Modelling and Measuring Price Discovery in Commodity Markets

Abstract

In this paper we present an equilibrium model of commodity spot (St) and future (Ft) prices, with finite elasticity of arbitrage services and convenience yields. By explicitly incorporating and modeling endogenously the convenience yield, our theoretical model is able to capture the existence of backwardation or contango in the long-run spot-future equilibrium relationship, (St - b2Ft). When the slope of the cointegrating vector b2>1 (b2 Independent of the value of b2, this paper shows that the equilibrium model admits an Error Correction Representation, where the linear combination of (St) and (Ft) characterizing the price discovery process, coincides with the permanent component of the Gonzalo-Granger (1995) Permanent-Transitory decomposition. This linear combination depends on the elasticity of arbitrage services and is determined by the relative liquidity traded in the spot and future markets. Such outcome not only provides a theoretical justification for this Permanent-Transitory decomposition; but it offers a simple way of detecting which of the two prices is in the price discovery process. All the results produced in this article are testable, as it can be seen in the application to spot and future nonferrous metals prices (Al, Cu, Ni, Pb, Zn) traded in the London Metal Exchange (LME). Most markets are in backwardation and future prices are information dominant in the most liquid future markets (Al, Cu, Ni, Zn).