Spot and futures markets linkages: Does contango differ from backwardation?

The existence of feedback-effects between spot and futures prices has been extensively studied in the extant literature, as documented by the survey article by Chow, McAleer, and Sequeira (2000). More recent contributions in the area are Brooks, Rew, and Ritson (2001), Pindyck (2001), Heaney (2002a, 2002b, 2006), Watkins and McAleer (2006), Tilton, Humphreys, and Radetzki (2011), Stepanek, Walter, and Rathgeber (2013), and Gulley and Tilton (2014), among others.

In particular, Tilton, Humphreys, and Radetzki (2011) and Gulley and Tilton (2014) concluded that spot and futures copper returns are more closely correlated during periods of contango (futures price higher than the expected spot price) than of backwardation (futures price is below the expected spot price). Such evidence suggests that speculation and investors demand in futures markets should affect spot prices to a much lesser extent during backwardation, due to an unfeasible inter-temporal arbitrage.

This article expands this line of research by analyzing daily series of the spot and 3-, 15-, and 27-month futures contracts of industrial metals traded on the London Metal Exchange between the 1990’s and August 2014. Estimates of convenience yields are provided, along with tests for Granger causality between futures and spot returns after accounting for cointegration, and tests for statistical differences between correlations of contemporaneous spot and futures returns during periods of contango and backwardation. After various robustness checks, the evidence of a stronger linkage of spot and futures markets in contango is found to be weak.

References

Brooks, C., A. Rew, and S. Ritson (2001). “A trading strategy based on the lead-lag relationship between the spot index and futures contract for the FTSE 100.” International Journal of Forecasting 17, 31-44.

Chow, Y., M. McAleer, and J. Sequeira (2000). “Pricing of forward and futures contracts.” Journal of Economic Surveys14, 215-253.

Gulley, A., and J. Tilton (2014). “The relationship between spot and futures prices.” Resources Policy41, 109-112.

Heaney, R. (2002a). “Does knowledge of the cost of carry model improve commodity futures price forecasting ability? A case study using the London Metal Exchange lead contract.” International Journal of Forecasting18, 45–65.

Heaney, R. (2002b). “Approximation for convenience yield in commodity futures pricing.” The Journal of Futures Markets 22, 1005-1017.