Limits to arbitrage and hedging: Evidence from commodity markets

We build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases in producers' hedging demand or speculators' capital constraints increase hedging costs via price-pressure on futures. These in turn affect producers' equilibrium hedging and supply decision inducing a link between a financial friction in the futures market and the commodity spot prices. Consistent with the model, measures of producers' propensity to hedge forecasts futures returns and spot prices in oil and gas market data from 1979 to 2010. The component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to financial arbitrage generate limits to hedging by producers, and affect equilibrium commodity supply and prices.     

Information transmission in informationally linked markets: Evidence from US and Chinese commodity futures markets

This paper investigates information transmission and price discovery in informationally linked markets within the multivariate generalized autoregressive conditional heteroskedasticity and information share frameworks. Based on both synchronous and non-synchronous trading information from Chinese futures/spot markets, the New York Mercantile Exchange (NYMEX), Chicago Board of Trade (CBOT), and CME Globex futures markets for copper and soybeans, we show that there is a bidirectional relationship in terms of price and volatility spillovers between US and Chinese markets, with a stronger effect from US to Chinese markets than the other way around. Additionally, the NYMEX and CBOT play a more important role than the CME Globex in the flow of information from US to Chinese markets. Moreover, we find that Chinese copper market adjusts more quickly than the NYMEX copper market to correct the disparity between both markets. However, the converse is true in the case of soybeans. Finally, our results highlight the remarkable role of Chinese futures markets in the price formation process, though NYMEX and CBOT futures markets are the main driving force in price discovery.     

Momentum strategies in commodity futures markets

The article tests for the presence of short-term continuation and long-term reversal in commodity futures prices. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies that generate 9.38% average return a year. A closer analysis of the constituents of the long–short portfolios reveals that the momentum strategies buy backwardated contracts and sell contangoed contracts. The correlation between the momentum returns and the returns of traditional asset classes is also found to be low, making the commodity-based relative-strength portfolios excellent candidates for inclusion in well-diversified portfolios.     

Are options redundant? Further evidence from currency futures markets

This paper investigates the impact of the introduction of options on the underlying asset's price formation process, using Geweke feedback measures. We derive the feedback measures from the Deutsche Mark, British Pound, Swiss Franc, Japanese Yen and Canadian Dollar futures and spot prices, before and after the introduction of options for these currency futures. While each currency market maintains some distinct characteristics in the post-option period, a common theme is found: after the option introduction, the instantaneous feedback between spot and futures markets improves drastically. The feedback from the spot to the futures market tends to decrease and remains small. The feedback from the futures market to the spot market tends to decrease as well. These results confirm the dominance of options markets, probably due to their smaller transaction costs. When made available, options assume a leading role for information transmission in currency markets.     

Does futures exhibit maturity effect? New evidence from an extensive set of US and foreign futures contracts

In a seminal article, Samuelson (1965) [Samuelson, P. A. (1965), “Proof that properly anticipated prices fluctuate randomly,” Industrial Management Review 6, 41-49.] proposes the maturity effect that the volatility of futures prices should increase as futures contract approaches maturity. This study provides new evidence on the maturity effect by examining a more extensive set of futures contracts than previous studies and analyzing each contract separately. Using 6805 futures contracts drawn from 61 commodities, including some data from non-US markets, we find that the maturity effect is absent in the majority of contracts. In addition, the maturity effect tends to be stronger in agricultural and energy commodities than in financial futures. We also examine the hypothesis in Bessembinder et al. (1996) [Bessembinder, H., J. F. Coughenour, P. J. Seguin, & M. M. Smoller (1996), “Is there a term structure of futures volatilities? Reevaluating the Samuelson hypothesis,” Journal of Derivatives 4, 45-58.], which states that negative covariance between the spot price and net carry cost causes the maturity effect in futures. Our results provide very weak evidence in favor of this hypothesis.     

Capturing the risk premium of commodity futures: The role of hedging pressure

We construct long–short factor mimicking portfolios that capture the hedging pressure risk premium of commodity futures. We consider single sorts based on the open interests of hedgers or speculators, as well as double sorts based on both positions. The long–short hedging pressure portfolios are priced cross-sectionally and present Sharpe ratios that systematically exceed those of long-only benchmarks. Further tests show that the hedging pressure risk premiums rise with the volatility of commodity futures markets and that the predictive power of hedging pressure over cross-sectional commodity futures returns is different from the previously documented forecasting power of past returns and the slope of the term structure.     

Tactical allocation in commodity futures markets: Combining momentum and term structure signals

This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66%, respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, our double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. The abnormal performance of the combined portfolios cannot be explained by a lack of liquidity, data mining or transaction costs.     

