Futures Market Failure?

1. Futures Market Failure? Philip Garcia, Scott Irwin, and Aaron Smith 2012 Alberta Finance Institute Conference July 6, 2012

2. How much would you have paid to buy wheat from a Toledo elevator on July 1 2008? • On that day, the futures price for delivery of wheat to Toledo OH • … in July 2008 was $8.49 • … in Sep 2008 was $8.65 • … in Dec 2008 was $8.88 • … in July 2009 was $9.30 $7.11

3. Non-Convergence Since 1986 SRW Wheat (Toledo) Corn (Toledo/IL Riv. N.)

4. Non-Convergence Since 1986 KCBOT Wheat (KC) Soybeans (Tol./IL Riv. N.)

5. Why Do We Care? • Futures markets exist to discover prices and facilitate risk management • The market may not fulfill these functions if it does not price the physical commodity • Much of economic (and finance) theory is founded on the notion that people pick up dollar bills if they see them on the sidewalk • It appears that firms should be buying wheat for $7.11 and selling it on the futures market for $8.49 • Why is that not happening? • A unique setting in which to assess the present value model • We show that the basis is the solution to a present value problem • Our present value model explains prices.

6. U.S. Senate Blamed Index Funds “This Report finds that there is significant and persuasive evidence to conclude that these commodity index traders, in the aggregate, were one of the major causesof “unwarranted changes”—here, increases—in the price of wheat futures contracts relative to the price of wheat in the cash market… Accordingly, the Report finds that the activities of commodity index traders, in the aggregate, constituted “excessive speculation” in the wheat market under the Commodity Exchange Act.”

7. What Happened? NO Some Hypotheses … • Limits to arbitrage • Trading against the basis is too risky • Arbitrageurs have limited access to capital • Commodity index traders have overpowered arbitrageurs • Market power • Large agribusiness firms control the delivery market and manipulate it for their benefit • Competitive firms respond optimally to the institutional structure of the market NO YES

8. Non-Convergence in a Nutshell • If you buy grain through futures, you don’t get actual grain • You get a delivery instrument that says you can pick up your grain when you want it • While you hold the instrument, the seller has to store your grain, which costs money • You pay a storage fee for as long as you hold the certificate • The storage fee is fixed – it is not a market price • The futures exchange set the storage fee too low • Firms issue delivery instrument at a premium as compensation for low storage fee

9. Essence of our Theoretical Model Three ways for firms in the grain industry to realize profits from storing the commodity: • Wait and sell at the prevailing cash price in the future • Take a short futures position today for delivery in the future • Issue a delivery instrument today that will be converted into grain in the future Absence of arbitrage implies that these 3 strategies are equivalent

10. Implications of our Theory • The basis depends on the “wedge” • The wedge is positive when • The cost of storing the physical commodity exceeds the cost of holding the delivery instrument • Capital costs of holders of grain inventory exceed those of holders of delivery instrument • The main driver of grain storage cost is the level of inventory • When the wedge is positive, firms that take delivery will hold the delivery instrument until the wedge disappears • A small monthly wedge can imply a large basis if it is expected to persist for a long time

11. Evidence: Basis Expands at High Inventory CBOT Wheat

12. Evidence: Basis Expands at High Inventory CBOT Wheat

13. Basis Opens When Wedge Appears CBOT Wheat

14. Regressions to Explain the Wedge Explanatory variables • Inventory in deliverable locations (CME) • Ratio of inventories of materials and supplies for food products manufacturing firms to sales by those firms (BEA) • Spread between commercial paper and T-Bill yield (FRED) • Open interest held by commodity index traders (CFTC) • Dummies for large inversions • Seasonal dummies

15. Inventory Drives the Wedge

16. Inventory Drives the Wedge

17. CBOT Wheat: The Model Fits

18. Summary • We show that inventories drive non-convergence by creating a wedge between the price of storing grain and the price of holding the delivery instrument • A solution is to raise the storage rate – CME did this for wheat • Irrational behavior or limits to arbitrage are not required to explain non-convergence • The market can do the math – the basis equals the expected present of future positive wedges • Consistent with the fact that volume and OI were large and increasing in CBOT wheat during this period

19. Some Alternate Slides Follow

20. Average Daily Volume Average Daily Open Interest

21. Regular Firm’s Storage Choices Three ways for the regular firm to realize profits from storing the commodity: • Wait and sell at the prevailing cash price in period 2 • Take a short futures position in period 1 for delivery in period 2 • Issue a delivery instrument in period 1 that will be converted into grain in period 2. Note: Above equation ignores capital costs

22. Supply of Storage • Supply of Grain Storage • Demand for Grain Storage

23. High Inventory => Non-Convergence • Supply of Del. Instrument • Demand for Del. Instrument

24. Low Inventory => Convergence • Supply of Del. Instrument • Demand for Del. Instrument

25. Basis Depends on Wedge and Expectation • Define Wedge • Define Basis

26. Two Episodes; Two Different Responses CBOT Wheat

27. It’s Time to Raise the Storage Rate for Corn CBOT Corn Soybeans

28. ….. and Soybeans CBOT Soybeans Soybeans