An investigation into the causes of non-martingale behavior in commodity futures prices

Typescript (photocopy).The weak form of the efficient markets hypothesis has been tested extensively in financial asset markets. The results of these tests indicate that the hypothesis that stock prices fully reflect available information generally cannot be rejected. When tested in commodity futures markets, however, the hypothesis does not retain its impeccable character. A survey of tests of efficiency in commodity markets reveals significant departures from the standard concepts of weak form market efficiency. The purpose of this research is to explain the causes or reasons for non-martingale behavior in commodity futures prices. The commodity futures market is modelled in a stochastic rational expectations structure in which risk averse firms and speculators maximize the expected utility of profits. Assuming a given stochastic aggregate demand, the aggregate supply and inventory demand functions are derived from the optimization processes of the individual participants in the market. From these aggregate relations the equilibrium spot and future prices are simultaneously determined. Emprically testable hypotheses concerning non-martingale behavior in futures prices are derived from the model. These hypotheses are compared to the standard tests of weak form market efficiency in commodity futures markets. The standard tests of market efficiency that are used in this study are univariate time series analysis in the time and frequency domains. In addition, the structural relations of the cash market, specified in the model, are estimated for various commodities. These results are used to analyze the relation between the structural parameters and variances of the model and the time series properties of futures prices. Other potential causes of non-martingale behavior in futures prices are also examined. In particular, the question of market thinness is examined through an analysis of the total volume and open interest in these markets.Evidence is presented that significantly links non-martingale behavior in futures prices to the coefficient of variation from the estimated equilibrium solution for the cash price. Furthermore, the average total volume and open interest in the commodity futures markets studied cannot significantly explain the non-martingale behavior. However, the coefficient of variation of total volume and open interest does significantly explain it