Price Discovery in the Presence of Embedded Location Options: The Evidence from Chana Contracts in India

The presence of embedded location options in agricultural commodity futures contracts allows for several additional deliverable locations in addition to the reference location for the delivery of the underlying asset using location specific adjustments to futures settlement prices. Price discovery contribution assessment in this context needs to be done simultaneously across futures and cash markets in all these deliverable locations in contrast to present bivariate studies in the Indian context, which only consider futures and the cash market at reference location. We assess price discovery contributions across all the deliverable cash markets and the most liquid futures contract for Chana (Gram/Chickpea) in India. We find that while futures lead price discovery as expected, the cash market at the reference location plays almost no role in price discovery with cash markets at additional deliverable locations playing a larger than expected role. We interpret these results as arising from large values of location options for Chana due to inappropriate specifications of deliverable asset locations and associated premiums and discounts. These results provide evidence that exchanges and regulators need to monitor option values and optimize delivery specifications of futures contracts so that they perform their functions of price discovery and risk transfer well.