Cash Settlement and Price Discovery in Futures Markets

Abstract

Prior to 1986, any opening position on feeder cattle futures contract must be settled with physical delivery after the last trading day. Due to dwindling commercial interests, Chicago Mercantile Exchange (CME) subsequently replaced the system with the cash settlement method. In December 1996 the CME abandoned the live hog futures contract and replaced it with the lean hog futures contract. While the former contract requires physical delivery, the later is settled in cash. It was argued that cash settlement would help improve the performance of these contracts. One of the main functions of the futures markets is the price discovery function. In this paper, we examine how cash settlement affects the ability of the futures market to predict future spot prices. Adopting the Geweke feedback measure, we find that the feeder cattle futures contract improves its price discovery function after the cash settlement was adopted in August 1986. Moreover, spot and futures markets become more integrated thereafter. We also consider the case in which the cash settled lean hog futures contract replaced the physical delivery settled live hog futures contract in December 1996. Herein the conclusion is drastically different. After cash settlement was adopted, the futures market is less effective in price discovery. Further, spot and futures markets are more segmented. We suspect other contract uncertainties, including the change in weighing scheme, gives rise to the undesirable results.