"The Effect of Futures Markets and Corners on Storage and Spot Price Variability".

Over the years I've mentioned the snappy little paper (12 page) with the above title, but only yesterday realized we had not linked. Time to rectify the oversight. Here's a copy via Wharton:

Janet S. Netz, PhD
The Effect of Futures Markets and Corners on Storage and Spot Price Variability.

When a futures market is introduced, the volume of storage should become more sensitive to changes in the return to storage. The increase in storage sensitivity means that storage will absorba larger proportion of demand and supply shocks than it did previously, reducing spot price volatility. Data from the Chicago Board of Trade support the hypotheses of increased storage sensitivity and reduced spot price volatility. The effect of futures on spot price volatility is sensitive to the competitive structure of the futures market. Futures market manipulation causes spot price variance to increase. Despite manipulation, the development of the wheat futures market caused the coefficient of variation of spot price to decline significantly. Key words: corners, futures markets, price volatility.

For many commodities, storage exists as a way to smooth consumption and production. Storage bolsters demand in times of abundance and sup- ply in times of scarcity, thus reducing cash price swings. Storage is risky, however, since next period's price is unknown when inventory levels are chosen. When available, futures can be used to manage price risk. It is argued that futures encourage storage, either by reducing the risk storers face (Gilbert) or by providing agents with more information regarding the actual return to storage (Gray, Williams, Working). Since futures markets reduce the risk of storage, storage will become more sensitive to changes in the return to storage. This increased sensitivity will in turn dampen cash price swings, leading to a less variable cash price. The present paper adds to the literature in several dimensions.

First, the effect of a futures market on storage is estimated. Several theoretical papers claim that whether the development of a futures market stabilizes spot price depends on how storage changes in response to a futures market (Sarris, Turnovsky 1979). However, futures markets' effect on storage has not been analyzed empirically. Second, the extent to which futures markets reduce spot price volatility fora storable commodity is estimated. Gilbert shows that storage removes a good portion of spot price volatility, leaving little for futures markets to contribute. The re- sults here show that, although spot price variance falls by a small amount, the coefficient of variation declines considerably.

Finally, the effects of corners and other market manipulation on spot price and storage are analyzed. Manipulation causes the spot price to be more volatile than it would be in the face of a perfectly competitive futures market. The effect of futures markets on price volatil- ity have been examined, theoretically and empirically. Much of the literature, however, ex- amines the role of futures as information disseminators. While futures prices do give information to agents, the focus of this paper is futures as risk management tools. The effect of futures on storage provides an additional means for futures to lead to increased price stability. Theoretical papers which have included risk- averse storers--for example, Kawai, Sarris, and Turnovsky (1983)--have each shown that, under certain assumptions, introducing a futures market will lead to decreased price volatility.

Thus, empirical work will not give a definitive answer for all cases; the effect will be different for each market.Turnovsky (1979) develops a model, similar to the model employed here, where storage is equal to the rate of storage multiplied by the return to storage. Whenever the rate of storage increases, price stability results. Turnovsky concludes that when storage occurs, a futures market may or may not stabilize price. However, his analysis is subject to the Lucas critique: Turnovsky has assumed that the rate of storage does not change when futures are available. The model below shows that the rate of storage does change, and in fact increases. Thus the development of futures for a storable commodity should lead to reduced price volatility. ....

Let's just skip ahead to the fun stuff shall we?

pp. 8 (of 12)

Effect of Futures Market Manipulation

The model derived above assumed perfectly competitive futures and cash markets. While in general this is an accurate description, the first fifty years of futures trading at Chicago were subject to numerous attempts to corner or squeeze the market. Manipulation arises through attempts to take advantage of temporary market power. Edwards and Edwards show that the variance of cash price will generally rise in the face of manipulation. As will become clear, manipulation affects storage as well.