Regime switching correlation hedging

This paper investigates the hedging effectiveness of commodity futures when the correlations of spot and futures returns are subject to multi-state regime shifts. An independent switching dynamic conditional correlation GARCH (IS-DCC) which is free from the problems of path-dependency and recombining is applied to model multi-regime switching correlations. The results of hedging exercises indicate that state-dependent IS-DCC outperforms state-independent DCC GARCH and three-state IS-DCC exhibits superior hedging effectiveness, illustrating importance of modeling higher-state switching correlations for dynamic futures hedging.     

Cojumping: Evidence from the US Treasury bond and futures markets

The basis between spot and future prices will be affected by jump behavior in each asset price, challenging intraday hedging strategies. Using formal cojumping tests this paper considers the cojumping behavior of spot and futures prices in high frequency US Treasury data. Cojumping occurs most frequently at shorter maturities and higher sampling frequencies. We find that the probability of cojumping is altered by the presence of an anticipated macroeconomic news announcement. The probability of cojumping is particularly affected by news surprises in non-farm payrolls, CPI, GDP and retail sales. However, the two cojumping tests are also more likely to provide contradictory results in the presence of surprises in non-farm payrolls. On these occasions the market does not clearly signal its short term pricing behavior.     

Stock index futures arbitrage in emerging markets: Polish evidence

The efficiency of the market for stock index futures and profitability of arbitrage for contracts on the Warsaw Stock Exchange Index WIG20 is studied in this paper. The Polish market has unique attributes: in a relatively short time the risk-free interest rate has decreased significantly, short sale cannot be used to construct an arbitrage position by institutional investors, and the dividends are small and paid in an irregular manner. Examining intraday transaction data shows that ex post and ex ante violations for short arbitrage reveal almost all properties of a mature market. Nonetheless, findings for long arbitrage indicate inefficiency of the market.     

Asset market linkages: Evidence from financial, commodity and real estate assets

We use a general Markov switching model to examine the relationships between returns over three different asset classes: financial assets (US stocks and Treasury bonds), commodities (oil and gold) and real estate assets (US Case-Shiller index). We confirm the existence of two distinct regimes: a “tranquil” regime with periods of economic expansion and a “crisis” regime with periods of economic decline. The tranquil regime is characterized by lower volatility and significantly positive stock returns. During these periods, there is also evidence of a flight from quality - from gold to stocks. By contrast, the crisis regime is characterized by higher volatility and sharply negative stock returns, along with evidence of contagion between stocks, oil and real estate. Furthermore, during these periods, there is strong evidence of a flight to quality - from stocks to Treasury bonds.     

Correlation dynamics in equity markets: evidence from India

This study is aimed at understanding the correlation dynamics of the equity markets from a developing country perspective using daily data from July 1997 to August 2006. A simple unconditional correlation estimate and dynamic time varying correlation estimate from a DCC-MVGARCH of Engle and Sheppard (2001) are derived for S&P CNX Nifty and other 10 world indices that includes four developed and six Asian country indices. The results show low correlation across S&P CNX Nifty with both Asian and developed nations. In addition a Logistic Smooth Transition Regression (LSTR) model is implemented and finds that the S&P CNX Nifty index is moving towards a better integration with other world markets but not at a very noteworthy phase. The low correlation provides space for the global funds to diversify risk in Indian markets.     

International transmission of information: evidence from the Euroyen and Eurodollar futures markets

This paper examines the information transmission between Japan and the US by using the Tokyo Euroyen and Chicago Eurodollar futures. These two interest rate futures markets provide a better understanding of international information transmission than stock markets, which have been shown to exhibit nonsynchronous trading and market segmentation. The results show that traders in Tokyo (Chicago) use information that is revealed overnight in Chicago (Tokyo). The bivariate EGARCH-t model provides no evidence of volatility spillovers in either direction, suggesting that the opening price rapidly reflects foreign information. The overall results support the hypothesis that the domestic market efficiently adjusts to foreign news. The results are also broadly consistent with the covered interest arbitrage effects.     

Empirical performance of multifactor term structure models for pricing and hedging Eurodollar futures options

This article compares two one-factor, two two-factor, two three-factor models in the HJM class and Black's [Black, F. (1976). The pricing of commodity contracts. Journal of Financial Economics, 3, 167-179.] implied volatility function in terms of their pricing and hedging performance for Eurodollar futures options across strikes and maturities from 1 Jan 2000 to 31 Dec 2002. We find that three-factor models perform the best for 1-day and 1-week prediction, as well as for 5-day and 20-day hedging. The moneyness bias and the maturity bias appear for all models, but the three-factor models produce lower bias. Three-factor models also outperform other models in hedging, in particular for away-from-the-money and long-dated options. Making Black's volatility a square root or exponential function performs similar to one-factor HJM models in pricing, but not in hedging. Correctly specified and calibrated multifactor models are thus important and cannot be replaced by one-factor models in pricing or hedging interest rate contingent claims.     

