Hassan, Taufik

Md Nassir, Annuar

Mohd Arshad, Fatimah

Universiti Putra Malaysia Institutional Repository

UPM Research Report 1997-2000, Section 2-Extended AbstractsInformational Efficiency of CPO Futures ContractsTaufik Hassan, Fatimah Mohd Arshad, Annuar MelNassirFacultyof EconomicsandManagementUniversitiPutraMalaysia43400 UPM,Serdang,SelangorMalaysiaE-mail olCorrespondingAuthor:fatimah@econ.upm.edu.myKey words: CPO futures contract, informational efficiency, hedging, cointegration and causality.IntroductionThe growing importance of palm oil inthe country's economy, in the worldtrade and to the welfare of participantsin the sector requires a more stableprice. To reduce the price risk of theproducers/investors in the underlyingmarket, appropriate information re-garding the future path of palm oilprice is essential. Therefore if produc-ers and investors are in fact using onlyfutures prices as expected prices (otherthan hedging and arbitraging) whenallocating resources, then an assess-ment of the quality of the price is alsoan important research issue. The uni-fying theme is that futures market col-lects, generates and synthesizes infor-mation (about underlying cash assets),which is instrumental in determiningthe futures prices. Therefore the futuresprice plays an important role in thecash price discovery process when cashmarket traders incorporate the futuresprice in their decisions (Kawai, 1983,Tumovsky, 1983, 1979). Hence thegreater the accuracy of the forecastembodied in the futures price, the lessis the impact of "random noise" in cashprice determination and the smaller isthe price uncertainty to cash markettraders. Therefore studies on the in-formational efficiency of futures mar-kets have important implications forthe issue of whether economic re-sources are being optimally allocated.The role of information in futurestrading is an important ingredient in theoverall smooth functioning of com-modity cash market. This study at-tempts to investigate these issues em-piricallyMaterials and MethodsThis study applies cointegration test toascertain the presence of stationarity inthe series examined. Cointegration testCordae and Ouliaris (1986), Nassir andAriff (1990) and Baillie and Bollerslev(1989) argue that, in the presence of352non-stationarity in many financial timeseries data, the unit root test providesunbiased and consistent results. Fortheoretical and practical reasons, theDickey-Fuller test is applied to theregression run. If two time series Xtand Yt are both non-stationary in levelsbut stationary in the first difference, itis said that variables Xt and Yt areintegrated of order I that is I (l). If twovariables are integrated of order I,denoted as I (1), their linear combina-tions, Zt = Xt-aYt are generally also I(1). However if there is an a, such asthat Zt is I (0), then Zt is integrated oforder 0 or stationary in level. If Zt is I(0), then the linear combination of Xtand Yt is stationary. It is said that thetwo variables are co-integrated. Underthe cointegration methodology, themaximum likelihood method is alsoused to estimate the cointegration rela-tionship between variables developedby Johansen (1988).By integrating the concepts of cointe-gration and causality in the Grangersense, it is possible to develop a modelthat allows for the testing of the pres-ence of both a short-term and a long-term relationship between the vari-ables. This model is known as the errorcorrection model (ECM) proposed byEngle and Granger (1987) and is dis-cussed in numerous papers. Key recentreferences include Zapata and Ram-baldi (1996) and Giannini and Mosconi(1992).Results and DiscussionThe findings suggest that the futuresand spot price series are non-stationaryin level form. These results demon-strate that the futures, spot price seriesand open interest are integrated in thefirst order [Le. I(l)]. The results usingthe Johansen procedure show that 4-month before the expiration, cointegra-tion relation between spot and futuresis weak. The null hypotheses cannot berejected at 5 percent level where three-month before expiration month to theexpiration month; the results showstrong cointegration relation betweenspot and futures prices. During 1990-1992 period, three-month before expi-ration month to the expiration month,the results show strong cointegrationrelation between spot and futuresprices. But in previous period, fourmonth before there was a long runrelationship.During 1993-1995 period, there aresome significant changes. Thesechanges reduce the reliability of futuresmarket as a forecasting tool for thefuture path of the cash price. The re-sults of Johansen test show that there isno long run relationship between spotand four-month and three-month andeven two-month ahead futures price.Only expiration month contracts priceshowed strong cointegration with spotprices. For several reasons, this periodis very important. First, there is a fi-nancial crisis during this period, sec-ond, increasing importance of agricul-tural