feasibility, forward pricing and returns: recent developments in the literature on futures trading

In recent years the feasibility conditions for market establishment and the information value of futures markets have been central issues in futures market research. This paper first discusses recent developments under the heading of feasibility conditions, including the obsolescence of the commodity characteristics approach and the search for a comprehensive framework. Second, futures markets collect and disseminate information, and in so doing they are centres of rational price formation, and the forms of tests that have been developed to ascertain whether they perform this function efficiently are considered. Futures markets also perform a forward pricing function: their prices may be regarded as market anticipations of subsequent cash prices. 1979s’ literature has addressed this question, finding differences in performance batween continuous and non-continuous inventory commodities. This paper discusses the reasons for and economic implications of these results.

The author is with the Faculty of Economics and Politics, Monash University, Clayton, Victoria, Australia 3168.

Feasibility, forward pricing and returns

Recent developments in the literature on futures trading

Barry A. Goss

In recent years the turnover in the futures trading industry in the USA measured in numbers of contracts traded has shown virtually exponential growth.’ This has been due partly to the switch from other assets to commodities in the face of the worldwide phenomenon of persistent inflation, and partly to the expanded scope of futures trading, which now includes not only the traditional basic raw materials and foodstuffs, but also financial instruments and foreign currencies. Accompanying this broader scope of futures trading has been a revision in the literature on feasibility conditions, although economic research in this area appears to have lagged behind market developments. The first section of this paper discusses the absorption of the traditional ‘commodity approach’ by a maximization of the net benefits approach which emphasizes, inter alia,

the effect on transactions costs of changes in market liquidity, and also the reasons for changes in contractual arrangements.

In the second part the discussion centres on the forward pricing function of futures markets. These markets collect information, and if this information is fully reflected in current futures prices, then these prices may be regarded as market anticipations of subsequent cash prices. Consequently futures markets have not only been tested, in weak and semi-strong form, for efficiency, but the hypothesis has been tested directly that futures prices are unbiassed estimates of maturity date spot prices. The discussion focuses on the second of these approaches.

Feasibility conditions

Futures markets are organized exchanges dealing in financial instruments relating to commodities or other financial instruments for forward delivery or settlement, on standardized terms. On these exchanges a clearing house interposes itself between buyer and seller and guarantees all transactions, so that the identity of the buyer or seller is a matter of indifference to the other party.

In the present state of the literature it would seem to be agreed that the major functions of futures markets include the following. First, they

110 0301-4207/81/0201 IO-08$02.00 0 1981 IPC Business Press


facilitate stockholding because the forward premium acts as a guide to inventory control, and has been interpreted as a price of storage,’ with

the holding of inventories at times of forward discount being explicable in

terms of the convenience yield.’ Second, futures markets facilitate risk management because they pro-

vide facilities for hedging, which is the holding of a futures position, in conjunction with an actuals position of opposite sign, in pursuit of expected gain, subject to a risk constraint. Recently the performance of futures markets as a hedging medium has been investigated from the portfolio viewpoint for some individual commodities’ and for a total asset

portfolio.’ Third, futures markets act as centres for the collection and dissemina-

tion of information, and if this information, including expectations, is fully reflected in current prices, these markets may be said to be efficient. Hence futures markets have been subjected to weak form tests for efficiency, some of which have recently found evidence of dependence” and some of which have not.’ Futures prices have also been subjected to semi-strong form tests for efficiency, some results8 being more favourable to the market under review than others.”

Fourth, futures markets perform a forward pricing function, with the

resultant futures prices being interpreted as market anticipations of subsequent cash prices. In this function, differential performance has been found between continuous and non-continuous inventory commodities, ‘O but not fully explained. ”

To state these functions in this way is to suggest reasons why these markets exist, and hence to some extent begs the question of feasibility conditions: for example, the first function suggests that the presence of inventories will appear as a feasibility condition although we now know this to be obsolete. Evidently, not all markets perform all these functions. We can say that the third and fourth functions have strong survival value, and while the second seems to have been performed by all markets known to the literature, there is no reason why this should be so in the future: that is there is no reason why all participants may not increase their risks by transacting in futures markets. On the other hand one may expect the second function to continue because much of the impetus for market establishment comes from hedgers.

