Basis variation and a common source of risk: evidence from UK futures markets

Using multiple equation Generalized Method of Moments (GMM) system estimation procedures and monthly data at the three maturity horizons of 6, 9 and 12 months, the paper explores whether conditional spreads between futures and spot rates on five contracts traded on LIFFE have a common predictable component driven by a single unobservable source of risk. The future contracts studied are: 3-month ECU; 3-month Euromark; FT100 Index; German Government Bond; and 3-month Short Sterling. The sample period is October 1989 through August 1996. Movement in the price of systematic risk is proxied by ex ante variables that have been shown to have predictive power for returns from bond and stock markets. These are: the return on the US Standard and Poor index; the return on the German Dax index; the UK and US 3-month treasury bill yield differential; the spread between the UK 20-year gilt yield and the UK 3-month treasury bill yield; the spread between the debenture and loan stock yield and, the 20-year gilt yield; the dividend yield on the FT Actuaries All Share index; and the change in the yields on UK government consol 2.5% bonds. The results indicate that common variation in bases exists and that relative conditional covariances are constant over all horizons. The evidence reported also suggests that, at short horizons, common basis variation is associated with both spot price forecasts and futures market risk while, at medium and long horizons, the dominant source of the reported common basis variation is due to the systematic risk associated with the futures position.