commodity (especially palm oiland rubber, largest foreign currencyearner). It is assumed that CPO futuresare a well-established derivative mar-ket. Therefore financial crisis shouldnot destabilise the market and, if any,then the correction process should bequick and efficient. There is stronglong run relationship between spot andfour-month, three-month, two-monthahead futures price and also with theexpiration month contracts price.The error correction results implieslong run bi-directional informationalflow between the two markets duringthe expiration month. Because of thelower transaction costs in the futuresmarket, spot price adjustment to shocksin the futures market should bestronger than its own shocks. The ECMexplains, on average, 25.1 percent ofthe variations in the spot price innova-tion and only 3.3 percent of the varia-tion in the futures price innovations.Social SciencesThe relatively high R2 for the futures tospot direction suggests that the futuresmarket playa leading role in incorpo-rating new information.In the case of short run adjustment,only lagged futures price coefficientsare statistically significant (measuredby F-value of 65.32,41.83,2668, and8.95). Whereas lagged spot price coef-ficients are not statistically significanteither individually or jointly. It sug-gests that most of adjustments in shortrun comes from the futures market notfrom spot market. It can be argued thatspot market, specially for the agricul-tural commodity, is not centralisedwhereas financial futures market iswell organised and centralised market.At the same time, informational ex-change in spot market is not highlysophisticated. Therefore most of theadjustments in the short run comesfrom the futures market. In the finan-cial market, both futures and its un-derlying asset market are centralisedand well organised. Therefore, shortrun adjustments occur instantaneouslyin both markets.For the period of 1990-1992, unidirec-tional informational flow from futuresto spot from three month before theexpiration to expiration month is ob-served. The cash and futures pricesstart to converge in the final month of acontract. In the ECM model, error termon spot equation is not significant withexpected sign at least at 5 percent levelof significance, which is contrary to thefutures market theory. It implies longrun bi-directional informational flowbetween the two markets during theexpiration month.For the period of 1993-95, there ap-peared to be lack of integration be-tween spot and futures price except inthe expiration month. There are severalreasons, which may responsible for thisdivergence. Strong industrial economy,high return on financial market (i.e.stock market, currency market) thatreduced the supply of arbitrage andspeculators in commodity futures mar-ket, high uncertainty of palm oil pricein the world market might have causedthis divergence. Lack of integrationbetween spot and futures will reducethe reliability of futures market.Between 1996-1998 there were evi-dencw to show strong long run unidi-rectional causality from futures to spotwith an expected sign for spot and fourmonth before expiration futures priceseries. For spot and three month beforeexpiration futures prices, the ECMresults show some surprises. The di-rection of causality changed to spot tofutures. In the short run, spot marketalso became dominant over the futuresmarket. R2 values also changed drasti-cally. The ECM explains only 4.7 per-cent of the variation in the spot pricechange and 45.2 percent of the varia-tion in the futures price change. Thisdirectional change may be due to thefinancial crisis. During the crisis, ring-git value depreciated and subsequentlymaking palm oil to become cheaper inthe world market, which boosted itsexports. Consequently the demand inthe spot market increased because ofthe short-term profit. But after the fixedcurrency and capital control, the de-mand and supply of CPO became sta-ble. Subsequent results suggest thatmarket adjust quickly after the crisis.All the error correction terms are sta-tistically significant with expected signfor spot and two-month and also expi-ration month futures prices. It indicatesthe bi-directional interaction betweenspot and futures in the short run. In thecase of short run adjustment, this pe-riod results showed a strong bi-directional causality even four monthbefore the expiration. This period re-sults showed some significant changesin spot price behaviour in term of in-formation role though futures priceshowed strong information role. It maybe due to the financial crisis that makesthe spot market more volatile compareto the normal economic condition.ConclusionsIn summary, in the futures market,delivery and non-delivery monthplayed a crucial role for restoring equi-librium. Therefore equilibrium situa-tions are different for delivery and non-delivery month contract. Therefore,one of the important contributions ofthis study is that it investigated theinformational efficiency by separatingthe