World Scientific Handbook Of Futures Markets, The

Anastasios G Malliaris, William T Ziemba

• Publisher: WSPC
• Year: 2015
• ISBN:
  9789814566933
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

The World Scientific Handbook of Futures Markets serves as a definitive source for comprehensive and accessible information in futures markets. The emphasis is on the unique characteristics of futures markets that make them worthy of a special volume. In our judgment, futures markets are currently undergoing remarkable changes as trading is shifting from open outcry to electronic and as the traditional functions of hedging and speculation are extended to include futures as an alternative investment vehicle in traditional portfolios. The unique feature of this volume is the selection of five classic papers that lay the foundations of the futures markets and the invitation to the leading academics who do work in the area to write critical surveys in a dozen important topics.

Contents:

• Introduction:
  • Futures Markets: An Overview (Anastasios G Malliaris and William T Ziemba)
• Classical Contributions:
  • Proof that Properly Anticipated Prices Fluctuate Randomly (Paul A Samuelson)
  • The Variation of Certain Speculative Prices (Benoit Mandelbrot)
  • Commodity Futures Prices: Some Evidence on Forecast Power, Premiums, and the Theory of Storage (Eugene F Fama and Kenneth R French)
  • Volume and Volatility in Foreign Currency Futures Markets (Ramaprasad Bhar and A G Malliaris)
  • The Strategic and Tactical Value of Commodity Futures (Claude B Erb and Campbell R Harvey)
• Institutions: New Invited Papers:
  • Central Counterparty Clearing and Systemic Risk Regulation (Robert S Steigerwald)
  • The Fast Track to the Futures: Technological Innovation, Market Microstructure, Market Participants, and the Regulation of High-Frequency Trading (Barbara J Mack)
• Established Markets: Invited Contributions:
  • Agricultural Futures Markets (Paul E Peterson and Jin Wook Choi)
  • World Metal Markets (Raj Aggarwal, Brian Lucey, and Fergal O'Connor)
  • Interest Rate Futures: Elements of a Successful Financial Innovation (Bluford H Putnam)
  • Currency Futures (Tim Weithers)
  • Energy Futures Markets (Betty Simkins and Yuecheng Jia)
• New Markets: Invited Contributions:
  • Volatility as an Asset Class (Tom Nohel and Steven K Todd)
  • Housing Futures Markets (Jin Wook Choi and Jin Man Lee)
  • Freight Futures Markets (Fotis Giannakoulis, Nikos Gavriilidis and Nikolas Arachovas)
  • Modeling the Dynamics of Temperature with a View to Weather Derivatives (Eirini Konstantinidi, Gkaren Papazian and George Skiadopoulos)
  • Electricity Futures (Paolo Falbo, Daniele Felletti and Silvana Stefani)
  • Climate Futures Markets (Rita l D'Ecclesia)
  • The European Sovereign Debt Crisis and the Role of Credit Swaps (Eleftherios I Thalassinos, Theodoros Stamatopoulos and Pantelis E Thalassinos)
• Advanced Topics: Invited Papers:
  • Returns from Investing in S&P500 Futures Options, 1985–2010 (Alexandre Ziegler and William T Ziemba)
  • How to Lose Money in Derivatives: Examples from Hedge Funds and Bank Trading Departments (Sebastien Lleo and William T Ziemba)
  • Nominal GDP Futures Contract Targeting (W William Woolsey and Scott Sumner)
  • The Ethics of Financial Speculation in Futures Markets (Ingo Pies, Matthias Georg Will, Thomas Glauben, and Sören Prehn)

Readership: Graduate students and researchers who are interested in the topic of futures markets.

