The impact of embedded location options on price discovery of agricultural futures contracts – the evidence from the Chana contract

Abstract

Purpose: Embedded options can create asymmetries in information impounded by cash and futures markets, causing errors in price discovery estimation. This paper aims to investigate the impact of embedded location options on measures of price discovery. Design/methodology/approach: Various price discovery metrics are computed using observed futures prices that contain embedded location options and cash prices for Chana. Prices of a futures contract that contains no options using observed futures prices and estimates of location option value are synthesized. The price discovery measures are recomputed using synthetic option-adjusted futures contract prices and cash prices, and changes in these measures are attributed to the impact of the embedded location option. Findings: If the presence of the location option is ignored, futures appear to dominate price discovery. Once the location option is adjusted for, cash markets are found to dominate price discovery. Research limitations/implications: The lack of complete time-series data from the exchange for multiple commodities allows only limited empirical evidence for generalizing conclusions. Practical implications: This paper highlights that regulators, exchanges and policymakers in India need to revisit delivery specifications of agricultural commodity futures contracts to enhance their utility from a price discovery perspective. Originality/value: This work shows that ignoring the presence of embedded options can cause significant errors in price discovery assessment of agricultural futures contracts, particularly in heterogenous cash markets. © 2021, Emerald Publishing Limited.