Pressure Effects in Financial Futures Markets

Abstract

Futures bias, the phenomenon that futures prices deviate from expected future spot prices, is widely acknowledged and documented by researchers and practitioners alike. Academic literature presents two prominent explanations for this effect. The first theory, documented by e.g. Black (1976), implies that futures bias is caused by systematic risk, the covariance of futures returns with market portfolio returns, and therefore can be viewed as a risk premium that market participants are willing to earn (or pay) when entering futures positions.

Besides systematic risk, futures bias is explained by hedging pressure, the effect of net positions of commercial traders on futures returns. Keynes (1930) and Hicks (1939) imply that excess supply of futures contracts resulting from producers hedging their long commodity positions drives futures prices below expected future spot prices. Later literature such as Rolfo (1980) and Hirshleifer (1988) show that quantity risk and elastic demand may cause producers to enter long futures positions, inducing upward futures bias.

Bessembinder (1992) and de Roon et al. (2000) introduce models combining systematic risk and hedging pressure in a single framework. The latter paper shows that, with market participants holding both marketable securities and non-marketable assets requiring futures hedging, futures returns should partly be determined by each futures contract’s own hedging pressure, as well as cross pressures from other futures markets. Hedging pressure is also shown to affect underlying asset returns. Testing their models empirically, both papers conclude that while hedging pressure effects are present on most futures markets, evidence in financial futures markets is inconclusive.

Commitments of Traders (COT) reports issued weekly by the Commodity Futures Trading Commission (CFTC) show aggregate futures positions of large commercial (hedging), non-commercial (speculative) and non-reportable (small) traders. This data allows for creating time series of hedging pressure, as well as speculative and small trader pressure variables, showing whether each trader class is net long or short futures on average. In addition, total open interest in each futures contract is documented in COT reports.

Building on the hedging pressure model introduced in de Roon et al. (2000), this study adds new variables for speculative and small trader pressure. The original model, extended pressure model and simple regressions from total open interest to returns are tested on six financial futures indices with data from 2003 to 2015. Splitting the sample in two sub-periods, temporal changes in pressure and open interest effects on returns are examined. The results show that, controlling for systematic risk, some statistically significant effects for all included pressure variables are present in both sub-periods. For five out of six futures indices, however, total open interest is more significant than any pressure variable in explaining futures returns. Effects of pressure variables on other financial futures, or on underlying asset returns, are not observed to a significant extent.