Until around 1973 feasibility conditions were discussed using the

‘commodity approach’, or at least ‘commodity’ conditions formed the basis of any set of conditions employed. A minimum list of such conditions usually contained the following: first, the commodity price should be variable, and second there should be a group of traders with actuals commitments; as a consequence of these two conditions there would be a demand for hedging facilities. A third condition was that the commodity should be deliverable, which brought the cash price and the price of a

maturing future into equality, and fourth the commodity should be storable, which permitted pre-delivery arbitrage between spot and futures markets. Further conditions were that it should be possible to

specify a measurable standard grade, in the interests of contract standardization, and moreover speculative capital should be present to prevent the market being lopsided. Finally, it was acknowledged that there should be adequate financial facilities for market settlement. I2

The major difficulty with this approach was that it simply generalized from past experience, and had little predictive power. The list could not be used to predict the development of markets in non-storable com-

This paper is an edited version of an earlier version presented at the Conference of The Australian Agricultural Economics Society, Adelaide, 12-14 February 1980. The paper draws in part on a wider project on storage and price determination in commodity markets financed by the Australian Research Grants Committee. Thanks are due to conference participants for discussion, to David E.A. Giles for permission to use results from joint research, and to Jenny S. Lau for research assistance. Thanks are also due to the Sydney Futures Exchange, Floor Members of the Exchange, the International Commodities Clearing House and the Australian Wool Corporation for the provision of data. Remaining errors are the sole responsibility of the author.

Commodity Year Book, Commodity Research Bureau, New York, 1979. *H. Working, ‘Futures trading and hedging’, American Economic Review, Vol43,1953, pp 314-343. 3M.J. Brennan, ‘The supply of storage’, American Economic Review, Vol48,1958, pp 50-72. “D.J.S. Rutledge, ‘Hedgers’ demand for future contracts: a theoretical framework with applications to the United States soy- bean complex’, Food Research institute Studies, Vol 11, 1972, pp 237-256; L.H. Ederington, ‘The hedging performance of the new futures markets’, Journal of Finance, Vol XXXIV, No 1, March 1979, pp 157-170. 5K. Dusak, ‘Futures trading and investor returns: an investigation of commodity market risk premiums’, Journal of Political Economy, Vol81,1973, pp 1387-1406. 6Eg T.F. Cargill and G.C. Rausser, ‘Temporal price behaviour in commodity futures markets’, The Journal of Finance, Vol XXX, No4,1975, pp 1043-1053. ‘Eg P.D. Praetz, ‘Testing the efficient markets theory on the Sydney Wool Futures Exchange’, Australian Economic Papers, December 1975, pp 246-249. 8The market for Treasury Bills; see M.J. Hamburger and E.N. Platt, ‘The expectations hypothesis and the efficiency of the Treasury Bill market’, The Review of Econ- omics and Statistics, Vol57, 1975, pp 190- 199. 9The market for hogs; see R.M. Leuthold and P.A. Hartmann, ‘A semi-strong form evaluation of the efficiency of the hog futures market’, American Journal of Agri- cultural Economics, Vol 61, No 3, August 1979, pp 482-489. ‘OW.G. Tomek and R.W. Gray, ‘Temporal relationships among prices on commodity futures markets: their allocatiie and stabilizing roles’, American JoumalofAgti- cultural Economics, Vol 52, No 3, August 1970, pp 372-380; R.M. Leuthold, ‘Measurement of a random process in futures prices’, Food Research Institute Studies, Vol 1, No 3, November 1974, pp 313-324.

RESOURCES POLICY June 1981


“D.E.A. Giles, and B.A. Goss, ‘The predictive quality of futures prices, with an application to the Sydney Wool Futures Market’, Australian Economic Papers, Vol 19, No 351980, pp 291-300. ‘RW. Gray, ‘Why does futures trading succeed or fail? An analysis of selected commodities’, Futures Trading Seminar, Vol Ill, MIMIR, Madison, 1966, emphasized the importance of such factors as contract specification and the customs of spot market traders, which may mean the difference between the possibility of futures trading and its success. “C. Veljanovski, ‘An institutional analysis of futures trading’, Monash University, Australia, mimeo, 1975. ‘“L.G. Telser and H.G. Higinbotham, ‘Organized futures markets: costs and benefits’, Journal of Political Economy, Vol 85,1977, pp 969-1000. ‘Vbid, p 998. 16K. Acheson and J. McManus, ‘The costs of transacting in futures markets’, Carleton University, Ottawa, Discussion Paper No 79-22, 1979. “M.J. Powers and P. Tosini, ‘Commodity futures exchanges and the North-South dialogue’, American Journal of Agricultural Economics, Vol59, No 5, December 1977, pp 977-985.

