Do Asset Prices Reflect Fundamentals?

Abstract

This paper reexamines frozen concentrated orange juice (FCOJ) futures returns as they relate to fundamentals, in particular, temperature. We show that when theory clearly identifies the fundamental, i.e., at temperatures close to or below freezing, there is a close link between FCOJ prices and that fundamental. Using a simple theoretical nonlinear model of the relation between FCOJ returns and temperature, we can explain approximately 50% of the return variation. This is important because while only 4.5% of the days in winter coincide with freezing temperatures, two thirds of the entire winter return variability occurs on these days. Moreover, when theory suggests no such relation, i.e., at most temperature levels, we show empirically that none exists. The fact that there is no relation the majority of the time is good news for the theory and market efficiency, not bad news. In terms of other FCOJ return volatility, we also show that other fundamental information about supply, such as USDA production forecasts and news about Brazil production, generate significant return variation that is consistent with theoretical predictions. The evidence in this paper suggests that the literature's conclusion about irrationality drawn from the FCOJ market have more to do with econometricians' lack of modeling ability than with the empirical facts.