Three essays on commodity markets’ quality

Agricultural commodity prices adjust to ever-changing factors including weather, technology, and policy. Prices signal which goods are abundant and which are scarce and generate responses in production, consumption, and trade. Frequent price changes increase business risks and drive the demand for hedging. In this context, derivatives markets play a key role in price discovery, price forecasting, and risk management. Since the introduction of electronic trading, U.S. agricultural commodity futures markets have undergone relevant changes that have raised market quality concerns. A reduced market quality may have implications for hedging effectiveness as well as for efficiency in price discovery and forecasting. This dissertation centers around commodity markets’ quality and their roles in price discovery and risk management. The first essay focuses on hidden liquidity in agricultural futures markets. Like many exchanges, the Chicago Mercantile Exchange (CME) allows traders to conceal part of their limit orders, known as a hidden-limit order (HLO) or iceberg order. This type of order is well known for attracting traders who cannot compete in the market in terms of speed. However, with HLOs, market participants have incomplete knowledge of the limit order book. We assess the effect of this lack of transparency on market quality during a period of high volatility. We focus on corn and live cattle futures markets. Our conservative estimates indicate that HLOs represent more than 10% (20%) of the total volume in corn (live cattle) futures market. The findings show that the existence of HLOs improves market quality in multiple dimensions: driving trading volume while reducing market volatility and enhancing market liquidity. Our results are critical for regulators and exchanges as they are supportive of a certain degree of opacity. They are also indicative that HLOs can protect traders who have speed disadvantages in the era of fast trading. The second essay investigates the existence of persistent profit opportunities in futures markets, which raises doubts on the quality of futures markets and challenges the market efficiency hypothesis. Specifically, with more than 30 years of data, we investigate Spread Time Series Momentum (STSM) in 22 U.S. commodity futures markets. First, we assess whether past spread returns can predict future returns, a necessary condition for the existence of momentum. We find predictability to be very weak after correcting for the issues affecting prior research. Second, we implement STSM-based investment strategies. We compare STSM profits for individual markets and portfolios to profits generated by a simple long-only benchmark strategy that does not require any predictability. STSM does not generate returns statistically different from the benchmark trading strategy, with both strategies generating very low or negative returns. For the momentum to outperform the benchmark strategy, predictability should be three times larger than observed from real data, but would entail substantial downside risk. In sum, the empirical evidence indicates that returns from STSM-type strategies are illusive for the commodities and period studied. The inclusion of unrealizable roll yield generates the illusion of profitable STSM trading strategies in previous research. The third essay investigates the role of U.S. agricultural commodity swap markets in price discovery and risk management. While swap contracts have become increasingly relevant financial derivatives in the past two decades, little is known about these markets. Using real-time released swap trade data for corn and soybeans from 2018 to 2019, we investigate swap markets from three different perspectives. First, we provide a descriptive analysis of the characteristics of swap markets relative to their futures market counterpart. We find that swap volume accounts for more than 16% (19%) of the total volume in corn (soybean) nearby futures market. Second, we investigate price discovery between futures and swap markets. Findings from our intraday analysis suggest that swaps and futures markets’ prices are bonded by an equilibrium relationship and their respective information shares are commensurate with their respective volume shares. Efficient price discovery in financial derivatives is at the core of hedging effectiveness, which we investigate in the third part of the article. Results suggest that futures contracts are superior to swaps in short hedging horizons. However, the two instruments are equally effective in hedging cash price risks for hedging horizons 35 (50) days or longer in corn (soybean) market.

Name thesis:degree_name

Ph.D.

Level thesis:degree_level

Dissertation

Discipline thesis:degree_discipline

Agricultural & Applied Econ

Grantor

University of Illinois at Urbana-Champaign

Year dc:date

2022

Author dc:creator

• Shang, Quanbiao

Contributors dc:contributor

• Serra Devesa, Maria Teresa
• Garcia, Philip
• Irwin, Scott
• Mallory, Mindy

• Commodity markets
• market quality
• futures markets

Statement dc:rights

• Copyright 2022 Quanbiao Shang

Language dc:language

en, eng

Handle dc:identifier

https://hdl.handle.net/2142/115855

OAI record oai:identifier

https://www.ideals.illinois.edu/oai-pmh?verb=GetRecord&metadataPrefix=etdms&identifier=oai%3Awww.ideals.illinois.edu%3A2142%2F115855