Price Discovery in Agricultural Futures Markets: Should We Look beyond the Best Bid-Ask Spread?

Price discovery is the incorporation of information to prices through the actions of traders. Previous studies in financial markets have found evidence that informed traders may submit limit orders instead of market orders as part of their trading strategies. If so, the steps of limit order book (LOB) beyond the best bid and best ask spread (BAS) may contain valuable information and contribute to price discovery of the underlying asset. This is the first attempt to examine the informativeness of the LOB beyond the BAS for agricultural commodities. We reconstruct the LOB using market depth data and use three information share approaches to test to what extent the steps of LOB beyond the BAS contribute to price discovery. This is done for five major agricultural commodities, namely live cattle, lean hogs, corn, wheat, and soybeans, as well as the E-mini Standard and Poor's 500 Index (S&P 500) futures contracts. The results show that the steps of the LOB beyond the BAS contribute by over 27% to price discovery of futures contracts. Across agricultural commodities, the steps of the LOB beyond the BAS have more information for grains than meats. Moreover, beyond the BAS, the steps closer to the top of the book contain more information for livestock and E-mini S&P 500. For grains, the steps farther from the BAS are as informative as the steps closer to the BAS. These findings suggest that informed traders in futures electronic markets actively use limit orders with price steps beyond the BAS.