modities (eg live beef) or non-deliverable commodities (eg share indices, price indices). Economists using this approach did not know what surprise they would encounter next. It is not that the commodities approach was misleading or irrelevant - indeed some of these conditions can still explain success or failure in markets we know - but rather that these factors are crude or partial proxies for the pertinent variables, I3 and at times these proxies are too remote. Hence we expect not that the commodity conditions will be discarded, but that they will be absorbed by a more comprehensive approach.

Let us consider briefly some developments that have occurred to meet this challenge. Telser and Higinbotham’” argue that the success or lack of success of futures markets can be explained in terms of maximization of a net benefit function, which includes, inter alia, turnover and open position variables. Net benefit is the difference between total benefit from and total costs of futures trading, and while the benefit function increases

with respect to all arguments, total costs are an increasing function of turnover and open positions, but a decreasing function of the standard deviation of market clearing prices, so that marginal costs can be negative or U-shaped. The standard deviation, which varies inversely with market liquidity, is predicted to vary inversely with turnover although several other predictions contain ambiguities of sign. Nevertheless, some important results emerge from the empirical section of that paper, which is concerned with 51 commodities for the period 19.59-71.

First, the most actively traded commodities have the most variable prices. This outcome could not be predicted by the theory; although costs and benefits are each increasing functions of price variability, the effect on net benefit is not predictable. Second, while unambiguous predictions for individual components of the cost function are difficult to obtain, the authors found that margin and commission costs varied inversely with turnover, but directly with open interest and average contract price. Third, the standard deviation of market clearing prices was found to vary inversely with turnover as predicted. Moreover, as turnover increases, the ratio of turnover to open interest increases which may be explicable in terms of margin and commission changes. I5

A hypothesis which emerges as an extension of the Telser- Higinbotham argument is that the introduction of futures trading may lower the standard deviation of market prices and hence increase the liquidity of the market. Although not discussed by the authors, one can think of several reasons why this might be so. These include the improved information flow likely to accompany the introduction of futures trading, so that inter-transaction variation in prices due to imperfect knowledge is reduced; moreover, the futures market is impersonal’” and standardized, so that price variation due to personal identity and other aspects of contract specification is eliminated. In addition, most exchanges impose limits on the extent of daily price variation, whereas spot markets usually do not. It has been reported, however, that developing countries using US exchanges have complained that the increased speculation accompanying futures trading increases price variability, ” and it would seem that this hypothesis requires further research. Whatever the outcome in terms of price variation and liquidity for particular markets, the total picture must take into account liquidity externalities, to which Powers and Tosini have drawn attention. Finally, on the Telser and Higinbotham paper, while the analysis and results are helpful, the framework is rather limited in its institutional conception, including

112 RESOURCES POLICY June 1981


contractual possibilities, so that it is difficult to use this analysis to predict,

for example, whether an exchange is likely to introduce a Consumer Price

Index (CPI) futures market, and its likelihood of success. For this reason the framework of Veljanovski’* seems potentially

powerful, although at this stage it has not been the subject of empirical work. He argues that futures markets develop when spot markets become an inefficient means of transferring certain property rights to commodities. Like Telser and Higinbotham, he shows that choice can be made among contractual arrangements on the basis of maximum net benefit, taking into account transactions costs. The same analysis can be used to show why futures trading is non-existent in some commodities. His ‘elasticity of contractual substitution’ expresses the change in contractual form in relation to changes in transaction costs. Veljanovski emphasizes that spot markets have a comparative advantage as delivery markets, but that futures markets have a comparative advantage in the temporary transfer of certain bundles of property rights between traders seeking gain, subject to a risk constraint.

