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Does the London Metal Exchange Follow a Random Walk? Evidence from the Predictability of Futures Prices

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Does the London Metal Exchange Follow a Random Walk? Evidence from the Predictability of Futures Prices A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Otto, Sascha Article Does the London Metal Exchange follow a random walk? Evidence from the predictability of futures prices The Open Economics Journal Provided in Cooperation with: The Open Economics Journal Suggested Citation: Otto, Sascha (2010) : Does the London Metal Exchange follow a random walk? Evidence from the predictability of futures prices, The Open Economics Journal, ISSN 1874-9194h, Bentham Open, Sharjah, Vol. 3, pp. 25-41, http://dx.doi.org/10.2174/1874919401003010025 This Version is available at: http://hdl.handle.net/10419/67422 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by-nc/3.0/ www.econstor.eu The Open Economics Journal, 2010, 3, 25-42 25 Open Access Does the London Metal Exchange Follow a Random Walk? Evidence from the Predictability of Futures Prices Sascha Otto* Helmut-Schmidt-Universität, Institut für Internationale Finanzierung, Holstenhofweg 85, D-22043 Hamburg, Germany Abstract: This paper analyses the validity of the weak-form market efficiency, using the random-walk hypothesis for the six industrial base metals - copper, aluminium, zinc, nickel, tin and lead - traded at the London Metal Exchange. I analyse the behaviour of daily and weekly prices of the daily rolling three-month futures contracts, as these contracts exhibit the highest level of trading activity. In contrast to other efficient-market studies, the efficiency of futures prices is not tested as an unbiased predictor of the spot prices but from the predictability of futures prices themselves. I focus on the post-Tin Crisis period of 1989 to 2007. My test methodology includes the Box & Pierce Q-statistics, variance ratio tests by Lo and MacKinlay with homoscedastic and heteroscedastic test estimates, nonparametric ranks- and signs-based variance ratio tests by Wright and wild bootstrapping variance ratio tests by Kim. My sample basis fails to reject the random-walk hypothesis for all base metal futures except for lead. Keywords: London Metal Exchange, LME, random walk, weak-form efficiency, futures markets, commodities. INTRODUCTION not tested as an unbiased predictor of spot prices, as is the usual practice in the literature, but from the predictability of Although the efficient-market hypothesis (EMH) has futures prices themselves. As many physical contracts are been extensively tested on different stock exchanges using cleared using the 2nd Ring settlement prices, there is a individual share and index data, most commodity markets feasible incentive for metal producers and consumers to have been neglected by recent studies (Moustafa [1]; manipulate these fixings in their favour. To avoid any Rahman and Hossain [2]). Particularly the markets for potential bias, I use the prices at the time of the NYMEX industrial base metals have been examined only close as a reference instead. superficially. Notably unexamined until now has been the period after the Tin Crisis (1985-1986), which nearly led to a I try to seek evidence supporting the existence of at least collapse of the London Metal Exchange (LME). In this paper weak-form efficiency. As weak-form theory asserts that I analyse the behaviour of daily and weekly prices of the six successive returns generated by an efficient market will be traded base metals at the London Metal Exchange - copper, independent, I evaluate the hypothesis by performing aluminium, nickel, zinc, lead and tin - for random walk, different tests for random walk. The methodology employed implying weak-form market efficiency, as defined by Fama, includes the Box & Pierce Q-statistics, variance ratio tests by during the period of 1989 to 2007. Lo and MacKinlay with homoscedastic and heteroscedastic test estimates, nonparametric ranks- and signs-based The LME, along with the New York Mercantile variance ratio tests by Wright and wild bootstrapping Exchange (NYMEX) and the Shanghai Metal Exchange variance ratio tests by Kim. I also divide the sample into two (SHME), is one of the leading commodity exchanges for separate subsamples to check for structural breaks. As all base metals. In particular, the official fixing after the second sample sets are highly nonnormal, I focus on the results of morning trading session (2nd Ring) is an often-used price the signs-based variance ratio tests and the wild basis for physically settled contracts in the global bootstrapping variance ratio test, as suggested by Kim [3], metalworking industry. because these tests are more powerful and robust for The data employed in this study consists of the prices of nonnormal sample sets with an unknown distribution and the daily rolling three-month futures contract, which has the heteroscedasticity. advantage that it has not been adjusted for potential backwardation or contango market structures. Furthermore, LITERATURE REVIEW the three-month futures contracts are subject to the highest Since Samuelson [4] and Fama [5] independently trading activity level and should be considered the most formulated the efficient-market hypothesis, it has been liquid contracts traded at the LME. In contrast to other extensively applied to empirical studies of financial efficient-market studies, the efficiency of futures prices is securities markets. Fama defined an efficient market as one in which prices always “fully reflect” available information. The hypothesis can be tested in various forms. The weak- *Address correspondence to this author at the Helmut-Schmidt-Universität, form efficient-market hypothesis defines the available Institut für Internationale Finanzierung, Holstenhofweg 85, D-22043 Hamburg, Germany; E-mail: [email protected] information set as just the security’s historical price time series. It has been tested extensively for stock markets using 1874-9194/10 2010 Bentham Open 26 The Open Economics Journal, 2010, Volume 3 Sascha Otto autocorrelation tests, tests for random walk, runs tests, tests information is assumed to appear at random, so prices should for seasonal effects and spectral analysis. follow a random walk. Price changes are not dependent on each other. A simple random-walk process can be defined as: There are some studies that have focused on the LME. The majority of these studies focused on the period prior to Pt = Pt1 + ut (1) the Tin Crisis. Furthermore, none of the studies analysed the random-walk hypothesis for all six base metals traded at the where LME. Moreover, all studies tested market efficiency of the Pt = Price at time t futures prices as unbiased prediction of the spot prices. ut = error term for time t Taylor [6] tested the random-walk hypothesis on spot prices for copper for the period 1966-1978 and for zinc, lead As Campbell, Lo and MacKinlay [16] stated, there are and tin for the period 1970-1978. His results rejected the three different versions of the random-walk hypothesis, each random-walk hypothesis for all base metals but tin. Goss [7] of them being slightly more stringent. The strongest analysed the relationship of futures and spot prices for the assumption implies that all error terms ut are independent and copper, zinc, lead and tin markets during the period 1971- identically distributed (i.i.d.): 1978. His results showed a bias of the futures prices for lead 2 ut ~ IID(0, ) (2) and tin. This assumption implies that absolutely no information Bird [8] used filter techniques to test for weak-form on price changes can be obtained from the past. I apply efficiency on LME prices for the same metals during the homoscedastic variance ratio tests by Lo and MacKinlay and period 1972-1982. His results showed evidence of market nonparametric variance ratio tests based on ranks by Wright inefficiency for copper and and no evidence for tin. Goss [9] to test the strong version of random-walk hypothesis. applied joint tests for the same metals for the sample period 1966-1984. His results rejected the EMH for copper and The semi-strong form implies that the distribution of the zinc, but failed to reject the EMH for lead and tin. arrival of news can change over time, but it is still independent: MacDonald and Taylor [10] tested for co-integration for 2 four metals in the LME for the period 1976-1987. They ut ~ indep(0, ) (3) concluded that the copper and lead futures markets could be considered efficient. They rejected the EMH for tin and zinc. This form is very difficult to test because every single ut Gross [11] examined unvaried
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