Basis speculation in commodity futures: The maturity effect

✍ Scribed by Mark G. Castelino; Jack Clark Francis

• Publisher: John Wiley and Sons
• Year: 1982
• Tongue: English
• Weight: 515 KB
• Volume: 2
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.3990020211

✦ Synopsis

he behavior of the basis from the time a hedge is placed until the time it is T lifted is of considerable importance to the hedger. The very essence of hedg--ing involves an exchange of risk-of price level risk for basis risk. In the placing of a hedge, a hedger is confronted with a choice of several futures contracts. The selection of the appropriate contract is no trivial matter, since it involves the incurring of the risk pattern associated with that contract, Samuelson (1965) has shown theoretically that futures prices become increasingly volatile as a contract approaches the delivery period. Testing of this proposition has yielded mixed results. Castelino (1981) provided strong evidence supporting the Samuelson proposition, while Dusak (1979), Rutledge (1976), and Segall (1956) have come up with evidence which provides mild to no support.

If futures prices do become increasingly volatile as contract maturity is approached, then that result has important implications for the behavior of the basis over the life of the same contract. In fact, this article shows that the volatility of changes in the basis must necessarily decline as maturity approaches. This means that hedging in a nearer contract involves less basis risk than hedging in a more distant contract. This in turn implies that if risk reduction is the motive for hedging, then a nearer futures contract is the preferred choice for hedging over a more distant contract. This article will analyze the behavior of the basis over the life of a commodity futures contract. Basis change volatility is discussed, and empirical evidence is presented on several commodities. We conclude with some suggestions for further research. A formal development of the model and a detailed description of the empirical tests are reported in the Appendices.