The idea that the spot market has a comparative advantage as a delivery market is the point of departure for Acheson and McManus,‘” who argue that while the futures market is always impersonal (the identity of the other transacting party is of no interest to a trader) the spot market may be personal or impersonal. If the spot market is personal then spot contracts will be incomplete, some attributes being subjectively evaluated by traders. If the futures contract attempts to fully describe the good, higher measurement costs will be imposed on sellers, thus raising the ask-bid spread and hence transaction costs. If the futures contract incompletely describes the good, any buyer who takes delivery will of course receive the cheapest eligible grade. Buyers will know this, and this knowledge will depress the futures price relative to spot, thus creating high hedging costs for shorts. Hence the absence or failure of futures markets in some commodities is explained in terms of excessive spot premium, although this theory has yet to be confronted with empirical work.

While these ideas were emerging in the literature, those economists writing feasibility studies were making their own informal assessments of the costs and benefits of the establishment of new markets, although generally speaking the profession learns little about these studies because they are usually prepared as confidential documents. For example, the terms of reference imposed by the Hong Kong government required that feasibility studies for the South East Asia Commodity Exchange analyse the potential benefits to traders in Hong Kong, with special reference to cotton textiles. In some cases the costs of non-economic factors had to be taken into account. Such factors may explain why an Australian futures exchange in copper and zinc”” never got off the ground.

The forward pricing function of futures markets

Futures markets collect, process and disseminate information. Among the main items of information produced is the futures price. If the market

Weljanovski, op tit, Ref 13. fully utilizes all available information it is said to be efficient, and futures “‘Acheson and McManus, op tit, Ref 16. 20The present author prepared a feasibility

markets have been tested for efficiency as mentioned in the first section.

study on this in 1971, part of which was If all information, incuding traders’ expectations, is fully reflected in

discussed in the press, Australian Financial current prices, then the best market anticipation of the price relating to a Review, 1976. later date is the current price, and both spot and futures prices may each

RESOURCES POLICY June 1981 113

Feasibility, forwardpricing and returns

ZIH. Working, ‘Quotations on commodity futures as price forecasts’, Econometrica, Vol 10.1942, pp 39-52. =H. Workina. ‘The theorv of vice of storage’, An-krican Econorrhc Review, Vol 39, December 1949, pp 1254-1262. 23Giles and Goss, op tit, Ref 11. %.A. Goss, ‘The forward pricing function of the London Metal Exchange’, Applied Economics, June 1981.

be regarded as estimates of subsequent spot prices. Hence if the market exhibits a forward premium in relation to a future date, this is not a prediction that prices will rise, but a market-estimated carrying charge.” Similarly, if the market exhibits a spot premium, this is not a prediction that spot prices will fall, but a market-estimated inverse carrying charge. This at least was the interpretation for continuously storable commodities, based on the price of storage theory.” Hence futures prices have been interpreted as market predictions of maturity date spot prices, although technically speaking they are not predictions but rationally formed prices relating to future delivery or settlement.

On the assumptions that the market is competitive, that information is used rationally, and that economic agents are risk neutral, we can put forward the hypothesis that the current futures price is an unbiassed estimate of the spot price at the maturity date of the future. This hypothesis is conditional on the set of information available at the time the futures price is formed.

In general terms we may represent the hypothesis as:

P t,m = E(At+k 4)

where: Pt,m = current futures price with maturity m; At+k = spot price k periods ahead - normally we would be interested in the case where t+k = m; Z, = set of information available at time f.

The spot and futures prices may be measured in absolute or logarithmic terms; if the latter is used, then

cQnAt+ k -lznpr,m)

is an approximate measure of the rate of return to a long speculative position, which is zero on the hypothesis.

If the market is efficient we would expect the hypothesis to be accepted, but rejection of the hypothesis does not necessarily imply that the market is inefficient, because for example the risk neutrality assumption may not hold, or there may have been unexpected intervention in the market during the sample period.

Two main methods of testing the unbiassed estimation hypothesis have been employed (as distinct from testing the hypothesis of market efficiency directly). One method has used the linear function

A t+k - -cK+fiPtm fu, (2) (z+ is a disturbance term) and has estimated the coefficients of this relation by regression methods, testing the joint hypothesis that (Y = 0 and p= 1.

