UK metal and energy basis variation and a common source of risk: A note

Abstract

Recent empirical studies reveal periods of strong mean reversion in futures market prices that cannot be wholly explained by asset specific variables implicit in traditional (certainty) theoretical models. It has been hypothesized that such characteristics may be due to time-varying factors such as the systematic risk associated with the futures position or cyclical factors associated with spot price forecasts. This note considers the extent to which these systematic influences can explain common variation in the spread between monthly spot and futures prices (the basis). The assets under consideration are: Aluminium and Copper futures, traded on the London Metal Market; and, Brent Crude Oil and Gas-Oil futures, traded on the London International Petroleum Exchange. The analysis covers the period June 1991 through September 1996. Using a portfolio approach to basis variation and multiple equation GMM estimation procedures, the hypothesis being tested is that conditional bases have a predictable component driven by a single unobservable source of risk. Movement in the price of systematic risk is proxied by ex ante variables that have been shown to have predictive power for returns from bond and stock markets. The results show that near-horizon, perfectly correlated commonalties exist across contract bases with similar maturities and that they are associated with systematic influences on spot price forecasts and on agents' perceptions regarding their futures market position. Copyright (C) 2000 John Wiley and Sons, Ltd.