The risk management effects of alternative settlement specifications in commodity futures markets

The economic function of a futures market is performed efficiently only when a high level of competition exists among the participants. The prevention of distortions such as "squeezes" or "corners" has been an area of major concern for futures institutions. At the heart of such distortions lies the type of settlement system associated with the futures contract. The general objective of the thesis is to analyze the present delivery system in the Chicago Board of Trade corn and soybean contracts, alternative physical delivery systems, and cash settlement systems. More precisely, the specific objectives of the study are: (1) to assess and compare the feasibility of alternative settlement delivery systems for corn and soybeans; (2) to develop a method for estimating optimal weights in a cash settlement index that minimizes basis risk; the value of the weighing scheme will be assessed relative to simple-average weights; (3) to construct an index where locations of the underlying prices are randomly selected in a manner which attempts to maintain a "consistent" index while inhibiting manipulation incentives.A theoretical model of futures pricing with delivery option is used to simulate futures prices with different delivery terms and construct cash indices. Several modifications to the current settlement system are made regarding the composition of the delivery set, the size and the nature of the discount/premium used to settle the contract at expiration, and the type of settlement. The results indicate that hedging effectiveness, when measured individually at non-delivery locations, responds to changes in delivery differentials as well as delivery locations. However, as results are aggregated over space, the changes in settlement specifications tend to affect hedging performance only marginally. Results also suggest that cash settlement provides slightly higher levels of hedging effectiveness than any type of multiple physical delivery.U of I OnlyETDs are only available to UIUC Users without author permissio