Abstract
We study the futures valuation and market manipulation implications of reallocating the right to choose the delivery grade from the short to the long futures position and show that the futures price will converge to the price of the most expensive-to-deliver grade asset at delivery. The shifting of the delivery grade option to the long has the potential to mitigate excessive selling of futures contracts in a crisis, thus contributing to price stabilization. However, it may distort the incentives for the longs, leading to large futures and “corner and squeeze” trades to raise the delivery time spot price above the locked-in futures price.
Highlights
Futures prices should accurately reflect the price of the underlying asset
We study the futures valuation and market manipulation implications of reallocating the right to choose the delivery grade from the short to the long futures position and show that the futures price will converge to the price of the most expensive-to-deliver grade asset at delivery
A At expiration, the futures price must converge to the delivery adjusted spot price of the cheapest to deliver grade, irrespective of whether an additive or a multiplicative system of price adjustment is in use
Summary
Futures prices should accurately reflect the price of the underlying asset. The concept of arbitrage is critical for understanding as to how spot prices and futures prices are linked. Futures contracts provide a mechanism to lock in at time t the purchase or sale price of an underlying asset on a future date T ( T > t ) While this mechanism to buy insurance against price uncertainty protects the buyer (seller) from any increase (decrease) in price over time t to T, it may distort the incentives of traders to engage in potentially illegal price manipulations that they would not without the price protection. Often price manipulations involve “corners and squeezes” (Jarrow, [1992] [14]; Cooper & Donaldson, [1998] [15]; Pirrong, [2008] [16]) To mitigate this risk, most futures contracts assign the right to choose the grade (quality) of the deliverable underlying asset to the short futures trader, resulting in the convergence of futures price to the price of the cheapest-to-deliver grade at delivery (T), as noted above.
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