Futures Market Failure?

25 Pages Posted: 15 Apr 2020

See all articles by Philip Garcia

Philip Garcia

University of Illinois at Urbana-Champaign - Department of Agricultural and Consumer Economics

Aaron Smith

University of California, Davis - Department of Agricultural and Resource Economics

Scott H. Irwin

University of Illinois at Urbana-Champaign

Multiple version iconThere are 2 versions of this paper

Date Written: January 2015

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.

Keywords: Agriculture, basis, bubble, commodity futures, convergence, delivery, grain, storage

Suggested Citation

Garcia, Philip and Smith, Aaron D. and Irwin, Scott, Futures Market Failure? (January 2015). American Journal of Agricultural Economics, Vol. 97, Issue 1, pp. 40-64, 2015, Available at SSRN: https://ssrn.com/abstract=3574222 or http://dx.doi.org/10.1093/ajae/aau067

Philip Garcia

University of Illinois at Urbana-Champaign - Department of Agricultural and Consumer Economics ( email )

1301 W. Gregory Drive
427 Mumford Hall
Urbana, IL 61801
United States
217-333-0644 (Phone)
217-333-5538 (Fax)

Aaron D. Smith (Contact Author)

University of California, Davis - Department of Agricultural and Resource Economics ( email )

One Shields Avenue
Davis, CA 95616
United States
530-752-2138 (Phone)
530-752-5614 (Fax)

Scott Irwin

University of Illinois at Urbana-Champaign ( email )

344 Mumford Hall
1301 W. Gregory Dr.
Urbana, IL 61801
United States
217-333-6087 (Phone)

HOME PAGE: http://https://scotthirwin.com/

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
1
Abstract Views
191
PlumX Metrics