Detecting Spot Price Forecasts In Futures Prices

Abstract

Futures markets are often described as having two important social functions. First, they facilitate the transfer of commodity price risk, and, second, they provide forecasts of commodity prices. The evidence that futures markets transfer price risk is irrefutable. However, there is some debate about the markets' forecasting ability. In particular, forecasts based on the current spot price are often as good as those based on the futures price. Some economists cite a failure to detect superior forecast power in futures prices as evidence of market inefficiency (see, e.g., Leuthold 1974; and Martin and Garcia 1981). There are at least two other explanations. First, there may be nothing for the futures market to forecast. If the current spot price equals the true expectation of the future spot price, the futures market cannot provide a better forecast. Second, a superior futures market forecast may be obscured by the unexpected component of the realized spot price. The true expectation of the future spot price is unobservable; one must approximate this expectation with the actual future spot price.