RDP 8804: Pricing Behaviour in Australian Financial Futures Markets 2. Review of Theories of Futures Markets

2.1 Economic Functions of Futures Markets

There are two main theoretical approaches to explaining the economic function of futures markets – the cost of storage theory, and the risk allocation theory. The cost of storage theory is usually traced back to Working (1949) and Telser (1958), and was originally developed with specific reference to commodity futures. The theory views the futures premium (difference between futures and spot prices) as a risk free return paid to holders of a commodity. For existing stocks to be willingly held, this premium must be equal to the implicit net cost of holding that commodity. Net cost in this context means the sum of interest opportunity and storage costs, less the value of the service yielded by the commodity when held as inventory. This condition is required to ensure that the riskless activity of holding an additional unit of the commodity, for delivery at the futures price, earns a zero profit. In applications of the Working model, it is generally assumed that storage costs and inventory service yields are dependent on the quantities of stocks held. Thus the futures premium is uniquely determined by the supply of stocks and the risk free interest rate.

An important feature of the cost of storage theory is its recognition that futures markets are redundant when short selling of the physical commodities is possible and transactions costs are negligible. For example, a sold futures position could be replicated by selling short in the spot market, investing the proceeds at interest, and buying back at the future date. Since short selling is generally not possible in commodity markets, or is expensive, it has been argued that futures markets perform the economically useful role of facilitating optimal allocation of inventories by permitting short selling at low cost. In particular, Williams (1987) suggests that some producers will generally wish to be short in futures during the production process because in doing so, they are “borrowing” inventories which have a positive convenience yield as an adjunct to production.

The second main theoretical approach views futures contracts as being primarily instruments of risk management. This view generally interprets futures prices as representing expectations of future spot prices, possibly including some premium for risk. Keynes is often regarded as having anticipated the theory in his hypothesis that commodity futures should generally be at a discount to spot prices, in order to compensate speculators for the risk involved in providing price insurance to producers. This is the so-called “backwardation” hypothesis. Once again, however, the essential redundancy of futures markets must be noted. Futures offer an independent risk management service only to the extent that transactions costs or short selling constraints prevent the underlying assets or commodities from being used for the same purpose.

The two theories of futures markets should probably be seen as complementary: one describes the difference between spot and futures prices on the basis of inter-market arbitrage, while the other describes the influence of expectations and risk on the level of those prices. In practice, the relative applicability of the two theories probably depends on the cost of inter-market arbitrage. When spot transactions costs are high and short selling constraints are present, the arbitrage relationship implied in the storage costs theory will tend to break down. In this case, futures prices might be expected to be determined primarily by expectations, so that these markets would play an enhanced role in reflecting the effects of new information in prices. With low or negligible transactions costs in the physical markets, futures would tend to have much less of an independent role. Interest rate and currency futures probably fall much closer to this extreme than do commodity or share index futures.

2.2 Effect of futures on volatility

A number of theoretical arguments have been put forward to justify a link between futures trading and price volatility. In the first place, there is the frequently expressed view that speculation in general can destabilise prices. Such a position has been argued in detail in classic texts such as J.S. Mill's Principles and Keynes' General Theory, as well as by numerous other authors. The idea of destabilising speculation has, however, proved difficult to reconcile in theory with individually rational behaviour by investors. Recent attempts to provide formal examples of rational but destabilising speculation by Hart (1977) and Hart and Kreps (1987) for example, give the impression of being rather contrived. The opposing case, that rational speculation is always stabilising, was forcefully made by Friedman (1953):

“People who argue that speculation is generally destabilising seldom realise that this is largely equivalent to saying that speculators lose money, since speculation can be destabilising in general only if speculators on average sell when the [price] is low … and buy when it is high.”

Friedman's position appears common sense to many, but has been challenged empirically by a body of recent literature on the claimed “excessive volatility” of asset prices, sparked initially by Shiller (1981, 1984). Shiller argued that medium-term speculative swings have made asset prices in the United States many times more volatile than could be justified by fundamentals alone. The issue remains a controversial one, and one which cannot be fully examined here.

The relevance of this debate for futures markets is that futures are among the markets which come closest to the textbook ideal of costless unconstrained trading. It is here therefore that proponents of both extreme views on the stability of speculative trading expect to see their views most clearly illustrated. Thus, Tobin (1976) proposed a tax on speculative transactions as a means of stabilising international financial markets, arguing that low transactions costs are harmful to price stability. Miller (1986) on the other hand sees futures markets as enhancing spot market efficiency by bypassing inefficient taxes and regulations. Ultimately, the relative merits of these views can only be judged on an empirical basis.

A second line of argument, in papers by Newbery (1987) and Weller and Yano (1987) addresses the issue of price stability in a general equilibrium framework. These papers suggest that even in fully efficient markets, futures trading can influence the volatility of spot prices by influencing the volatility of private wealth distribution (Weller and Yano) or by influencing the supply behaviour of risk averse producers (Newbery). This influence can be in either direction, depending on the parameters of the models. These ideas are relatively new and likely to be developed further, but their empirical relevance is perhaps limited by the fact that futures contracts are generally traded only at short maturities. It seems particularly unlikely that the channel by which futures influence the volatility of spot prices, should be via effects on production as suggested by Newbery.

As a final point, it should be noted that changes in price volatility have no necessary implications for welfare, although some such implications often seem to be assumed. On the contrary, it has been shown that improved informational efficiency may sometimes be associated with greater price volatility. Green (1986) for example has shown in a simple theoretical model that a removal of short selling constraints will generally increase the information content of prices, and that this may increase price volatility. There is no obvious reason to consider such an outcome undesirable.