Does the design of spot markets matter for the success of futures markets? Evidence from dairy futures

• Date: 01 March 2018
• Author: Jędrzej Białkowski,Jan Koeman
• DOI: http://doi.org/10.1002/fut.21883
• Published date: 01 March 2018

Received: 10 September 2015

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Accepted: 26 August 2017

DOI: 10.1002/fut.21883

RESEARCH ARTICLE

Does the design of spot markets matter for the success of futures

markets? Evidence from dairy futures

Jędrzej Białkowski

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Jan Koeman

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Department of Economics and Finance,

University of Canterbury, Christchurch,

New Zealand

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PhD Candidate, Department of Economics

and Finance, University of Canterbury,

Christchurch, New Zealand

Correspondence

Jędrzej Białkowski, Department of

Economics and Finance, University of

Canterbury, Private Bag 4800,

Christchurch, New Zealand.

Email: jedrzej.bialkowski@canterbury.ac.nz

This study provides evidence of the importance of a well-defined and functioning spot

market for the success of the associated futures market. Our analysis of hedging

effectiveness and hedge ratio persistence shows that none of the United States (US) spot

market indices may be hedged effectively with the Chicago Mercantile Exchange nonfat

dry milk futures at short hedging horizons, whereas the New Zealand (NZ) Stock Exchange

whole milk powder futures contract is an effective hedge for the Global Dairy Trade spot

pricing benchmark. Four important dimensions of spot market design are identified—

timeliness, market-based measurement, forward-spot separation, and inclusiveness.

KEYWORDS

agricultural commodities, CME NFDM futures, dairy, futures market effectiveness, hedging, NZX

WMP futures, settlement to average spot price, spot market design

JEL CLASSIFICATION

G13, G14, Q14, Q17

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INTRODUCTION

A number of newly introduced futures contracts have failed to attract substantial interest from market participants and their

trading is characterized by low volume (Black, 1986; Brorsen & Fof ana, 2001; Carlton, 1984). Several studies investiga te the

possible reasons behind the success or failure of exchange traded derivatives and in particular futures contracts (see

Białkowski & Jakubowski, 2012; Garcia, Irwin, & Smith, 2015; Johnston & McConnell, 1989; Till, 2014; Webb, 2015).

Although past studies point out several features of futures and related cash markets that increase the chance of success, the

topic is the subject of debate, an d Bhardwaj, Gorton and Rouwenhorst (2015) argue that more research into the success and

failure of futures contract s is needed. In this paper, we provide evidence that a previous ly unstudied aspect of futures markets

—the underlying spot market inde x design—is a strong determinant of the hedging effectiveness of futures contracts and

hedge ratio persistence over short to long hedging horizons.

Gray (1978) outlines three broad classes of reasons for the failure of futures contracts: poor design of the futures contract that

favors either the buyer or the seller, the motivation to boycott a futures market because of the loss of pre-existing market power

by either the buyer or seller, and the failure to attract speculation. In addition, Gray argues that the futures markets must serve a

hedging function for commercial traders. Till (2014) and Webb (2015)

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reinforce these considerations.

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Professor Robert Webb's keynote speech during the 2015 Derivatives Markets Conference in Auckland enumerated 10 characteristics that are related to

the successful introduction of a futures contract: 1) price volatility in the cash market, 2) the need to hedge for commercial participants, 3) public order

flow of genuine commercial (i.e., hedging) trades, 4) good contract design that does not favor the long or short side, 5) first mover advantage, 6) actively

traded related futures that facilitate spread trading, 7) liquidity in comparison with existing cross-hedges, 8) low explicit trading costs (e.g., brokerage

commissions), 9) speculator interest to take the long side of hedger trades, and 10) timing of the introduction of the contract.

J Futures Markets. 2018;38:373–389. wileyonlinelibrary.com/journal/fut © 2017 Wiley Periodicals, Inc.

