“Futures Market Hedging and the Behavior of Commodity Prices” by Arjun CHATRATH
University of Portland
Several contributors to the Theory of Commodity Prices are of the opinion that there exist very close links between the distribution of spot prices and the supply shocks arising from the rise and fall of speculative interests in inventories. An important implication is that the behavior of spot prices, especially the autocorrelation and conditional variance, will be regime-dependent. The question of the role such regime behavior might play in the evidence of the relatively weak relationship between commodity spot and futures prices remains to be addressed. We test for regime-behavior in the daily price evolution in three commodity markets, corn, cotton, and soybeans, where any supply shocks are limited to harvest and storage alone. The results on the patterns of autocorrelation and conditional variance are mostly inconsistent with the Theory. For instance, the Theory predicts that the autocorrelation will be at the highest levels at times of plenty, i.e., when stocks are at their highest. Instead, we document patterns of periodicity that are mostly consistent with the arguments in Deaton and Laroque (1996) that demand shocks, and factors other than speculative inventories, are driving the observed patterns in commodity prices. We assess the extent to which the observed patterns are responsible for the evidence of poor hedging effectiveness (large basis risk) of commodity futures contracts. We note modest gains in hedging effectiveness when existing static and dynamic techniques are augmented with seasonal and threshold-price controls.