futures prices according to maturity(delivery and non-delivery) life cycle.In this case, we choose four monthsahead to expiration month prices series.If futures price formation follows therational expectation, then informationwill flow from futures to spot and notthe other way around.As pointed out by Granger (1986), anerror correction model should producebetter short-run forecasts and will cer-tainly produce long-run forecasts thathold together in an economicallymeaningful way. Therefore, if futuresprices become reliable proxies of ex-pected cash prices, it will lead to thespot price into equilibrium.The results are generally consistentwith the assumption. That means, alldistant month error terms in spot equa-tion are statistically significant forthree sub-samples (87-89, 90-92, 96-98). It suggests that futures priceGranger cause the spot price by pro-viding future information regarding theexpected CPO prices. The evidence istherefore consistent with the importantprice discovery role served by the fu-tures market.The results from the third sub-sample(1993-1995) are not consistent with theassumption. All the error term surpris-ingly are insignificant except the onesfor expiration month. There is nocausal relation either from futures tospot or spot to futures. It requires someeconomic explanation why both mar-kets became independent. The tremen-dous increase in industrial output re-duced the importance of agricultureeconomy. Liberalisation of the econ-omy further exposed the CPO marketopen to tough competition from im-ported edible oils. With high unccr-tainty investors were not keen to investin the commodity market and thereforemarket lost equilibrium. During thisperiod there are some important finan-cial liberalisation strategy (innovation)introduced in the country, which pro-duced high return with low risk in thefinancial market compared to thecommodity market. This might be an-other important reason for divergencebetween spot and futures, which re-duced the informational role of futuresmarket.Terminal month equilibrium indicatesthe supply of arbitrage activity andefficiency of this activity. If terminalmonth equilibrium holds, then spreadwill tends to be zero after adjustment Oltransaction cost. In addition, all expec-tation will converge into the terminalmonth prices. Therefore, spot marketwill play dominant role along withfutures to adjust each other. The resultsare generally consistent with this as-sumption. All error terms in both equa-tions are statistically significant. There-fore, spot and futures prices appear to353UPM Research Report 1997-2000, Section 2-Extended Abstractsbe dependent on each other in terminalmonth.This study found that regional eco-nomic crisis does not change CPOfutures market's microstructure. Onlythe 3-month ahead price series (1996-1998) shows that spot market surpris-ingly became dominant over the futuresmarket whereas market adjustedquickly after this period of financialcrisis. Therefore subsequent price se-ries (2-month ahead futures and spotprice series) shows the dominant roleof futures market over the spot market.Therefore, these findings support thestrength of the market microstructureof a matured market.Benefits from the studyThe study provides an understanding ofthe informational efficiency of the CPOfutures market. It also provides someempirical evidence on the behaviour offutures market, which is useful for354policy analysis and further research onthis subject matter.Literature cited in the textEngle. R.B. and Granger. C.W 1987. Co-Integration and Error Correction.Representation. Estimation and Testing.Econometrica. 55: 251-276.Granger, C.W.J. 198I. Some Properties ofTime Series Data and Their Use inEconometric Model Specification.JournalofEconometrics.16: 121-130.Johansen, S. 1988. Statistical Analysis ofCo-integration Vectors. Journal ofEconomic Dynamics and Control. 231-254.Kawai, M.l983. Spot and Futures Prices ofNonstorable Connnodities Under RationalExpectations. Quarterly Journal ofEconomics. 98: 235-254.Project Publications inRefereed JournalsFatimah, M.A. and Zainalabidin, M. 199I.The Efficiency of the Crude Palm OilFutures Market in Establishing ForwardPrices. Journal of Malaysian AgriculturalEconomics. 8: 25-39.Project Publications inConference ProceedingsTaufiq Hassan, Fatimah Mohamed Arshadand Annuar Md. Nassir. 200I.Informational Efficiency of CPO FuturesContract, paper presented at the SeminarFEP 2001, organized by the Faculty ofEconomics and Management, UniversitiPutra Malaysia, Kuantan, 2-5 October2001, Kuantan, Pahang.Graduate ResearchAbdullah Farah Ahmed. 2001. AgriculturalEconomics [M.Sc]. Universiti PutraMalaysia.Chan Tung Sing. 200I. Economics [M.Sc].Universiti Putra Malaysia.Taufiq Hassan. 200I. Finance [Ph. D].Universiti Putra Malaysia.

Informational efficiency of CPO futures contracts

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Informational efficiency of CPO futures contracts

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