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  • Pollcy, Roesrch, and ExterNal Afflrs

    WORKING PAPERS uSO%5 International Commodity Markets

    International Economics Department The World Bank

    June 1990 WPS 436

    Commodity Price Forecasts

    and Futures Prices

    Boum-Jong Choe

    Commodity futures prices have biases due to risk premia and expectational errors, thus limiting their usefulness as a short- term price forecasting tool. Also, futures prices are more adaptive to spot price movements than price expectations, but not necessarily more rational. x ,t

    The Policy, Reearch, and External Arfairs Complex disrnbuLcs PRI- Working Papers todissumninatethe rudLnp of wozt in pm and to mtnouage the exchange of ideas among lank staff and aU others interested in developnnent issuCs. These papes carry the names of the authors, flect only thcir views, and should he used and cited accordingly lbe rindings, intapractuons, and conclusiomi are the authors' own, They should rot be &attrbutd to the World lank its loard or Directors. iL managernint, or any of its menber countries.

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  • Policy, Research, and External Affairs

    International Commodity Markets

    WPS 436

    This paper - a product ol' the International Commodity Markets Division, International Economics Department- is part ol' a larger effort in PRE to understand the short- and long-run behavior of primary commodity prices and the implications of movements in these prices for the developing countries. Copies are available free from the World Bank. 1818 H Street NW, Washington DC 20433. Please contact Sarah Lipscomb, room S7-062, extcnsion 33718 (23 pages with charts and tables).

    Choc investigates the relationship between Choc investigates whether commodity commodity futures prices and price expectations, futures prices exhibit similar characteristics. He to determine the usefulness of futures prices as a also estimates a relationship between futures short-term price forccasting tool. prices and price expectations. His main findings

    include: Previous studies of forecasts from thc B;.;ik's

    Intcrnational Commodity Markets Division * The rational expectations hypothesis is morc found evidence that commodity specialists' widely rejected with futures prices than with the forecasts are outperfomied by "naive" (static) division's forecasts. l'orecasts, which will hold if commodity markets are efficient. On the other hand, lutures prices * Risk premia and expectational errors are also have shown biases, typically underforecast- equally impornilt in explaining the futurcs ing subsequent spot prices. Some researchers forecast bias --- SO l'utures priccs have to be attribute this futures discount bias to time- adjusted for risk prcmia to be uscful for short- varying risk premia. Others assumc that aoenis temi forecasting. are risk-neutral and that biases reflect market inreficiencs and the failure of rational expecla- * TIhe varitance of risk premia is not larger tions. than that of cxpected price changes for most

    comImIoditics. The infomiational value of' futums lrrices for

    lorecasting depcnds on thc sizc of' thc risk * The risk premium appears to be correlated prcnlium relative to the expectational error. A iit tihe l'utures discounit lor at Icast half the recent studv found that expeclational errors cominmo(ities. dominae the lforu ard discounit bias o' the foreign cxchange rate and that thc risk premiunm is small. Futures prices are rmorc heavily influenced relatively stable, and uncorrelated Mith the bT current spot prices than by expected future expectational crror. pnces.

    The PRE Working Palpr Series disseninates the fitdings of sAork under A i in the Bank s Pohlic, Research. and External Affairs Complex. An objictis c of the seri.s i to gCt Lhese findings gOut quckl\ , Ie en if presentations arc less than fullt pv1ished. The findings. interpretaItions. auid .owl. hlsixins iI the.e papers do neot necessarild re present official Bank polic.

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  • Commodity Price Forecasts and Futures Prices

    by Boum-Jong Choe

    Table of Contents

    I. Introduction 1

    II. Data and A Comparisu.t of Performance 2

    A. Data 2 B. Forecast Performance: A First Comparison 3

    III. Rationalitv of Futures Prices 6

    A. Rationality Test 6 B. Decomposition of Futures Forecast Bias 10 C. Variances of Risk Premium and Expected Price Change 11

    IV. Tests of Risk Premia and Expectational Errors 12

    A. Tests of Risk Premium 13 B. Tests of Expectational Error 14

    V. Futures Prices and Price Expectations 19

    VI. Conclusions 20

    References 22

  • I. INTRODUCTION

    The International Commodity Markets Division (CM) of the World Bank started forecasting primary commodity prices more than two decades ago. The forecasts have been prepared mainly for the Bank's internal use in project evaluation and balance-of-payments forecasting. As such, the forecast accuracy, or forecast biases and informational efficiency, has been a major concern and the subject of occas_.onal retrospective studies. Two recent examples are Castelli et al. (1985) and Warr (1988). Their main conclusions were that the forecasts have been biased and also informationally inefficient; that the forecasters have tended to adhere too long to their previous forecasts.

    Furthermore, these studies found some evidence that commodity specialists' forecasts have been outperformed by "naive" (static) forecasts,1 prompting the suggestion that for the purpose of short- term (up to one year) forecasting it may be better to rely on current spot prices or futures prices. Theoretically, this proposition derives its rationale from the belief that the commodity futures markets are efficient and that the futures prices incorporate all available information about the expected future spot prices. If so, commodity specialists would not be able to outperform the futures prices.

    However, a large and growing number of empirical studies of futures market efficiency have mostly rejected the unbiasedness hypothesis of futures prices as a predictor of the future spot rates. Typically, futures prices underforecast the subsequent spot prices. Although there has been a consensus regarding the existence and direction of the futures price bias, opinions are divided as to its causes. Hansen and Hodrick (1980), for example, assume that the investors are risk averse and the biases represent time-varying risk premia. The underprediction therefore, should not be interpreted as evidence of market inefficiency or irrational expectations. Other researchers have assumed that agents are risk neural and, therefcre, attribute the biases to market inefficiency and the failure of rational expectations .2

    Carrying the Hansen and Hodrick results a step further, Fama (1984) and Hodrick and Srivastava (1986) advanced the proposition that the variance of the risk premium is greater than the variance of expected changes in prices and that the two are correlated. In its extreme form, under the conditions of truly efficient markets, the proposition implies that the futures price bias consists only

    1 In fact, evidence on this point is mixed as will be shown in the next section.

    2For a survey of literature on the efficiency of the foreign exchange futures market, see Hodrick (1988).

    1

  • of a risk premium. Thus, the use of futures prices for short-term price forecasting wLll produce biased forecasts, with the biases being the risk premium. Under such conditions, since prices are martingales, the naive forecasts will do better than futures prices. Therefore, to give credit to futures prices as predictors of subsequent price changes is to admit market inefficiency, nullifying the very rationale for their use. Thus, the informational value of futures prices for forecasting the future depends on the size of the risk premium relative to the expectational error.

    The main purpose of this paper is to explore the relationship between commodity futures prices and price expectations. It focuses on the usefulness of futures prices as a short-term price forecasting tool. Recently, Froot and Frankel (1989) used survey data on exchange rate expectations to estimate the relative importance of risk premium and expectational error in explaining the forward discount bias in foreign exchange rates. They found that, contrary to the claims of Fama and of Hodrick and Srivastava, expectational errors dominate the forward discount bias and that the risk premium is small, relatively stable, and not correlated with the expectetional error. This paper follows the Froot and Frankel analysis to see if commodity prices exhibit similar characteristics. It goes a step further and estimates a relationship between futures prices and price expectations, a relationship derived from an explicit model of spot and futures price determination developed by Turnovsky (1983).

    The paper is organized as follows. The ne