Metals market efficiency in relation to foreign exchange and financial markets

Metals Market Efficiency in Relation to Foreign Exchange and Financial Markets Christopher L. Gilbert Division Working Paper No. 1987-9 October 1987 International Commodity Markets Division International Economics Department The World Bank Division Workine Papers report on work in progress and are circulated to stimulate discussion and comment,  METALS MARKET EFFICIENCY IN RELATION TO FOREIGN EXCHANGE AND FINANCIAL MARKETS Christopher L. Gilbert (Consultant) October 1987 The World Bank does not accept responsibility for the views expressed herein which are those of the author and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are -the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitation of its boundaries, or national affiliation.  TABLE OF CONTENTS SUMMARY ................................................................1iii I. INTRODUCTION ...................................................... 1 II. THE IMPACT OF EXCHANGE RATE CHANCES ON COMMODITY PRICES ...........5 III. DATA AND VARIABLE CONSTRUCTION...................................11 IV. ECONOMETRIC STRATEGY ............................................. 16 V. RESULTS ..........................................................21 VI. CHOICE OF EXCHANGE RATE INDEX .................................... 27 VII. CONCLUSIONS ......................................................30 REFERENCES.;............................................................39 Table 1 Estimates on the Null Hypothesis .................................32 '2 Tests for Departures from Market Efficiency ......................33 3 Price Innovation Relationships--OLS Estimates ....................34 4 Price Innovation Relationships--ARCH-OLS Estimates ............... 35 5 Innovation Relationships--SUR Estimates .......................... 36 6 Price Innovation Relationships--ARCH-SUR Estimates ................ 3' 7 Choice of Exchange Rate Index .................................... 38  SUMMARY The paper reports on the results of an extension of the testing of the efficiency of metal trades at the London Metal Exchange (LME). Earlier work by the author pointed to the importance of financial market variables such as interest rates, exchange rates and inflation to primary commodity markets--because they affect the terms on which futures or forward traders will be prepared to hold title to the commodity--and modelled these relationships. This theoretical development allows an extension of the concept of futures or forward market efficiency to include the potential for arbitrage between commodity prices and interest rates and exchange rates. A second point of interest is a revisiting of the question of the size of the response of metal prices to exchange rate changes. Earlier empirical analysis by the author had produced results which indicated, contrary to theory, that the elasticity of primary commodity prices to exchange rate changes was greater than one. The period of study covered LME forward prices over the period 1978- 85 and included seven metals. Previous tests of market efficiency by the author, using weak-form efficiency tests, had concluded that there was no evidence of departures from efficiency in LME copper trading, but that evidence for lead, tin and zinc was mixed. The tin market appeared to exhibit a significant risk premium while in lead, and perhaps also in zinc, current prices could be- predicted from previous prices. This paper extends - the. analysis to cover aluminum, nickel and silver and to include semi-strong form tests of efficiency of the LME in relation to foreign exchange and treasury Sill markets. In light of the tests carried out, none of the LME metals markets appear to conform to the efficient market paradigm. There is clear evidence of weak-form inefficiency through lagged dependence in the case of aluminum and possibly also copper, lead and zinc; there is somewhat weaker evidence of bias in aluminum, nickel, tin and zinc; there is evidence that the lagged forward premium (backwardation) has predictive value in aluminum and lead; and some evidence that exchange rate changes (and possibly also changes in inflation) are not transmitted efficiently to metals prices in the case of aluminum and possibly also lead, silver, tin and zinc. Aluminum, nickel and zinc are seen as having negative bias over this sample period, implying a preponderance of short hedging (typically associated with producer sales), while tin provides evidence of positive bias. This latter result may well be the consequence of very heavy forward support activities by the International Tin Council during the period. The exchange rate response parameters all take the predicted sign. The long-run elasticities are distributed fairly widely around the theoretical value of unity. Aluminum, nickel and zinc show much lower elasticities, which is