Commodity Futures Markets and the Law of One Price, by Arvind K. Jain, Michigan International Business Studies, No. 16, Division of Research, Graduate School of Business Administration, University of Michigan, Ann Arbor, 1980
✍ Scribed by P. J. Kaufman
- Publisher
- John Wiley and Sons
- Year
- 1981
- Tongue
- English
- Weight
- 136 KB
- Volume
- 1
- Category
- Article
- ISSN
- 0270-7314
No coin nor oath required. For personal study only.
✦ Synopsis
This monograph on international commodity arbitrage, which was a rework of Mr. Jain's dissertation at the University of Michigan, represents a fine piece of analysis. Readers will be most impressed with the author's understanding of the practical problems and implications involved in price change and arbitrage. However, by clearly explaining all the variables, conditions, and assumptions needed to complete his analysis, the reader may be left with the feeling of fruitlessness concerning the outcome.
The "law of one price" is a theory which claims that prices in different countries are equalized through arbitrage. Therefore, if the exchange rate changes, the prices of the products in either one or both countries will adjust in such a way that they will return to the balance that existed prior to the change in exchange rates. This differs from the opposing principle called the "purchasing power parity" doctrine which states that the exchange rate provides the equilibrium for stabilizing international prices; therefore, a higher price in one country will be followed by a proportional drop in its rate of exchange.
Mr. Jain uses the futures markets in the United Kingdom and the United States to test the "law of one price." Since a price adjustment is most likely in a commodity which has all the characteristics of a futures market (i.e., liquidity, broad supply and demand, etc.), he studies those seven commodities common to both those markets: cocoa, copper, silver, sugar, coffee, soybean meal, and wheat. Two periods were chosen to compare the arbitrage: a fixed or stable period of exchange rate (1966)(1967)(1968)(1969) and a floating or unstable period (1971)(1972)(1973)(1974)(1975)(1976)(1977).
In presenting his analysis the author gives perhaps the best discussion of arbitrage available. He selects his data carefully, considers the spot market, contract maturity, choice of exchange rate, changing transportation costs, delivery points, the relative interdependence of the United States-United Kingdom markets, time differences, and various sampling errors. His perception of the impact of these factors seems very realistic to a professional trader.
From his study he is able to conclude that any support of the "law of one price" is not yet justifiable. By showing a strong mathematical correlation between the United States and United Kingdom markets, he claims that the futures markets represent the best vehicle for proving the "law of one price," but there is little chance of its validity in the results.
Despite all of the author's hard work, there are still a great number of uncertainties. The selection of commodities should have eliminated the wheat and soybean markets, since they are neither liquid nor comparable in the United Kingdom. The building of the three-and six-month data bases also presents possibly serious problems unless they were indexed. The author may have failed to account for the differentials in switching from one delivery month to another. When that switch involves two different crop years the price change can be large.