Forecast Encompassing as the Necessary Condition to Reject Futures Market Efficiency: Fluid Milk Futures
Posted: 20 Dec 2005
The traditional necessary condition for futures market inefficiency is the existence of alternative forecasting methods that produce mean squared forecast errors smaller than the futures market. Here, a more exacting requirement for futures market efficiency is proposed - forecast encompassing. Using the procedure of Harvey and Newbold, multiple forecast encompassing is tested using Chicago Mercantile Exchange fluid milk futures. Time series models and USDA experts provide competing forecasts. Results suggest milk futures do not encompass the information contained in the USDA forecasts at a two-quarter horizon. While the competing forecasts generate positive revenues, it is unlikely that returns exceed transaction costs in this relatively new market.
Keywords: forecast encompassing, milk futures, pricing efficiency
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