The most common form of market manipulation comes from speculators long in futures. 16 The agent buys futures contracts such that the obligations to deliver to the trader exceed the available deliverable supply. The agent then accepts delivery, which forces both the spot and futures prices to rise. The spot price rises as those who hold short contracts try to buy the cash commodity to deliver, and the futures price rises as agents try to offset in the futures market by purchasing an offsetting contract. When a manipulator is taking advantage of a market-based shortage of deliverable supply, the action is referred to as a squeeze. In a corner, the agent contributes to the shortage in the cash market. The agent can manipulate the market by simultaneously buying futures contracts and the actual good. By monopolizing the cash good, the supply available for delivery will be kept small. The agent can also fill up the regular elevators with grain, which further limits deliverable supply. Thus hedgers could be caught short in a corner, even if they have the good, if they are unable to move it to a regular warehouse.

Attempted corners are very risky. To be successful, the agent must act secretly. If a corner is suspected, other speculators will try to free- ride by also buying contracts, which increases the futures price to the agent. People will not be willing to sell contracts, and shorts will in- crease the deliverable supply. Even assuming success in this part of the manipulation, after the contract expires, the agent now has a long supply of the grain which must be sold off. Having to dispose of the grain often causes corners to be unprofitable.

In the event of a squeeze or a corner, the spot price rises as shorts try to obtain supplies to deliver. After expiration, the spot price will drop at least to the normal level, and it might plummet as the agent's supply of the grain floods the market. Thus some control over the influence of corners in estimating spot price is necessary. Furthermore, as today's spot price rises relative to tomorrow's expected spot price, the return to storage falls and the model shows stocks should fall. This effect will be captured in the coefficient on the return to storage. However, despite the low or negative return to storage, stocks re- main high or rise as wheat flows to Chicago in response to the high spot price. On the other hand, elevators may be filled to capacity with any grain, so that there is no room for increased wheat stocks. Thus, some control must also be taken for the effect of corners on stocks.

Incidents of corners are taken from historical accounts, primarily Taylor. Dates used are September 1865; July and August 1866; 18 August 1867; June 1868; July and August 1871; May, July, and August 1872; May, June, and July 1873; October 1875; February and September 1876; September 1877; March, May, and July 1878; June and December 1879; January, March, June, and August 1881; February, April, June, July, and September 1882; May 1883; March, April, May, and June 1887; and September 1888.

Each corner gives rise to two dummy variables. The first dummy takes on a value of one for the last two weeks of the month in which a corner is indicated. Although the agent may have begun purchasing contracts (and stocks) earlier, the abnormal price rise is expected toward the expiration date at the end of the month. The second dummy takes on a value of one for the first two weeks of the following month. This dummy attempts to control for effects as the agent sells off the cash good held. The first dummy, referred to as "during," is expected to be positive in the price equation, and positive or negative in the storage equation. Storage may be abnormally high as the agent buys the deliverable supply and keeps elevator space scarce.

On the other hand, storage may be low either in a squeeze, where there is a natural dearth of deliverable supply, or, as in Leiter's attempted wheat corner in 1897-1898, when the agent ships wheat out of Chicago to keep deliverable supply low. The second dummy is expected to be negative to indicate instances where the manipulator had to dispose of a large supply of grain, thus driving down the spot price. Of the thirty-eight corners or attempted corners identified through historical accounts, only seven have significant impacts on spot price and seven have significant impacts on storage. Results are presented in table 3....

....MUCH MORE
PDF] psu.edu

If that link should fail here is the Google Scholar page:  

The effect of futures markets and corners on storage and spot price variability

JS Netz - American Journal of Agricultural Economics, 1995 - academic.oup.com

When a futures market is introduced, the volume of storage should become more sensitive to
changes in the return to storage. The increase in storage sensitivity means that storage will
absorb a larger proportion of demand and supply shocks than it did previously, reducing
spot price volatility. Data from the Chicago Board of Trade support the hypotheses of
increased storage sensitivity and reduced spot price volatility. The effect of futures on spot
price volatility is sensitive to the competitive structure of the futures market. Futures market