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The majority of studies focus on the characteristics of the commodity, the salient features of the cash and futures market,

and the aspects of the futures contract that are associated with success or failure. There is the implicit assumption that the

cash market is structured to produc e a single benchmark price to serve as the futures’underlying. Only a few studies,

primarily in the shipping and freight markets, examine the characteristics of the cash market's underlying price index that

promote success. In the case of these markets, the construction of price indices is necessary due to the wide range of product

or service grades.

The contribution of this paper is threefold. First, it highlights the importance of the proper institutional design of the

spot market to produce a benchmark with the necessary features to serve as the underlying for a successful futures

contract. Second, the paper illustrates the trade-off between the settlement of futures contracts to a historical average and

settlement to the spot price of the underlying. Third, this paper aims to serve as a source of information on the United

States (US) and New Zealand (NZ) dairy futures and spot markets, a commodity market that has not received significant

academic attention despite its importance and size. The analysis of the US and NZ futures contracts and their underlying

spot markets illustrates that the design of spot markets strongly impacts the functioning of futures markets. In particular,

the design of the spot market affects the hedging efficiency and hedge ratio persistence from short to long hedging

horizons.

The remainder of this paper is organized as follows. Section 2 enumerates the important dimensions of spot market design.

Section 3 illustrates how the selection and design of the spot market influences the riskiness of arbitrage, hedging, and

speculative activity. Section 4 provides an overview of the US and NZ dairy spot market indices, and formulates our research

hypotheses. Section 5 presents the data examined in this study. Section 6 reports our methodology. Section 7 reports results, and

section 8 concludes.

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SPOT MARKET DESIGN DIMENSIONS

Little academic research focuses on spot market design as a factor affecting the performance of futures markets; all studies make

an implicit assumption that the spot market is structured in a competitive manner so as to produce a single cash price.

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assumption is valid in the case of highly liquid underlyings with well-established mechanisms for single-price determination.

The situation is different with less liquid assets traded in several locations with multiple price indices. Good examples of such

assets are dairy products. In their case, the spot market was often designed shortly before a futures market was launched. In

addition, government regulation has resulted in global market segmentation.

A few studies in the shipping, trucking, fishing, and forestry markets examine the design of the underlying cash

market. These markets exhibit a wide range of product grades and quality, requiring the explicit construction of a single-

price index. Kavussanos and Visvikis (2006) examine the maritime shipping industry and enumerate 10 characteristics

that a cash market price index should exhibit—accuracy, absence of bias, familiar units, broad coverage, frequent

publication, auditability, low access cost, and the participation of major market participants. Bignell (2013) adds the

abilitytobreakdowntheindexintoseparate sub-indices and the ability to update the index structure as market

conditions change.

We identify four important dimensions of spot market design for producing a single-price index that can serve as an effective

underlying for a futures contract: timeliness, market-based measurement, inclusiveness, and forward-spot separation.

Timeliness measures the extent to which the information is current for price formation. Timeliness will be lower for indices that

incorporate a range of historical information into the spot price or for indices that induce a delay between the price measurement

and publication date. Hedging effectiveness is ultimately determined by the correlation between unexpected spot and futures

price changes. At a point in time, the correlation between a single futures price and a range of spot prices will be lower than that

between two single prices. Indices that use more current information are superior. The market-based characteristic indicates the

extent to which the measure is determined by markets rather than surveys among market participants. Prices generated by

financial and commodity markets are more accurate than survey prices and mandatory surveys are more accurate than voluntary

surveys. Forward-spot separation indicates the separation of spot and forward market sales. A price index that mixes forward and

spot sales, or that only provides spot or forward sales, will be less effective than a structure that provides both spot and forward

price information. In markets for perishable commodities, it is often advantageous to have forward rather than immediate

delivery. Inclusiveness assures that a significant representative portion of trades are included in the spot market index. A price

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Appendix 1 contains a detailed review of the factors that have been related to the success and failure of futures contracts.

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BIAŁKOWSKI AND KOEMAN