consistent with producer pricing on a dollar basis (moreover, these three markets are dominated by a few large producers); while lead, silver and tin appear oversensitive to changes in the value of the dollar (i.e., elasticity  - iv - much larger than one). Copper alone has an estimated value close to the theoretical value of one. The interest, inflation and activity innovation effects are relatively poorly defined, except in the case of copper. It is notable that the activity variable, industrial production, is insignificant in the tin equation; this again may demonstrate the effects of international support of tin prices. Tests using differently constructed exchange rate indices yielded very different results. Theory suggests that in a multicommodity model the weights in the index will be complicated functions of all own and cross demand and supply elasticities and al-l market share parameters. Besides the GNP- weighted index used in the major part of the study other constructions of the exchange rate index included (i) the IMF's MERM index in which the weights reflect the weights of each currency in US overseas trade; and (ii) commodity- specific indices using weights proportional to, respectively, consumption of the commodity in each country, production of the commodity and production plus consumption. The commodity-specific indices gave the best fit with weighting by consumption shares giving superior results to weighting by either production shares or by an average of the two. The choice of the index had a significant effect on the size of the elasticity of the response of commodity prices to exchange rate changes. Use of the MERM index gave rise to high elasticities, reflecting the fact that the use of trade weights gives a particularly high. impact to currencies (in particular to the Canadian dollar) which vary little in relation to the US dollar. Since the MERM index shows relatively less variation than the other indices, the variation that exists must take a higher weight in the estimated regression. The size of the elasticity parameters should be regarded with some caution as they have been estimated in relationships which omit most of the fundamental determinants of price. This approach is reasonable as the study was mainly a test of market efficiency. In further work it may be useful to undertake the analysis using daily data which should strengthen the results on the question of the efficiency of these markets.  I. INTRODUCTION 1. Many important primary commodities are traded on forward or futures exchanges. These commodities may be regarded as either physical or financial assets. Producers and consumers are concerned with physical. properties of the commodity (location, purity, flavor, etc.), while futures traders are concerned with likely changes in the commodity price and, in particular, with movements in the basis (i.e. in the relative price of nearby and more distant futures). One should therefore expect that commodity prices will be affected not only by those factors which affect the supply and demand of the physical commodity (Cfundamentals"), but also by financial market variables which affect the terms on which futures traders will be prepared to hold title to the commodity. But despite this elementary observation, scant attention has been paid to financial mar'.et variables in the commodity modeling literature. 2. There are three sets of financial market variables that will, in principle, be important in considering commodity price dynamics. These are exchange rates, interest rates and inflation rates. The relationship between exchange rates and commodity prices was discussed in an equilibrium model by Ridler and Yandle (1972). That analysis was extended to include inflation in Gilbert (1973). However, neither of those models apply directly to markets in which stocks are carried and where interest rate changes will also be important. This extension was made in Gilbert (1985). A rise in interest rates * The work reported in this paper was completed while I was employed as a consultant in the Commodity Studies and Projections Division of the World Bank. I am grateful to Ron Duncan for encouragement and to Manuel Arellano, David Hendry and Harold Cataquet for comments. The current version of the paper has benefited from -seminar discussions at the World Bank and at the Oxford Quantitative Economics and Finance workshops.  -2- leads to a fall in asset prices as the given dividend stream is required to generate a higher yield. The same should be true in commodity markets where stock holders will be looking for a higher convenience yield. Gilbert (1985) also shows that if futures traders are risk neutral and if futures markets are unbiased commodity prices will respond only to the unanticipated components (the "innovations") of the exchange rate and inflation movements. 