Research On The Micro-floundation Of Futures Market

The futures market can not be fully functional or increase its efficiencies without the enhancement of the micro fundamentals. The variability in the market micro fundamentals determines the characteristic changes in the futures market, e.g. the market liquidity, volatility, transaction costs, the efficiency of hedging and etc. Such variability will further change the mechanism of how the market processes information and formulates the prices, which shall have significant impact over the volatility of yields and the price-discovery function.This paper is constructed on the foundation of studying the theoretical research on the microstructure of both domestic and foreign financial markets. By referring to theoretical studies on futures market in recent years, the paper closely follows the interaction between market micro fundamentals and functionality, studies the functionality of the futures market and applies theories into the analysis of the operation of China’s futures market, thus further revealing the relationship between micro fundamentals and market functionality in China’s futures market.Based on the results produced by both domestic and international studies, this paper, first of all, studies the microstructure characteristics of China’s futures market, including market depth, broadness, intra-day volatility, price continuity and price convergence. The analysis of over3.6million pieces of recorded high frequency data on7longest listed and most actively traded products at Dalian Commodity Exchange (DCE)-Soybean1, Soybean Meal, Soybean Oil, Palm Oil, Corn, PVC and LLDPE-indicates, among all7products, corn and soybean meal are the most liquid while palm oil is the most illiquid; soybean oil shows the highest intra-day volatility, soybean meal the second highest while corn the lowest. Also, the intra-day volatility at Dalian market roughly tends to become smoother as the trading becomes more active, which is similar to the overseas market.Secondly, the paper analyzes the efficiencies of China’s futures market from the perspective of both price discovery and hedging functions. The efficiency of price discovery is mainly measured by the correlation, stability, causality and co-integration of prices. Specifically, the paper uses correlation coefficient to measure correlation, ADF test to testify the price stability, Granger test to decide the causality between prices and Johansen co-integration test to decide the co-integration of prices. The empirical study on the soybean oil and meal data demonstrates that the correlation coefficient of futures and cash prices of soybean meal in2011is0.86(it is0.83in2010), which means the correlation between futures and cash prices has increased. The CBOT and DCE futures prices and the cash prices at both places in2011are integrated of order one. The Granger Test between every pair of the4price series reveals the following causal relationship:the CBOT price and the DCE price are the causality of each other; the DCE price indicates the cash price; the CBOT price indicates the cash price. The co-integration test result shows that from Mar8of2011to Dec20, there exists no co-integration between the DCE price and the cash price. The correlation coefficient of futures and cash prices of soybean meal in2011is0.98(the coefficient is0.99in2010), which means the correlation between futures and cash prices has decreased. The2011CBOT and DCE futures prices as well as cash prices in both places are non-stationary series. The causality test of each series, which has taken first order differential, shows that the CBOT price indicates the DCE price and the cash price in the states. The DCE price indicates the cash price. The co-integration test indicates that there exists co-integration between soybean oil futures and cash prices in2011.In the study of hedging efficiency, the paper uses not only the traditional methodology but also the Cash Flow at Risk (CFaR) method. Results of the basis analysis on the most active soybean meal contracts (Jan, May and Sep contracts) in the nearest15days before the last trading day have shown that the convergence degree of soybean meal futures and cash prices in2011is slower than that in2010. The average basis of the contracts in the last trading period has increased to85Yuan/Metric Ton from53Yuan/Metric Ton in2010and the basis of the contracts in the maturity stage has increased to3%in2011from2%in2010. The hedging efficiency of Dalian soybean meal active contracts has increased by3.74%in weekly hedging and1.8%in monthly hedging from2010to2011; monthly hedging efficiency has outperformed that of CBOT.Results of the basis analysis on the most active soybean oil contracts (Jan, May and Sep contracts) in the nearest15days before the last trading day have shown that the convergence degree of soybean oil futures and cash prices in2011has improved from2010. The average basis of the contracts in the last trading period has decreased to86Yuan/Metric Ton from135Yuan/Metric Ton in2010and the basis of the contracts in the maturity stage has decreased to0.88%in2011from1%in2010. The hedging efficiency of Dalian soybean oil active contracts has increased by3.47%in weekly hedging and2.74%in monthly hedging from2010to2011. The hedging efficiency of Dalian soybean oil active contracts is still behind that of CBOT.In order to further analyze market liquidity, the paper uses not only the traditional market depth and broadness indices but also the adjusted Amivest liquidity ratio as the measurement of market liquidity to compare the liquidity, especially the intra-day features, between domestic and foreign futures markets. The intra-day liquidity of futures market features an upright U shape. During the last30minutes before opening quotation, the market is active with a large volume and a small bid-ask spread and it tends to cool down afterwards. During the last30minutes before the closing quotation, especially the last15minutes, the market again becomes active with a large volume and a small bid-ask spread. The