficiency. However after 1993, the return reduction in most cases exceeds the risk reduction in the CPO futures contracts. Contracts that mature within 1 and 2 months, performed better than the distant or expiration month contracts in terms of reduction of risk per unit of returns. An important policy implication of these findings is that futures market authority (CPO) should concentrate on how to transform the market for the hedgers. Supply of adequate capital for hedgers, storer and also for clearinghouse is important to buffer against the shortage of capital due to losses. The reduction of transaction cost could increase the participation of hedgers and arbitrageurs. Coordination between futures industry authority and underlying market authority (especially for CPO futures) is important to increase the performance of the hedging and arbitrage activities. Stock index futures lacks the depth required for effective liquidity. Lack of participation could be due to the lack of knowledge and therefore less confidence to trade in the contracts or high transaction cost. One approach to mitigate this problem is to initiate a nationwide marketing program with intensive training for potential participants. Cost reduction could be another important factor. Participation can be increased if the contracts can be traded on a cost-effective manner