Publication: Modelling and measuring price discovery in commodity markets
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2007-05
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Abstract
In this paper we present an equilibrium model of commodity spot (St) and future (Ft) prices,
with finite elasticity of arbitrage services and convenience yields. By explicitly
incorporating and modeling endogenously the convenience yield, our theoretical model is
able to capture the existence of backwardation or contango in the long-run
spot-future
equilibrium relationship, (St-ß2Ft
). When the slope of the cointegrating vector ß2>1
(ß2<1) the market is under long-run backwardation (contango). It is the first time in which
the theoretical possibility of finding a cointegrating vector different from the standard
ß2=1 is formally considered.
Independent of the value of ß2, this paper shows that the equilibrium model admits an
Error Correction Representation, where the linear combination of (St) and (Ft)
characterizing the price discovery process, coincides with the permanent component of the
Gonzalo-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 future 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 produced in this article are testable, as it can be seen in the application to
spot and future non-ferrous
metals prices (Al, Cu, Ni, Pb, Zn) traded in the London Metal
Exchange (LME). Most markets are in backwardation and future prices are ?information
dominant? in the most liquid future markets (Al, Cu, Ni, Zn).
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Keywords
Backwardation, Cointegration, Commodity markets, Contango, Convenience Yield, Future prices, Price discovery, Permanent-transitory decomposition