Re-examining the Futures Market Efficiency using a New Approach in the Presence of a Time-Varying Risk Premium

46 Pages Posted: 14 Mar 2013 Last revised: 30 Oct 2014

See all articles by Duminda Kuruppuarachchi

Duminda Kuruppuarachchi

University of Otago - Department of Accountancy and Finance

Hai Lin

Victoria University of Wellington - School of Economics & Finance

I. M. Premachandra

University of Otago - Department of Accountancy and Finance

Date Written: September 19, 2014

Abstract

We re-examine the market efficiency of commodity futures using a new approach that accounts for both time-varying risk premium and conditional heteroscedasticity of spot prices. The conventional market efficiency tests so far in the literature are based on either risk neutral or constant risk premium assumptions as such they are biased towards the rejection of the market efficiency hypothesis especially for commodity futures. The time varying risk premium is estimated using a state space model with a modified Kalman filter. Using a Monte Carlo simulation, we show that the proposed test produces robust and superior results under varying market conditions compared to the conventional approaches. By employing the proposed test we analyse the efficiency of crude oil, corn, copper and gold futures and find that gold futures is inefficient throughout the sample period 2000-2011 while others are efficient especially after the global financial crisis (GFC) in 2008. We also find significant changes in the underlying risk premiums due to the GFC. We extend the analysis to a comprehensive sample of 85 commodities traded on 16 exchanges worldwide and find that efficiency and risk premiums vary across the four market sectors while GFC has caused to increase both efficiency and risk premiums in all markets other than precious metals.

Keywords: Commodity Futures; Market Efficiency; Futures Risk Premium; State Space Model; Kalman Filter.

JEL Classification: G13, G14, G15

Suggested Citation

Kuruppuarachchi, Duminda and Lin, Hai and Premachandra, I. M., Re-examining the Futures Market Efficiency using a New Approach in the Presence of a Time-Varying Risk Premium (September 19, 2014). Available at SSRN: https://ssrn.com/abstract=2233117 or http://dx.doi.org/10.2139/ssrn.2233117

Duminda Kuruppuarachchi (Contact Author)

University of Otago - Department of Accountancy and Finance ( email )

PO Box 56
Dunedin, 9054
New Zealand

Hai Lin

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6001
New Zealand

I. M. Premachandra

University of Otago - Department of Accountancy and Finance ( email )

PO Box 56
Dunedin, 9054
New Zealand

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