The rising trend in grain prices has stoked fears of food price inflation because of the forward connections of grains with many food items, ranging from meat and eggs to sweets and chocolates, to cereals and pasta. Financial analysts have attributed the hikes in grain prices to increases in the demand for ethanol. These analysts have questioned the prevailing view that the culprits underlying the rising trend in grain prices are carnivores in countries like China and India, droughts in Russia and Eastern Europe, or heavy rain in North America. Instead, they view the real culprits to be increases in the consumption of ethanol and other bio-fuels which, through the derived demand, have led to increases in prices of these goods. Some researchers view the use of commodities by financial investors (the so-called “financialization of commodities”) as partly responsible for the recent price spike (Baffes and Haniotis, 2010).
This paper concentrates on the price discovery functions of four related commodities, namely bio-fuel ethanol, corn, soybeans and sugar. The first objective of the paper is to compare the price discovery performance of the ethanol futures price relative to the spot price of each of the three bio-fuel ethanol types which are traded at different commodity exchanges that are located in different countries. The second objective is to compare the performance of the spot price of each of the three associated commodities in corn, soybeans and sugar against their own futures and ethanol futures prices. The ethanol futures contracts are traded in a thin market, while those of the three associated commodities, corn, soybeans and sugar, are traded in more tightly traded markets.
The second objective has become particularly significant in light of recent studies that have compared the hedging effectiveness of ethanol futures contracts against those of corn and soybeans (Dahlgran, 2009, 2010). The third objective is to determine whether positive and negative shocks, which can cause narrowing and widening of the spread between spot and futures commodities, have a different impact on the price discovery function of the futures markets for the bio-fuel and commodities of interest in this paper.
It is interesting and vital to examine the behavior of futures and cash prices of ethanol and the associated agricultural commodities in corn, soybeans and sugar, which serve as cross-substitutes, because they share the same cropland. The futures contracts of these four commodities differ in terms of liquidity, as manifested in the respective sizes of their trading volumes and open interest positions, hedging capabilities in thinly and tightly traded markets, and integration over longer and shorter time intervals.
Comparing, for example, ethanol and gasoline futures contracts (Dahlgran, 2010), the trading volume of ethanol futures was 37 contacts per day through December 2008, with a maximum of 646 contracts per day, while the daily trading volume of gasoline futures contracts was 134,211 contracts, with a maximum of 516, 000 contracts per day for the same period. 2 Ethanol futures open interest is about two percent of its annual U.S. usage in March 2010, while that of gasoline futures is nine percent for the corresponding period. A futures contract’s trading volume should reach a threshold to suit both hedgers and speculators so that price risk can be passed between them without a high pricing penalty. Thus, some of these commodities, such as ethanol, have thin markets while others, like corn, do not.
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Asymmetric Adjustments in the Ethanol and Grains Markets
