The Economic Value of Linkages between Spot and Futures Market

Abstract

In this paper we study the economic value of predicting the equity risk premium using market variables that reflect the positions of traders in futures and derivatives market. The economic value is ascertained by studying the performance of market timing strategies that use the positions of commercial hedgers and small speculators as predictive variables. Our market timing strategies have high positive Sharpe ratios over the 1999-2007 period compared to a Sharpe ratio of almost zero for the market index. They avoid losses during major downturns and have significant positive alphas, in contrast to timing strategies based on business cycle variables which under-perform the index over this period. The predictive ability seems to originate from a response to changes in fundamentals ahead of the market for large hedgers and from herding among small speculators. Overall these results indicate that futures market variables could play an important and economically significant role in predicting the equity risk premium.

Keywords: Return Predictability, Hedging Pressure, Timing Strategies

JEL Classification: G11, G12, G15