Futures markets: Optimal contract innovation in the presence of liquidity costs and price dynamics with storable goods

A model of futures contract innovation incorporates hedging with liquidity costs by imposing sequential and uncertain entry of hedgers with markets clearing after each entry. Hedgers have mean-variance preferences and rational expectations about their opportunities to trade upon future entry. It is shown that the optimal contract chosen by a volume-maximizing monopolistic exchange is one which perfectly correlates with the endowment differential of hedgers. Further, the exchange may choose not to offer closely correlated contracts when liquidity is sufficiently low. Next, a simple Lucas-type model of an infinitely-lived barter economy is generalized to allow for storability of goods with the goal of examining the time-series properties of prices. The model is solved numerically and fitted to futures time-series data using methods of moments. Its implications for other moments of interest are tested with the null hypothesis that if the model is correctly specified these additional moments should be close to those of the actual data. It is found that models where all goods are storable generally outperform a model where only one of the goods is storable. While the storage model can generate price series which display high levels of autocorrelation and a degree of conditional heteroskedasticity, overall the specified null hypothesis is rejected by the data.