Steven Engelhardt

An article was brought to my attention today that indicated that spot and futures prices are failing to converge in certain futures markets. Below is an excerpt:

A futures contract is an agreement to deliver a specific amount of a commodity — 5,000 bushels of wheat, say — on a certain date in the future. Such contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices. A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than today’s cash market price. But as each day goes by, its price should move a bit closer to that day’s cash price. And on expiration day, when the bushels of wheat covered by that futures contract are due for delivery, their price should very nearly match the price in the cash market, allowing for a little market friction or major delivery disruptions like Hurricane Katrina.

But on dozens of occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day’s cash price for those grains.

For example, soybean futures contracts expired in July at a price of $9.13 a bushel, which was 80 cents higher than the cash price that day, Professor Irwin said. In August, the futures expired at $8.62, or 68 cents above the cash price, and in September, the expiration price was $9.43, or 78 cents above the cash price.

Corn has been similarly eccentric. A corn futures contract expired last September at $3.36, which was a remarkable 55 cents above the cash price, but the contract that expired in March 2007 was roughly even with the cash price.

Henriques, Diana B. “Odd Crop Prices Defy Economics“. The New York Times: 28 March 2008.

Why aren’t arbitrageurs buying grain on the spot market, selling futures, and making delivery?

Financial theory asserts that nominal interest rates can never go below zero¹; investors would rather hold on to currency than invest it at a loss. The real world disagrees.

Here is some quick-and-dirty SQL to calculate an geometric annual return (as a percent) from a column of monthly returns (in percents).

Update 2008-01-30 10:52PM: Here’s the equivalent “one-liner”:

Morgan Stanley has lost $3.7bn on subprime mortgage-linked investments in the past two months after a big market bet went disastrously wrong, the bank revealed Wednesday night.

…

Mr Kelleher said Morgan Stanley’s losses were not related to such client-linked business but were the result of a big bet at the end of last year that subprime securities prices would fall.

For some months this looked highly profitable but as subprime prices fell far further than the traders expected, the investment became heavily loss-making, due to a phenomenon known as negative convexity [emphasis mine].

Wighton, David. “M Stanley loses $3.7bn on one subprime bet.” The Financial Times 8 November 2007.

The bet that prices of subprime mortgage-linked securities were going to fall turned into a big loss because they fell too much? Bizarre. I should look into this further.

Update 2007-11-09 9:05AM: Aha!

Morgan Stanley lost its money on a badly engineered bet. It is particularly galling because its traders were right that subprime mortgages would get hit. The problem was, they had built up long super-senior mortgage exposure (which was meant to be safe) to help defray the cost of their expensive short positions. The subprime wipe-out ended up so extreme that those “safe” securities were hammered and ended up overwhelming the short positions.

“LEX COLUMN: Morgan Stanley’s hit.” The Financial Times 9 November 2007.

Rather than betting on subprime prices falling, Morgan Stanley was actually speculating that the spread between subprime and super-senior positions would widen. Unfortunately for them, they were wrong.

Many investors who thought they had avoided putting all of their eggs in one basket just got egg on their faces instead.

…

In the past few years, more assets have been acting similarly, says Anthony Richards, managing principal at money manager Stairway Partners. He has found that corporate bonds and emerging-market stocks increasingly have been moving in step with U.S. stocks. Lately, this has been true even for commodities broadly.

…

…with the flood of cash into financial markets in recent years making it harder to generate returns, the search for uncorrelated assets has become particularly keen.

But by deliberately investing in assets that have shown little correlation in the past, investors may be making those assets more correlated, says Craig Asche, executive director of the Chartered Alternative Investment Analyst Association.

…the riskiest financial assets are now showing the highest degree of correlations to one another, Mr. Richards says.

Lahart, Justin. “Ahead of the Tape.” The Wall Street Journal 1 March 2007: C1.

Bill Miller, manager of the $19 billion Legg Mason Value Trust fund, has posted returns better than the Standard & Poor’s 500-stock index 15 years in a row — a legendary run known in the industry simply at “The Streak.” No one else in the $8 trillion mutual-fund business is even close. Manu Daftary, manager of the Quaker Strategic Growth Fund, is second, with eight years of outperformance. But this year, Mr. Miller’s fund is down 3.6%, putting it 12% behind the S&P on a total-return basis, according to Morningstar (Mr. Daftary’s run is also in jeopardy; his fund is 6.4% behind the S&P). While Mr. Miller has made strong end-year runs in the past (last year’s big Google holding helped the fund edge past the benchmark at the last minute), it’s looking increasingly unlikely that he’ll do so this year.

MarketBeat: Where’s the Soda Pop? The Wall Street Journal 12 Oct 2006.

While I may have concerns about index investing, it remains extremely hard to consistently outperform an index.