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Nov. 21, 2016

The failure of U.S. grain futures contracts to properly price commodities has spurred considerable controversy in agricultural futures markets and raised questions over the value of grain futures contracts as a useful hedging tool. Aaron Smith and his co-authors, using a dynamic econometric analysis, show that the problems are generated by the institutional structure of the delivery system, not to bubbles or irrational traders. This paper received the 2016 AAEA Quality of Research Discovery Award, and outreach publications on the topic won the 2014 AAEA Quality of Communication Award.

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Abstract

In a well-functioning futures market, the futures price at expiration equals the price of the underlying asset. This condition failed to hold in grain markets for most of 2005-2010, calling into question the ability of these markets to perform their price discovery and risk management functions. During this period, futures contracts expired up to 35% above the cash grain price. We develop a dynamic rational expectations model of commodity storage that explains how these recent convergence failures were generated by the institutional structure of the delivery system. When delivery occurs on a grain futures contract, the firm on the short side of the market provides a delivery instrument (a warehouse receipt or shipping certificate) to the firm on the long side of the market. The firm taking delivery may hold the delivery instrument indefinitely, providing it pays a daily storage rate. The futures exchange sets the maximum allowable storage rate at a fixed value. We show that non-convergence arises in equilibrium when the market price of physical grain storage exceeds the maximum storage rate on delivery instruments. We call the difference between the price of carrying physical grain and the maximum storage rate the wedge, and demonstrate theoretically and empirically that the magnitude of the non-convergence equals the expected present discounted value of a function of future wedges.

Citation

Garcia, P., Irwin, S. and A.D. Smith. 2015. "Futures Market Failure?" American Journal of Agricultural Economics, 97(1): 40-64.

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