“Financial futures have spawned enormous innovation in the investment industry over the past four decades. Hedging and speculation in financial markets have been revolutionized. More recently, commodity futures have served as a gateway for institutional investors to a new investible asset class, and not without some interesting controversy over the implications for the underlying commodity markets. The World Scientific Handbook of Futures Markets helps us make sense of these developments with its carefully selected compendium of classic articles by the pioneering giants along with a tasteful assortment of new work that helps bring us to up date with the current state of the field. With this volume, Malliaris and Ziemba have significantly lowered the cost of entry of readers from industry and academia.”

Darrell Duffie
Dean Witter Distinguished Professor of Finance
Graduate School of Business, Stanford University

“Twenty years after their inception, Nobel Laureate in Economics, Merton Miller, named financial futures as ‘the most significant innovation of the past two decades’. He peered into the future. These instruments have become an integral part of the financial system in the world's leading economies and are used to hedge and manage risk by international and domestic banks, public and private pension funds, mutual funds, hedge funds, asset and liabilities managers, swap dealers, insurance and mortgage companies, and energy companies. This process has improved national productivity, growth, and standards of living … The World Scientific Handbook of Futures Markets is a welcome addition to the body of expert work providing comprehensive information on futures markets to the world. The papers selected read like the ‘who's who’ of futures markets offering invaluable theoretical and practical information.”

Leo Melamed
Chairman Emeritus, CME Group

“The World Scientific Handbook of Futures Markets is a unique volume thoughtfully edited by Professors Tassos Malliaris and Bill Ziemba, two experts in the field. Classic papers authored by Samuelson, Fama, French and Mandelbrot, among others, demonstrate how the area of futures markets has attracted seminal economists and finance thinkers. The volume also includes 18 original essays covering traditional futures markets, such as agricultural, energy, metals, the more recent financial futures markets such as interest rates, equities and currencies, and finally, new markets such as weather, housing, climate, electricity and freight futures. With its innovative and comprehensive coverage, this forward-looking Handbook instructs and guides both researchers and practitioners in the field of futures markets.”

George Constantinides
Leo Melamed Professor of Finance
University of Chicago Booth School of Business

PART I

Introduction

CHAPTER 1

FUTURES MARKETS: AN OVERVIEW

Anastasios G. Malliaris and William T. Ziemba

In general, markets are divided into two broad categories: (i) cash markets and (ii) futures markets. Consider, for example, the cash market for coffee. Coffee producers supply a variety of coffee beans, which are sold in grocery stores or specialty coffee stores to interested consumers. The main characteristic of cash markets is the exchange of the product or service for payment in cash or with a credit arrangement. Economic analysis can be applied to examine this cash market, often also called the spot market, by considering the factors determining supply, demand, market characteristics, and price formation for the specific product or service. The majority of business activities in any economy are generated in cash markets and with appropriate national income accounting methods, these cash transactions are aggregated to measure the economy’s gross national product.

Let us next consider the futures market for coffee and examine why it is different from the cash market. In futures markets, we also have buyers who demand and sellers who supply not the actual coffee but a highly standardized futures contract traded in a specific exchange. For example, coffee futures contracts are each for 37,500 pounds of a certain quality grade traded at the Intercontinental Exchange (ICE) for delivery in a certain date in only the months of March, May, July, September, and December. Unlike the cash market, where the physical coffee is exchanged for a price paid, in the futures market for coffee, it is the futures contracts that are sold and bought contributing to price formation and discovery. A very small percent, say about 1%, of these futures contracts entail actual delivery, in contrast to the cash markets. Arbitrage activities align cash and futures prices to reflect “cost of carry” considerations and the convergence of the two prices at the expiration of the futures contract contributes to the success of such arbitrage. Immediately after a buyer and a seller establish a futures position between them, the execution is guaranteed by the clearing house of the exchange which acts as a seller to all buyers and a buyer to all sellers.

