The trilogy of China cotton markets: The lead–lag relationship among spot, forward, and futures markets

• Published date: 01 April 2019
• Author: Terrence F. Martell,Mert Demir,Jun Wang
• DOI: http://doi.org/10.1002/fut.21981
• Date: 01 April 2019

Received: 16 August 2018

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Revised: 25 October 2018

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Accepted: 27 October 2018

DOI: 10.1002/fut.21981

RESEARCH ARTICLE

The trilogy of China cotton markets: The lead–lag

relationship among spot, forward, and futures markets

Mert Demir

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Terrence F. Martell

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Jun Wang

2

1

Weissman Center for International

Business, Baruch College, City University

of New York, New York, New York

2

Center for Futures and Financial

Derivatives Research, China Agriculture

University, Beijing, China

Correspondence

Mert Demir, Weissman Center for

International Business, Baruch College,

City University of New York, 137 E 25th

St. Box J‐0810, New York, NY 10010‐5585.

Email: Mert.Demir@baruch.cuny.edu

Abstract

China is a leading participant in the world cotton market. China’s distinctive

regulatory structure and procedures and business environment provide an

opportunity to explore some unique market dynamics. This study investigates

the interrelationship among the spot, futures, and forward cotton markets in

China over a period of a major policy change: A temporary State reserve

program for cotton that was established in 2011 and ended in 2014. This

government intervention significantly distorted the way farmers, manufac-

turers, and speculators interacted and was not sustainable. Overall, our results

support futures market’s dominant role in the price discovery process.

KEYWORDS

China, commodity futures, cotton futures, forward market, futures markets

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INTRODUCTION

China has grown over the years to be the dominant market for cotton. China is the world’s number one importer,

consumer, and holder of stocks andthe number two producer of cotton (MacDonald, Gale,& Hansen, 2015, p. 2). Because

of its growing importance in the world cotton market there have been several studies examining the interrelationship

between the cotton market in China and the US market (Gale, Arnade, & Cooke, 2017; Ge, Wang, & Ahn, 2010).

However, there has been little work to date examining the interrelationship among the spot, futures, and forward cotton

markets in China. To fill this gap in the literature,this paper seeks to examine those interrelationships. Moreover, it seeks

to do so while considering a major policy change: The introduction of a state reserve purchasing price for cotton.

Using daily data for China cotton spot, futures, and forward prices for the period January 2005–April 2017, the

impact of two major policy changes dated March 31, 2011 and January 18, 2014 on the interrelationships among cotton

spot, futures, and forward markets are analyzed. We used two different futures price series (main and nearby futures

contracts) to better capture the underlying dynamics of futures markets. Our results indicate that (a) there exists a

linear and stable long‐term relationship among the three markets, and (b) this relationship is highly influenced by the

two policy shifts during the course of our sample period. Specifically, the lead effect of spot prices on all other futures

and forward price series in the first two periods disappears with the second policy change, which abolished the State

reserve program for cotton. We also find a mostly unidirectional lead–lag relationship (futures lead forward prices),

while the leading role of futures prices fades with the introduction of the State reserve program for cotton in 2011.

These reactions to policy changes from the different cotton markets demonstrate a key characteristic of agricultural

markets in general: While their relatively isolated nature insulates them from potential negative spillover effects, it

amplifies the influence of policy forces and other macroeconomic factors. These features of cotton spot, futures, and

forward markets provide a rare opportunity to investigate a broad range of potential effects of regulatory and policy

changes on market dynamics in total isolation from other factors. Therefore, we strongly believe our findings will

contribute to the ongoing debate on the implications of financial market regulations for price discovery mechanisms

J Futures Markets. 2019;39:522–534.wileyonlinelibrary.com/journal/fut522

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© 2018 Wiley Periodicals, Inc.