Modelling and Measuring Price Discovery in Commodity Markets Articles uri icon

publication date

  • September 2010

start page

  • 95

end page

  • 107

issue

  • 1

volume

  • 158

International Standard Serial Number (ISSN)

  • 0304-4076

Electronic International Standard Serial Number (EISSN)

  • 1872-6895

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 - b2Ft). When the
    slope of the cointegrating vector b2>1 (b2<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 b2=1 is formally considered. Independent of the
    value of b2, 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 nonferrous 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).