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Portfolio Diversification, Futures Markets, and Uncertain Consumption Prices

Peter Berck; Stephen G. Cecchetti

American Journal of Agricultural Economics, Vol. 67, No. 3. (Aug., 1985), pp. 497-507.

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Portfolio Diversification, Futures Markets, and Uncertain Consumption Prices Peter Berck and Stephen G. Cecchetti

This paper examines the robustness of the Keynes-Hicks backwardation hypothesis for futures markets in a model that admits diversification and inflation protection as speculative motives. It presents a criterion in terms of the correlation of futures price with anticipated consumption net of other asset holdings for the Keynes-Hicks proposition to be true. The paper finds the effect of changes in net wealth and commodity demand on the risk premium, spread, open interest, and storage.

Key word: futures.

The conditions for a futures market to have contracts outstanding, for hedgers to pay speculators to accept risk, and for the futures markets to affect commodity storage are re- lated to the characteristics of both the underly- ing commodity market and the assets market. The important features of the commodity market include the demand in each period and the costs of storage, while the characteristics of the assets market include the size, composi- tion, and return on the economy's wealth. In the context of a two-period model with infla- tion, uncertain prices, and uncertain asset re- turns, this paper studies the way in which these components of economic structure af-fect observed outcomes in a futures market.

One important futures market outcome is the risk premium. In the Keynes-Hicks (KH) view of futures markets, hedgers pay speculators a risk premium for the insurance services the speculators offer. As a theoretical proposition, the KH view depends on the premise that speculators increase their risk when they buy futures.' However, empirical

Peter Berck is an associate professor, Department of Agricultural and Resource Economics, University of California, Berkeley; Stephen G. Cecchetti is an assistant professor of economics, Graduate School of Business Administration, New York Univer- sity.

Giannini Foundation Paper No. 737 (reprint identification onlv). Thanks are due to Vincent Crawford, Stephen Figlewski, Law-

rence White, and anonymous referees for comments on earlier versions of this paper. Responsibility for remaining errors is solely that of the authors.

Review was coordinated by Peter Helmberger, associate editor. ' Hirshleifer constructs a model in which only differences in

belief matter. Differing expectations on the part of hedgers and speculators as groups, a possibility which is discounted, could lead to payment observationally equivalent to a risk premium.

evidence, such as that presented in the Cootner (1%0a,b)-Telser debate, lends only weak support to the KH proposition and its premise. The robustness of the KH proposi- tion is examined in an equilibrium model of cash and futures markets that admits diver- sification and inflation protection as specula- tive motives, and, therefore, need not yield the KH proposition. In this general model, a simple criterion for the validity of the KH proposition is presented. It is found that the size of the risk premium, and whether or not the KH hypothesis holds, depend on the size and sign of the covariance of the futures price with (risk-adjusted) anticipated second-period consumption net of other asset holdings.

The success or failure of a futures market is measured by the size of the open interest-the number of contracts outstanding. Economic attributes that lead to a large open interest include a high level of demand in future pe- riods, low storage costs, and the ability of individuals in the economy to trade risk suc- cessfully. Risk trades are most successful when the commodity represents a small per- centage of aggregate real wealth and consump- tion and the individuals are sufficiently risk averse.

The paper is organized in five parts, begin- ning with this introduction. The second part presents the pricing of assets in a two-period world where both second-period asset payoffs and second-period consumption prices are un- certain. It is an extension of both Stein's model, where storage is endogenous, and Stoll's model of futures as part of a complete

Copyright 1985 American Agricultural Economics Association

capital market. It makes use of Berck and Cecchetti's earlier results on consumers which are very similar to those of Stiglitz. In the third section, the model is solved for the equilib- rium values of storage, open interest, the risk premium, and other variables. The fourth sec- tion presents the conditions under which the KH proposition is true and examines how the open interest, risk premium, etc., change with demand, storage costs, and wealth. The next section discusses the results and presents some further conclusions. Finally, there are two appendices that provide the formal math- ematical arguments for the fourth section.

Asset-Pricing Equations

Consider the portfolio problem of dividing wealth, W, among assets, z, at purchase prices, s, to maximize expected utility when both second-period asset prices and consump- tion prices are uncertain. Expanding the first- order conditions for this problem in a Taylor series (as Arrow and Pratt did for the direct utility function) gives both a risk premium and an asset-pricing equation in terms of expected real return (for a demonstration that third- order terms could matter-a problem we as- sume away for the sake of the algebra in the last section-see Stiglitz). The expected real return is approximately the expected nominal return less the covariance of the asset's return with the cost of a unit step along the income expansion path, which is the inflation pre- mium. The risk premium can be characterized by the covariance of the asset's return with the entire asset portfolio net of anticipated con-sumption. When applied to pricing futures, these equations are found to differ from con- stant consumption price asset-pricing equa- tions in their inclusion of terms related to second-period consumption. They differ from the equations of Grauer and Litzenberger in their use of a Taylor expansion and their ad- mission of nonhomothetic utility functions as well as their emphasis on second-period con- sumption rather than on covariance of margi- nal utility and real price.2

The wealth holder's problem is to maximize utility subject to an endowment constraint in the face of uncertainty posed by unknown

2 The model presented here is similar to Stoll in its mean-variance approach to the market for futures. This paper extends Stoll's model by making the quantity of the commodity to be stored endogenous.

Atnrr. J . A g r . Ecnti.

asset and consumption goods prices. Define the N-dimensional vector p with the first M elements containing the stochastic asset prices and the remaining elements containing the stochastic consumption goods prices. Simi-larly, the vectors z and s are N-dimensional with their last N-M elements equal to zero. The utility maximization problem can be stated formally as

(1) max E [t'(plz. p)] subject to s '2 = W

where E is the expectation operator; t' is the indirect utility function defined as the maxi- mum utility attainable at a given level of in- come, y = p'z; and p is prices.

Equation (1) differs from the usual expected utility problem because it includes prices twice. Prices change both the value of in- come-producing assets and the cost of pur- chased goods. For instance, the value of wheat producers' assets depends greatly on the price of wheat, but the gain from a price increase is partially offset by an increase in food prices.

Assuming that the first and ith assets are both included in an optimal portfolio and that s, # 0, the first-order condition for this prob- lem is:

The ratio of asset prices equals the rate of asset substitution, or

A futures contract is an asset that (in its perfect form) costs nothing (s, = 0) and pays off its closing or settlement price, pF, less its opening price, PFO. Applying this definition to equation (2) gives a more general form (not restricted by homotheticity) of the Grauer- Litzenberger asset-pricing equation for fu-tures,

This first-order condition can be extended to the case of an imperfect future (one for which s, f 0) by pri

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