results are consistent with those produced by empirical studies overseas.Besides, due to the fact that the futures vs. cash spread and the inter-month spread attract corresponding participants and help increase the market liquidity, this paper analyzes not only the price volatility but also the inter-month spread volatility. Statistical results show that the volatility of soybean oil, soybean meal, corn, PVC and LLDPE has gradually decreased. The average basis of soybean oil in2011changes to-191.19from-196.80in09-10, indicating the2011average basis doesn’t change a lot. The standard deviation of the average basis has significantly decreased to173.94from247.80and the volatility decreases. The maximal basis changes to150from300while the minimal basis changes to-718from-1350; volatility range changes to868from1650:these also demonstrate that the basis volatility range is relatively smaller. The average basis of soybean meal in2011has significantly increased to77.37from-361.19in09-10, reflecting the change from a negative basis to a positive one. The standard deviation of the average basis has significantly decreased to129.43from226.36and the volatility decreases. The maximal basis changes to344from72while the minimal basis changes to-180from-830; volatility range changes to524from902.The main conclusions of this paper are as follows:(1) China’s futures market largely realizes its price-discovery function. For products like soybean, soybean oil and soybean meal listed on DCE, there exists the causality relationship between Dalian futures prices and Chicago futures prices; the DCE futures prices have already become leading indicators to corresponding prices in the cash market.(2) China’s futures prices have a much stronger say in the globe:it has already begun to take shape of a global pricing center in products like the Shanghai copper and the Dalian soybean oil and soybean meal. However, in order to completely grow into one of the world’s futures pricing center, China needs to continuously diversify its futures product portfolio, and gradually include options and other derivatives. Moreover, it is necessary to deepen the process of the open-up of China’s financial market and involve the participation of industry clients and institutional investors on a global scale.(3) The liquidity in China’s futures market has decreased and the position structure demonstrates some unreasonableness. In2011, as the government took a series of macroeconomic measures against inflation, the changes in the macroeconomic policies of the futures market influenced the micro fundamentals:the liquidity decreased and the market prices became less elastic, which, as a result, has prohibited the realization of the market functions. More attention shall be paid to these changes and proper measures taken to increase the market liquidity.(4) The efficiency of hedging in China’s futures market is increasing and the practices in the overseas futures markets demonstrate that hedging practices can be more precisely quantified, in either trading strategies or risk management. In order to attract more large institutional players to the market, it is necessary to improve the trading skills for hedging, study quantitative models and risk management practices for hedging adopted by foreign institutions and standardize the quantitative management practices.The paper suggests the following:First, promote the innovation and development on futures products and rules. China’s futures market, after20years’development, has just acquired voice globally. Therefore, it requires attentive care and stable growth. In recent year, there hasn’t been too much innovation in the domestic futures market; the launch of options, index products and financial futures derivatives is yet to start and get enhanced. Only a complete product portfolio can help bring the emergence of hedge funds, increase market liquidity and gain more voice in pricing. Second, explore the possibilities of the open-up of China’s futures market and introduce foreign industry and institutional investors to the market. It is suggested to start with the trial of QFII mechanism, better realize the price discovery function and have more say in the global futures market. The futures market is more globalized and cannot become the pricing center without participation of global industry and institutional investors even if is relies on a strong real economy. For instance, Thailand is the largest producer of rubber, however, Agricultural Futures Exchange of Thailand is not yet a pricing center on rubber futures. In contrast, Tokyo Commodity Exchange has become a global pricing center because of the participation of industry and institutional investors from all over the world.Third, enhance investor education on institutional investors, improve the market investor structure and increase the market liquidity. It is necessary to diversify trading order types in the futures market and encourage the development of quantitative trading techniques like programming and algorithm trading, thus providing more flexibility to institutional investors. It is also a must to enhance the training of institutional investors to get them better prepared for future participation in the futures market.Forth, support the market for quantitative research. In recent years, the increased volatility of global financial derivatives market demands more on the enhancement of market research and risk management. Currently domestic institutions still stick to the traditional trend following strategy with a qualitative perspective. With the upcoming internalization of RMB, the open-up of the financial derivative market is just around the corner. Foreign industry and institutional investors are well equipped with developed and complete strategy trading and management platforms. Domestic investors need to strengthen research on quantitative trading, more precisely follow the changes in the market microstructure, adjust the trading strategies accordingly and get better prepared for future challenges posed by new market trends.