Dating back to the 1700s in Japan (and in some ways, to the earliest beginnings of commerce), futures markets were initially developed to help agricultural producers and consumers manage the price risks they faced with harvesting, marketing, and processing of annual crops. The futures industry still serves these markets, but has also broadened its scope along with the expansion of our economy beyond its agricultural roots. The need for efficient futures pricing and risk management mechanisms is the reason for the tremendous growth in futures markets. Futures markets enable raw material producers and users, financial intermediaries, and international trading firms to manage, among other things, their price, interest rate, and exchange rate risks. And speculators throughout the world, as they interpret the information that converges on exchange floors, decide to enter the futures markets as investors. Thus, while cash markets contribute to the actual exchange of goods and services for payment, futures markets exist for a limited group of agricultural, metallurgical, energy, and financial products and assets whose price fluctuations create sufficient uncertainty that requires risk management. These futures markets may involve a limited group of products, services, and assets in comparison to the cash markets, but their significance to any economy is quite substantial.

Because of its ease of use and its many economic benefits, futures trading has expanded to include numerous and varied markets throughout the world. The increased importance of futures, which can be seen by the tremendous growth in terms of volume and number of contracts, makes their study an increasing necessity in today’s financial world. In the early 1970s, approximately 13 million futures contracts were traded in the United States — most of which were agricultural. By 1999, trading volume exploded to more than 593 million, with only 11% related to agricultural products. During 2006, over 3.5 billion futures contracts were traded globally. By the end of 2013, the annual total volume of futures contracts traded and/or cleared at some 80 exchanges worldwide surpassed 10 trillion.

Today, there are futures contracts for interest rates, stock indexes, manufactured and processed products, non-storable commodities, precious metals, as well as foreign currencies and foreign bonds, and the number of proposals for new contracts continues to grow. This introductory chapter review the special characteristics of futures markets, discuss its evolution, and highlight and contrast these markets to other financial markets. As is well known, markets are economic and cultural institutions that have been developing and evolving over many centuries. Their growth has spectacularly accelerated during the past two decades as markets have embraced innovative technologies that have enabled price formation and exchange over the internet. In particular, futures markets have rapidly adopted the technological developments of the internet and moved to electronic trading from the traditional open outcry methods of the old-fashioned trading pit.

World Scientific Handbook of Futures Markets is divided into six parts. Part I includes the Introduction that offers a synopsis of this volume. In Part II, we have selected a sample of five classic academic contributions that demonstrate how the field of futures markets has always nurtured creative thinking and has contributed in considerable ways to the progress of the wider field of financial economics. Part III addresses the institutions surrounding futures trading and illustrates the dramatic transformations that have occurred during the last couple of decades. Part IV has several invited papers on established markets. In Part V, we are pleased to offer, perhaps for the first time in the form of a handbook, several contributions on new markets that have emerged recently and are currently in their developmental stages. Finally, in Part VI, we introduce certain advanced topics.

The Classics

Working (1962) argued that in the early 1920s, it was believed that futures prices were highly unreliable and did not reflect correctly existing information, with such prices following random fluctuations with some cyclicality impressed upon them. Two decades later, these erroneous ideas were replaced by newer thoughts that became the precursors of market efficiency. These newer concepts included the proposition by Samuelson that futures prices follow a martingale. Samuelson’s classic paper is reproduced in this handbook.

To explain Samuelson’s argument, let p(t) denote the spot price of a commodity or a financial asset at time t and p(t + T) denote the spot price T periods from t. Next, introduce a futures market in addition to the spot market and denote the futures price of the contract for the same asset expiring at T periods from t as y(t, T). Samuelson investigates the behavior of the sequence of futures prices as t increases to t + 1, t + 2, …, t + T written below:

Samuelson uses the axiom of mathematically expected price formation that implies that information is valuable, therefore not wasted and consequently is fully incorporated into futures prices. Put differently, futures prices reliably anticipate the spot price at the expiration of the contract p(t + T) written as:

This equation says that today’s futures price is the best expectation of the spot price at the expiration of the contract, conditional on what information is available today, written as I(t). From this axiom of mathematically expected price formation expressed in the last equation, Samuelson proves, using the law of iterated expectation from probability theory, that the sequence of futures prices follows a martingale. A martingale generalizes the simple idea of a random walk, usually written as p(t + 1) = p(t) + u(t + 1), where u(t + 1) is a random variable with mean zero and a given variance. While the random walk model does not account for information explicitly, the concept of a martingale stresses the idea of conditional information. Thus, Samuelson connects cash and futures markets and emphasizes that information is fully exploited in both markets. This idea is foundational for all activities that drive futures markets such as hedging, arbitrage, and speculation.

