Base Metals Futures Price Formation Mechanism Study

China has become the world's largest consumer of copper, aluminum, lead, zinc and other nonferrous metals, with the second largest commodity futures market in the world, many studies have shown that the Shanghai Futures Exchange(SHFE) has not obtained the pricing power compared with China's consumption. London Metal Exchange (LME), established in 1877, is the world's premier non-ferrous metals exchange with more than 95% of its business coming from overseas. It offers a range of futures and options contracts for non-ferrous & minor metals, steel and plastics but most of trading volume comes from copper, aluminum, lead, zinc and other base metals. From the beginning of 20th century, LME has been releasing the market data of every trading day which are widely used as the benchmark of international metals trading. The price and inventory of LME have an important impact on the worldwide production and sales of non-ferrous metals. London Metal Exchange remains the leading market in the international trading of non-ferrous metals. So it is important to study the pricing mechanism of LME, and understand the key factors which dominate the price. Thus we can help domestic enterprises to make reasonable arrangements for the production to avoid price fluctuations. On the other hand, since the fluctuations of metal futures price would affect the costs and benefits of non-ferrous enterprises directly or indirectly, stock investors could develop a reasonable investment strategy through researching the price fluctuations of LME base metals.This paper reviews the theoretical and empirical researches of other scholars on future prices, and analyzes the trading mechanism of LME. Then it analyzes price volatility characteristics of basic metals on LME, and the dynamic price relationship between LME, SHFE and domestic spot market (SMM). As the speculative money plays an increasingly important role in base metals future market, it is hard to explain the price only with supply and demand theory. This paper propses goods and financial attributes of basic metals, corresponded with different factors affecting the prices. Finally, this paper builds a VAR model concluded LME stock, the OECD leading index of economic sentiment (OECD CLI), interest rates (Libor) and the US Dollar Index (USDX) to explain the future price formation mechanism of base metals, and analyzes the dynamic effects of the four factors on base metals prices with Impulse Response Function (IRF).This study proves the market effectiveness of LME, and its leading role in price discovering function compared to SHFE and SMM. The comparison results of VAR model indicate that copper, zinc & tin have stronger financial attribute, while aluminum, lead & nickel have stronger goods attribute. The further comparison results of IRF model indicate properties the order of six basic metals with financial attribute from strong to weak are:tin, copper, zinc, lead, aluminum, nickel.