Testing futures market efficiency: an empirical study

Some researchers have found that futures prices were biased predictors of future cash prices due to the risk averse behavior of market participants. This paper tested efficiency of corn and wheat futures market using the theoretical model developed by Turnovsky (1983).[superscript]1 The risk premium under the assumption of constant absolute risk aversion of producers and inventory holders was estimated using a nonlinear estimation technique and was used to specify another model of equilibrium expected prices to test if corn and wheat futures markets were efficient. The expectations in this study were formed rationally, which is a necessary condition of an efficient market;The empirical results showed that the risk premiums did exist in corn and wheat futures market and they were different for different group of traders. All of the estimated risk premiums were small, however, they were statistically significant different from zero. The estimated risk aversion coefficient of hedgers was higher than the estimated risk aversion coefficient of speculators for corn futures market. However, for wheat futures market the estimation showed that speculators had higher risk aversion coefficient than hedgers;It was found out that futures prices were biased predictors of future cash prices but the biases were very small. However, not only futures price was important in predicting future cash price, production cost, carrying cost and cost of using futures market were also important. The influence of futures price on future cash price would be diluted by the magnitude of these variables;The efficiency test based on the proposed equilibrium expected model in this paper found the corn futures market to be efficient, while the result was ambiguous for wheat futures market. This study showed that the existence of risk premiums and the biased predictor of futures price had nothing to do with the efficiency of futures market. The empirical test on corn futures market based on the proposed equilibrium expected price model in this study confirmed the efficiency of corn futures market despite the presence of the bias. ftn[superscript]1Turnovsky, Stephen J. "The Determination of Spot and Futures Prices with Storable Commodities." Econometrica, 51(5) (September, 1983): 1363-87.