However, if (2) is underspecified, we would expect to find serious autocorrelation among the residuals, especially if monthly average data are used, and hence the ordinary least squares (OLS) standard errors will be understated. Moreover, with autocorrelated errors and a lagged endo- genous variable, the OLS estimates of Q: and pIwill be both biassed and inconsistent. A more appropriate method of estimation therefore is by instrumental variables and this method has been used by Giles and GossZ3 and Goss’+’ (although the t, Durbin-Watson and Wallis test statistics are only approximately valid for this procedure).

An alternative procedure which has been employed is to regress the current forecast error on recent forecast errors for the same commodity, using the form



=Hamburger and Platt, op

Vol 11,1972, pp 313-341, gives a fuller explanation for potatoes. The evidence on potatoes is not unambiguous. B.S. Yamey, ‘Continuous inventories, futures prices and prophecies’;

self-fulfilling mimeo, London School 2

Economics, 1977. found that the relative inferiority of potato futures prices as predictors was greater during intraseasonal periods (in the presence of inventories) than during inter-seasonal periods (when inventories were discontinuous). “Giles and Goss, op tit, Ref Il.

A t+k ) -pf m = a+ PI& -Pf_k,f) (3)

+ PAAf_, -p,-k-, ,f-,) f. . . Vf

This procedure may be extended by regressing the current forecast error for a particular commodity on recent own and other related forecast errors, using the form

A t+k , -‘tm = OL +=&(Ajt-Pj f_k,r) + vrf (4) j=l

for IZ commodities (vfr vlf are disturbance terms). While (3) is a weak form test of market efficiency, (4) is a semi-strong form test, because it is concerned with whether the market is efficiently using all publicly available information. Most US and Australian empirical work on agricultural commodities and minerals has employed functions of the form of (2), while Hamburger and PlatVs used a function of the form of (3) for US Treasury Bills, and Hansen and Hodrickz6 used (3) and (4) for foreign exchange.

In their semi-strong form test of the efficiency of the US hogs market Leuthold and Hartmann”’ estimated a function of the form

where Et m is a rival predictor of At+k (for example derived from a forecast&g agency or an econometric model) and Et is a disturbance term. A priori the more efficient predictor can be expected to have the larger coefficient, and while at times the futures price did outperform its rival, changes in Pt itself were found to be predictable, supporting the view that the hogs market had not fully utilized all information.

The evidence to date supports the view that futures prices are unbiassed predictors for a range of US continuous inventory agricultural commodities such as corn, soybeans and coffee,” for Australia wool,“’ for tin, copper and zinc on the London Metal Exchange (LME),” and for some currencies.3’ On the other hand the evidence does not support the unbiassed prediction hypothesis for discontinuous inventory commodities such as potatoes3z or non-inventory commodities such as US and Australian finished live beef cattle (with lags greater than three months from maturity) ,33 nor for US Treasury Bills” nor for lead on the LME. 35 The reasons for the differential performance of the continuous and non-continuous inventory commodities are still under discussion. Leuthold has offered an explanation for the brief efficient prediction period for beef in terms of the typical hedging period, and Kofi sought an explanation in terms of the quality of information on demand and supply conditions. While there is some support for the latter, the hypothesis that the predictive performance of futures prices varies directly with the degree of price administration can also be supported on the same evidence. Tomek and Gray attempted to account for this difference in predictive performance (at least in the case of potatoes) with the suggestion that the futures price represents expectations only, although this explanation is perhaps incomplete because the expectations are always wrong and exhibit no learning process. 36

Other reasons suggested for this phenomenon are that the discontinuous and non-inventory markets are newer, with relatively smaller trading volumes. This hypothesis was tested by Giles and Goss3’ for wool on the Sydney Futures Exchange, where the predictive performance of



wool futures prices for 1963-67 (a youthful period for the exchange) was compared with that for 1968-78, and found to be inferior. Another suggestion advanced is that the absence of inventories increases the possibility of expectational error, because there is less opportunity for arbitrage between the spot and futures markets.