Benoit Mandelbrot, in the second classic reproduced in this handbook, examines a central problem in financial economics. The question is: what are the distribution characteristics of an asset’s price changes? Mandelbrot asserts that price changes in security and commodity markets do not follow a Gaussian or normal distribution. The paper presents a new model — the stable Paretian model — to describe price behavior. Mandelbrot then tests the new model with cotton prices and discusses its properties.

According to a Gaussian model, the differences of stock prices are normally distributed with a finite standard deviation. However, empirical data shows that prices are more peaked and have fatter tails than a normal distribution. The stable Paretian model explains the empirical data in a better way. There are four parameters in the stable Paretian model, α β δ, and γ. The parameter α measures the peakedness of the distribution, and varies from 0 to 2. The parameter β represents the degree of skewness, ranging from −1 to 1. When β equals zero, it means the distribution is symmetric. Parameter δ is a location factor and γ is a scale factor. One important property of the model is stability, which means the sum of independent and identically distributed stable Paretian variables also follows a stable Paretian model.

Mandelbrot uses cotton prices to test the stable Paretian model. He assumes that the population moments are infinite. The differences of logs of cotton prices show that the sample moments behave erratically, and that the price complies with asymptotically Paretian behavior. In addition, the model is examined by double log graphs. The result shows that the various cotton prices are horizontal translates of each other, which is consistent with the stable Paretian model. The graphical method is then used to study price distribution across time. From the long time horizon, monthly price changes follow mixtures of stable Paretian laws. However, if the stable Paretian distribution holds, several statistical tools will be questionable. For example, the least-squares forecasting and kurtosis are based on the assumption of finite variance. But according to stable Paretian, the variance is infinite.

In the third classic paper, Fama and French develop two models related to commodity futures prices. One is motivated by the theory of storage, indicating that the difference between spot and futures prices (called the basis) comes from interest rate costs to hold the commodity today, from warehousing costs, and from a convenience yield on inventory. The second model states that the basis exists because of an expected premium and expected changes in the spot price. This paper tests the two models with data from 21 commodities’ futures prices. The authors conclude that the theory of storage interprets the behavior of futures prices in a better way.

According to the theory of storage model, the basis is positively related to interest and warehousing costs, and negatively related to convenience yield. Monthly data from January 1967 to May 1984 is used to test the model. The analysis of standard deviation supports this model. Different commodity groups have systematically different basis standard deviations. The standard deviation of metals is the lowest (1.5–4.2%), followed by agricultural products (4.6–9.7%) and animal products (10.1–22.2%). Agricultural products and animal products are subject to seasonal supply and demand, leading to various warehousing costs. That is why commodities with high and seasonal warehousing costs have high basis standard deviations. In addition, the authors run a regression analysis to test the relationship between basis, nominal interest rate, and convenience yield. The results show that for metal and agricultural products, the basis varies almost the same amount as the interest rate. But the interest rate plays less important role for animal products. In addition, seasonal variation in basis is tested. There are no seasonal effects for metals, some effect for agricultural commodities, and the strongest effect is for animal products.