Bubbles in food commodity markets: Four decades of evidence

We use daily prices from individual futures contracts to test whether speculative bubbles exist in 12 agricultural markets and to identify whether patterns of bubble behavior exist over time. The samples begin as far back as 1970 and run through 2011. The findings demonstrate that all 12 agricultural markets experienced multiple periods of price explosiveness. However, bubble episodes represent a very small portion—between 1.5 and 2%—of price behavior during the 42-year period. In addition, most bubbles are short-lived with 80–90% lasting fewer than 10 days. Though receiving far less attention, negative bubbles contribute significantly to price behavior, accounting for more than one-third of explosive episodes. Markets over-react during both positive and negative explosive episodes, leading to a correction as they return to a random walk. This adjustment back to fundamental values is most pronounced with positive bubbles particularly in the earlier part of the sample. While the magnitudes of the corrections are generally small, there were a few instances of significant increases in prices and large over-reactions, most notably in the softs (e.g., cocoa 1973, coffee 1994, cotton 2010). We also find that explosive periods did not become more common or last longer in the second half of the sample period and that the most recent bubble episodes may not have been as severe as in mid-1970s.     

Analytical pricing of discretely monitored Asian-style options: Theory and application to commodity markets

We compute an analytical expression for the moment generating function of the joint random vector consisting of a spot price and its discretely monitored average for a large class of square-root price dynamics. This result, combined with the Fourier transform pricing method proposed by Carr and Madan [Carr, P., Madan D., 1999. Option valuation using the fast Fourier transform. Journal of Computational Finance 2(4), Summer, 61–73] allows us to derive a closed-form formula for the fair value of discretely monitored Asian-style options. Our analysis encompasses the case of commodity price dynamics displaying mean reversion and jointly fitting a quoted futures curve and the seasonal structure of spot price volatility. Four tests are conducted to assess the relative performance of the pricing procedure stemming from our formulae. Empirical results based on natural gas data from NYMEX and corn data from CBOT show a remarkable improvement over the main alternative techniques developed for pricing Asian-style options within the market standard framework of geometric Brownian motion.     

Identifying VARS based on high frequency futures data

Using the prices of federal funds futures contracts, we measure the impact of the surprise component of Federal Reserve policy decisions on the expected future trajectory of interest rates. We show how this information can be used to identify the effects of a monetary policy shock in a standard VAR. This alternative approach to identification is quite different, and, we argue, more plausible, than the conventional identifying restrictions. We find that a usual recursive identification of the model is rejected, as is any identification that insists on a monetary policy shock having an exactly zero effect on prices contemporaneously. We nevertheless agree with the conclusion of much of the VAR literature that only a small fraction of the variance of output can be attributed to monetary policy shocks.     

Trend-following trading strategies in commodity futures: A re-examination

This paper examines the performance of trend-following trading strategies in commodity futures markets using a monthly dataset spanning 48 years and 28 markets. We find that all parameterizations of the dual moving average crossover and channel strategies that we implement yield positive mean excess returns net of transactions costs in at least 22 of the 28 markets. When we pool our results across markets, we show that all of the trading rules earn hugely significant positive returns that prevail over most subperiods of the data as well. These results are robust with respect to the set of commodities the trading rules are implemented with, distributional assumptions, data-mining adjustments and transactions costs, and help resolve divergent evidence in the extant literature regarding the performance of momentum and pure trend-following strategies that is otherwise difficult to explain.     

The Samuelson hypothesis in futures markets: An analysis using intraday data

This paper considers the Samuelson hypothesis, which argues that the futures price volatility increases as the futures contract approaches its expiration. Utilizing intraday data from 20 futures markets in six futures exchanges, we find strong support for the Samuelson hypothesis in agricultural futures. However, the Samuelson hypothesis does not hold for other futures contracts. We also provide supporting evidence that the ‘negative covariance’ hypothesis is the key factor for the empirical support of the Samuelson hypothesis. In addition, our findings remain largely unaltered even after we control for seasonality and liquidity effects.     

Mean reversion in stock market prices: New evidence based on bull and bear markets

In this paper we test whether mean reversion in stock market prices presents a different behavior in bull and bear markets. We date the US bull and bear periods using Bry and Boschan (1971) algorithm. We examine the order of integration in the S&P 500 stock market index covering a daily period from August 1929 to December 2006 in bull and bear phases. Our results indicate the existence of different episodes of mean reversion, which mainly correspond to bull market periods.