Although the forward Treasury Bill rate had little predictive power, it nevertheless performed better than other monetary variables in a semi- strong form test. j8 The comparatively poor performance of lead futures prices compared with those of other non-ferrous metals on the LME is difficult to explain. A possible reason is that traders in this commodity may be risk averse, although why this should be more important for lead than for copper, zinc and tin is impossible to say. A more appealing suggestion is that the lead market, with its higher scrap recovery rate, is more susceptible to personal consideration in the spot market, and in terms of the Acheson-McManus approach3’ this may depress the futures price relative to the spot price resulting in biassed estimation.

Finally we may ask what are the implications of futures prices perform- ing their forward pricing function as unbiassed estimates of subsequent cash prices. First, economic agents using such futures prices for forward contract pricing or for tendering for forward contracts will be as well off on average as if they had known the maturity date cash price in advance. On the other hand economic agents using futures prices which are not unbiassed estimates, for such purposes will find themselves taking unexpected profits or losses. This does not necessarily mean that traders in the latter category should not use those (biassed) markets for hedging purposes. If the futures market is biassed downwards, short hedgers will have to trade off the hedging costs of those markets against the risks of being unhedged. Moreover, economic agents would be wise to use futures prices in such markets for forward contract purposes, because even though biassed, these prices are likely to be more accurate anticipations of subsequent cash prices than the price expectations of individual

economic agents. Second, if futures prices are unbiassed estimates of subsequent cash

prices, then greater coordination of plans, which futures trading facili- tates, will be achieved than otherwise. If plans are poorly coordinated, then revision of plans, in the light of expost errors, is necessary, because of the misallocation of economic resources. Improved coordination

means that part of these adjustment costs will be avoided. 38Hamburger and Platt, op tit, Ref 25. R.J. Rendleman and C.E. Carabini, ‘The efficiency of the Treasury Bill futures Returns to traders market’, The Journal of Finance, Vol XXXIV, No4, Sept 1979, pp895-914, found evidence of a slight inefficiency in the

In an efficient market the expected rate of return to a persistent specul-

Treasury Bill futures market. Ederington, ative position is zero, although professional speculators, by virtue of their

op tit, Ref 4, found that the Ginny Maes expertise in forecasting short-term price changes, may earn positive futures market was a superior hedging medium to the T-Bill market, from a portfolio

profits. Their comparative advantage is enhanced if they have access to

viewpoint. information which is not freely available. Because futures trading is a

39Acheson and McManus, op tit, Fief 16. zero-sum game professional speculators may earn their profits at the “‘C.S. Rockwell, ‘Normal backwardization, expense of other speculators who are less expert at forecasting price forecasting, and the returns for commodity _ futures traders’, Food Research Institute

changes, or at the expense of hedgers who are pursuing their objectives

Studies, Vol7, 1967, Supplement, pp 107- subject to risk constraint, or both. Discretionary hedgers who success- 130. fullv forecast price and/or basis changes may also earn positive profits, “‘H.S. Houthakker, ‘Can speculators d

_

forecast prices?‘, Review of Economics although at times this may require short hedgers taking a long position in

and Statistics, Vol XXXIX, No 2, May 1957, futures, and vice versa for long hedgers. pp 143-151. RockwelP applied the method of HouthakkeP to data for 25 US



found that

Conclusions

In this paper we have discussed some recent developments in the literature on futures trading. In the first section we saw that in the search for a feasibility framework with predictive power, the traditional commodity characteristics approach is being absorbed by models which hypo- thesize that active futures markets develop where maximization of net benefits indicates that type of arrangement, taking into account in particular the liquidity impact of futures trading, the transactions costs of contract specification and enforcement, and the comparative benefits of other contractual arrangements.

In the second section we saw that efficient futures markets can be expected to form prices which are unbiassed estimates of subsequent cash prices, although rejection of the unbiassed estimation hypothesis does not necessarily mean that the market is inefficient. Empirical work to date indicates that continuous inventory commodities perform the forward pricing function better than non-continuous inventory commodities, although at this stage it is not possible to say to what extent this difference is due to the lack of inventories per se (because inventories

4ZB.A. Goss, Monash University, Australia, have an information value), relative youthfulness of the non-continuous Economics Seminar Paper No 4/80,1980. inventory exchanges, or to other factors.


feasibility, forward pricing and returns: recent developments in the literature on futures trading

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