This paper presents the causal relationships between futures and spot prices of six metal and agriculture commodities in Chinese commodity market, using GC test, frequency domain approach proposed by Brietung and Candelon (2006) and Garbade–Silber (G–S) Model. Frequency domain approach indicates that futures price of each commodity is really a powerful predictor for spot price in both long and short terms, but not vice versa. From the results of G–S model, futures price of each commodity decides more than 70% of the price movements, which plays a dominant role in price discovering process. There are bi-directional casual relationships between futures and spot prices of all the six commodities excluding aluminum (Al) from the conclusions of time domain GC test.
Futures markets serve several functions, among which price discovery function is usually regarded as the leading indicator of judging the efficiency of a futures market. The existence of causal relationship between futures and spot prices is usually used as a best description of price discovery function in empirical studies. If close causality exists, either price can provide signals for the other in price movements to avoid risks. Obviously, it is very important for market participants to know whether there is a bidirectional or unidirectional causal relationship between the two prices, for financial risk management is really vital in arbitraging and hedging. Moreover, the causal relationship can be useful to judge if the market has a good information transformation and if price movements adjust to the information volatility well.
Numerous insights have yielded about our topic, but they generally ignore the possibility that the strengths and/or directions of the causal relationships could vary over different frequencies. If causality exists, when can futures price be a powerful predictor? When in reverse? When can't? These questions are rarely fully studied but rather practical in investing. The frequency domain approach gives a complete inter-frequency characterization of causality, instead of a one-shot measure which is supposed to apply across all periods only with one result. This paper will first apply frequency domain approach (or called “a spectral-density approach”) to study the causality between futures and spot prices, which is never used before in previous papers; furthermore, we have paid great attention to the booming but neglected emerging market, Chinese commodity market.
After Chinese transition into a market economy, various commodity futures markets have been launched to discover price and hedge risks. Among them, metal and agricultural branches are the most active and fluctuant transacting ones from past to now. To summarize, metal and agricultural commodity futures contracts are in larger quantities, relatively faultless and briskly traded, so they are good representatives of Chinese commodity futures market. So, the study can be a useful reference to evaluate if Chinese commodity futures market operates efficiently in price discovering.
This paper first applies frequency domain approach to examine
the causality between futures and spot prices, and first pays great
attention to an emergingmarket neglected before, Chinese commodity
market. Our study gives a complete inter-frequency characterization of
causality, instead of a one-shot measure used in previous researches.
Previous studies just show the lead–lag relationship result without details, while this paper is supposed to show clearer details about the
directions and strengths of causalities. We give the horizon length(s)
when futures price can predict spot price most accurately, which is
never given in previous studies but really practical and needed for
both markets and investors. All above are the meanings and purposes
of this paper.
From GC test, we know that there exists a bi-directional causality between
futures and spot prices of each commodity (Cu, Zn, bean, sugar and
cotton) except Al; for commodity Al, causal relationship is unidirectional
from futures to spot price. For further study, when can futures and spot
prices be powerful vehicles for each other in price discovery, in long or
short term? To solve this puzzle, we apply frequency domain approach,
its empirical results support the evidence that feedbacks exist between
futures and spot prices in long term of all the commodities; in short
term, for Al, sugar and cotton, causality is unidirectional from futures to
spot price, but bi-directional for other three. Granger causality from spot
to futures price will be obviously weakened in short and medium terms
for all the commodities, especially in medium term. Only the prices of
Cu, bean and cotton have feedbacks during medium-run cycles. To sum
up, we can judge that futures price is an accurate predictor for spot
price in any frequency. Chinese commodity futuresmarket has great efficiency
in price discovering process. Then we use G–S model to find out
which price is decisive in price discovery, it is found that futures price is
the leading and striking price, which decides more than 70% of forward
price movements of each commodity.
The study in this paper is useful in some aspects: For investors,
it helps them to know more about the efficiency of markets, which
will help them in hedging and risk aversion, estimating forward price
movements more accurately, so that they can confirm when investing
and arbitraging chances appear and how long they will last; For our
market, this paper can be a good reference to evaluate the operating situations
of Chinese commodity market because metal and agricultural
commodity branches are good representatives, both of them have efficient
price discovery functions, leading to less unreasonable volatility
in price movements. So, we can judge that Chinese commodity market
is well established and has enough maturity; it operates efficiently
and has good abilities to endure unreasonable shocks. The conclusions
in this paper may be very helpful in economic order management and
financial policy settings of Chinese market.