3. This allows an extension of the concept of futures market efficiency. A futures market is regarded as efficient if it is not possible to devise a trading rule based on a specified information set that will have positive expected profitability. In weak form efficiency tests, 1/ the information set is confined to the past price history of the asset price. Here, evidence of bias or of lagged dependence provides prima facie evidence of inefficiency, although there is no certainty that ihe implied trading rule would have covered transactions costs, or, in thin markets, that trades could have been made in sufficient volumes at the quoted prices. The results derived in Gilbert (1985) allow extension to semistrong form efficiency tests in which the information set is extended to include exchange rates, interest rates and inflation rates. Here one is asking whether it is possible to devise trading rules that involve simultaneous positions in commodity and forex markets, commodity and t-bill markets or commodity and physical markets which would have positive expected profitability. 4. The London metals markets provide a convenient and important testing ground for this theory. The London Metal Exchange (the LME) trades (or has 1/ See Fama (1970).  -3 recently traded) 1/ contracts in seven metals. These are silver (Ag), aluminum (Al), copper (Cu), nickel (Ni), lead (Pb), tin (Sn) and zinc (Zn). Silver, aluminum and copper are also traded on Comex in New York, and tin on the Kuala Lumpur Futures Exchange (Malaysia). 2/ The LME prices of these metals effectively constitute the free market prices, at least outside the United States., and in copper (and previously in tin) most trade outside the United States and the centrally planned economies takes place at or close to the LME price. 5. Gilbert (1986a) used weak form tests to examine the efficiency of LME trading in copper, lead, tin and zinc. He concluded that there was no evidence of departures from efficiency in the copper market where LME trading has been most active, but that the evidence for efficiency of the'other three markets was more mixed. The tin market appeared to exhibit a significant risk premium, while in lead, and perhaps also in zinc, the previous price history allowed prediction of current movements. 3/ In this paper, we extend that analysis to cover all seven LME metals and consider semistrong form tests of the efficiency of the LME in relation to forex and t-bill markets. 6. These tests also allow us to throw more light on the issue of the exchange rate response of commodity prices. The models derived in Ridler and Yandle and Gilbert (1973, 1985) imply that the equilibrium exchange rate elasticity of dollar commodity prices to a change in the value of the dollar 1/ Trading in the tin contract was suspended indefinitely in October 1985 after the International Tin Council default. 2/ Previously in Penang. 3/ This work was prompted by earlier discussions in Goss (1981, 1983) which were vitiated by serious econometric problems.  -4- will fall withirn the (0,1) interval. In practice, however, dollar commodity prices appear to have been overresponsive to exchange rate changes during the first half of the eighties. The model derived by Van Duyne (1979) allows the possibility of overshooting, but does not affect the equilibrium elasticity. Gilbert (1987) provides some evidence for the view that developing country debt service obligations have forced supply shifts which would have the effect of increasing this elasticity. The results reported in this paper a'low direct estimation of the exchange rate elasticity for the LME metals from the market price reactions to exchange rate changes. 7. The plan of the paper is as follows: in Section 2 we review the theory relating exchange rate changes to commodity prices; in Section 3 we discuss the data used for the efficiency tests reported in Section 5; Section 4 is devoted to econometric issues; in Section 6 we consider the implications of alternative weighting procedures in the construction of exchange rate indices; and Section 7 contains brief conclusions.  -5- II. THE IMPACT OF EXCHANGE RATE CHANGES ON COMMODITY PRICES 8. We first derive the Ridler and Yandle (1972) result, as generalized in Gilbert (1973). Write the price of commodity as p. Suppose country i's dollar exchange rate is x (domestic units per dollar). There are n countries with the United States taking index 1, so that xi = 1. Denote consumption of the commodity in country i by Ci = Ci [xip/qi] where qi is the appropriate price deflator in country i. Similarly, Let production of the commodity be Qi =. Q'[xip/qi]. Write the country i demand and supply elasticities as ei and c., respectively, with ei defined as positive. Let country i's share in world consumption of the commodity be w. = C./IZC and its share in world 1 i k k production be w. = Qi/kQk Define e and e as the weighted average demand and supply elasticities res,t-ctively (i.e.,