The second model explains the basis based on forecast power and premiums. However, because measurement errors and irrational forecasts of spot prices are included in the basis variance, the regression results of this model may be unreliable. No systematic difference exists in the standard deviations of spot price changes and premiums across commodity groups. From the regression results, 10 out of 21 commodities’ future prices have reliable forecast power and 7 commodities’ future prices show reliable time-varying expected premiums. The forecast power is related to storage cost and seasonal variation. The predictable seasonal variation in spot price increases with the rise of storage cost. The authors also test for the existence of expected premiums. When combining commodities into a portfolio, future prices show normal backwardation. But the evidence is insufficient to prove the existence of non-zero expected premiums.

The first three classic papers have recognized the fundamental issues of asset pricing in futures markets. The next paper is on issues of volume of trading and volatility. Bhar and Malliaris study the relationship between price and volume of foreign currency futures. The purpose of this study is to find the determinants of trading volume changes. The authors first mention three general models, then develop four hypotheses based on such models, and finally test these hypotheses using data related to currency futures for the British Pound, Canadian Dollar, Japanese Yen, German Mark, and Swiss Franc.

Three models are used to study the determinants of trading volume. According to the first model, price and time influence the trading volume of currency futures. It could be explained by the supply and demand framework. With changes in supply and demand, prices move correspondingly which affects trading transaction. Another model suggests that price follows an Itô process. Combing above models, the authors come up with the third model:

where V denotes trading volume, μ is a drift, σ is volatility, Vt, V_P, and V_PP are partial derivatives.

Four hypotheses are proposed based on the above models. First, Bhar and Malliaris test the randomness and stationarity for prices and volume. They also test whether trading volume follows a random walk if futures prices are assumed to follow the same behavior. The second hypothesis is that the average change in volume is determined by time, a price trend coefficient, and volatility of futures prices. Third, in addition to the expected changes in trading volume, the unexpected changes are correlated with price volatility as well. Finally, the futures price volatility is a determinant of trading volume volatility.

Daily, weekly, and monthly data from 1972 to 1994 are used to test the hypotheses. Because there was a structural break in 1984, the sample period is adjusted to 1984–1994. The results show that price series are non-stationary while volume series are stationary. So the first hypothesis is not supported. For the second hypothesis, regression results indicate that price volatility influences the expected changes in trading volume. In addition, price volatility is also a determinant of unexpected volume changes. What is more, a significant relationship exists between price volatility and volatility of trading volume.

The last paper in the classics collection illustrates the importance of futures returns in a larger portfolio of assets. Erb and Harvey study historical performance of commodity futures, and state that it is not reasonable to forecast future performance by naively extrapolating past performance. Alternatively, two steps are required to develop a forward-looking framework. And finally, the authors provide several trading strategies related to commodity futures.

The first step to forecast commodity futures performance is to study the historical returns and market performance. The annual excess return of individual commodity futures was almost zero. However, once combined commodity futures into a rebalanced and equally weighted portfolio, the excess return of the entire portfolio increased to 4.5%, an equity-like return. The reason is that the component commodity futures have high standard deviations and low correlation with each other, so that the portfolio could take advantage of diversification. In addition, the authors argue that commodity futures indices are good indicators for portfolio strategy.

In order to understand the price behavior, drivers of individual and portfolio returns were studied using data from 1982 to 2004. From the analysis on cross-sectional data, roll return was the dominant element to influence individual commodity futures return; and spot return was the main driver of time-series variation of commodity futures return. The spot return varies across time because it has great exposure to unexpected inflation. These two kinds of returns are drivers that influence individual futures, while the third driver, diversification return, is specifically for a portfolio. Combining individual futures into a portfolio could reduce variance, so a rebalanced portfolio creates higher return than its constituents.

After reviewing the historical performance of commodity futures, we can expect future returns based on the three drivers mentioned above. If a portfol...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Endorsements
• Dedication
• Preface
• Contents
• About the Contributors
• Part I Introduction
• Part II Classical Contributions
• Part III Institutions: New Invited Papers
• Part IV Established Markets: Invited Contributions
• Part V New Markets: Invited Contributions
• Part VI Advanced Topics: Invited Papers
• Index