Modelling and measuring price discovery in commodity markets
Abstract
no procede In this paper we present an equilibrium model of commodity spot (st ) and futures (ft ) prices,
with finite elasticity of arbitrage services and convenience yields. By explicitly incorporating and
modelling endogenously the convenience yield, our theoretical model is able to capture the existence
of backwardation or contango in the long-run spot-futures equilibrium relationship, st D _2ft C _3.
When the slope of the cointegrating vector _2 > 1._2 < 1/ the market is under long run backwardation
(contango). It is the first time in this literature in which the theoretical possibility of finding a cointegrating
vector different from the standard _2 D 1 is formally considered.
Independent of the value of _2, this paper shows that the equilibrium model admits an economically
meaningful Error Correction Representation, where the linear combination of (st ) and (ft ) characterizing
the price discovery process in the framework of Garbade and Silber (1983), coincides exactly with the
permanent component of the Gonzalo and Granger (1995) Permanent_Transitory decomposition. This
linear combination depends on the elasticity of arbitrage services and is determined by the relative
liquidity traded in the spot and futures markets. Such outcome not only provides a theoretical justification
for this Permanent_Transitory decomposition; but it offers a simple way of detecting which of the two
prices is dominant in the price discovery process.
All the results are testable, as can be seen in the application to spot and futures non-ferrous metals
prices (Al, Cu, Ni, Pb, Zn) traded in the London Metal Exchange (LME). Most markets are in backwardation
and futures prices are ``information dominant'' in highly liquid futures markets (Al, Cu, Ni, Zn).