The relationship between spot and future prices: An empirical analysis

Abstract

In their recent article, Tilton et al. (2011) contend on the basis of conceptual and theoretical arguments that spot and futures prices for metals and other commodities should be closely correlated during periods of strong contango and much less correlated during periods of backwardation or weak contango. If true, this hypothesis implies that speculation and investor demand, most of which takes place on futures markets, should affect spot prices much less or not at all during periods of backwardation or weak contango.This study provides an empirical test of this hypothesis using daily changes in LME average copper prices over the 1994-2011 period. It finds that the correlation coefficients between day-to-day changes in spot and futures prices are quite close to one during periods of strong contango. During periods of backwardation and weak contango, the correlations are positive but lower. These findings provide empirical support for the hypothesis advanced by Tilton et al. that investor demand on futures markets affects spot and futures prices similarly when the markets are in strong contango but somewhat less so when they are in weak contango or backwardation.