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Micro-Structure of Futures Prices: Convenience Yield and Open Positions Data as Source for Predicting Inflation and Inflation Targeting Based Monetary Policy in G7 Countries Doctor of Philosophy Topic Proposal Presentation November 15th, 2012 Submitted to: Open University

Submitted By: Okan Aybar, ETU20111319 2

Introduction

• Mercantalist economies and commodity

driven markets.

– Rising world population. (80 Million per year) – Scarce Resources. – New Consumers (China, India) – Fall of paper assets and economic confidance and the financial crisis.

Submitted By: Okan Aybar, ETU20111319 3

Introduction (continued)

• Monetary policy methods.

– Price Level Targeting – Monetary Aggregates – Fixed Exchange Rates – Gold Standard – Mixed Policies – Inflation Targeting

Masson et al. (1997) Inflation targeting as a monetary policy framework that contains a specific target of future inflation and adjust all available monetary tools to accomplish this objective regardless of what happens in other sectors of financial and economic structure. Paper Claim

Submitted By: Okan Aybar, ETU20111319 4

The Rise of Inflation Targeting

Lars Svensson and Glenn Rudebusch (1999) The main success factor of inflation targeting is to forecast the inflation accurately. Tober and Zimmermann (2009) Focusing on either headline or core inflation depends on whether inflation is permanent or temporary. Jose De Gregorio (2012) Core inflation is better indicator than headline inflation in that the first

• ne signals inflationary pressure better than the latter one

Friedman (1968) and Phelps (1968) Policy makers should focus more on maintaining inflation under control while paying relatively less attention on unemployment. Their reasoning depended on that, accommodative monetary stances to lower unemployment may produce economy wide desired results only temporarily. (Bernanke et al. 1999) Thanks to inflation targeting that central banks and public established improved lines of communication and share the information about where the economy is headed. (Svensson 1997) Monetary policy can be achieved by following inflation targeting method. Paper Claim

Submitted By: Okan Aybar, ETU20111319 5

Drawbacks of Inflation Targeting

(Svennsson 1999) It may be a critical for a central bank to forecast and define the possible sources of the inflation. Mishkin (1999) and Kadıoğlu et al. Targeting inflation may cause interrupted production and unemployment. (Marquis and Cunningham, 1990; Cody and Mills, 1991). Commodity prices cannot be used effectively in formulating monetary policy because they are subject to large, market-specific shocks, which may not have macroeconomic implications Mnyande (2009) Inflation targeting regime is too narrow and that it focuses on consumer prices too much while ignoring the developments in the broader prices and markets in general. Lars Svensson and Glenn Rudebusch (1999) Inflation Targeting is not Perfect! Inflation targeting monetary policy framework is not perfect for its failure to respond to exogenous commodity price increases and asset price bubbles. Paper Claim

Submitted By: Okan Aybar, ETU20111319 6

Commodities vs Inflation

(Hassan and Salim, 2011) The overall index of commodity price, commodity price index for rural commodities, commodity price index for non-rural commodities and commodity price index for base metal commodities. They found these prices actually precede inflation. Paper Claim

Submitted By: Okan Aybar, ETU20111319 7

Commodities vs Monetary Policy

(Bessler, 1984; Pindyck and Rotemberg, 1990; Hua, 1998) Commodity price movements are the result of macroeconomic/monetary factors and that the causality should run from macroeconomic/monetary variables to commodity prices. Scrimgeour (2010) Commodity Prices are in strong co-relation with monetary policies as he found that every 10 basis points increase in interest rates cause commodity prices to fall by 0.5%. Paper Claim

Submitted By: Okan Aybar, ETU20111319 8

What do Today’s Central Banks Look At?

Commodity Prices + Macro Economic & Financial Indicators Inflation Targeting (Weller, 2002) Monetary policy makers study macro-economic indicators such as unemployment, real output growth and stock market returns which are used as important indicators for central banks. (Awokuse and Yang, 2002) Commodity prices signals the future direction of the economy. Paper Claim

Submitted By: Okan Aybar, ETU20111319 9

New Approach May Be Needed

Convenience Yield Open Positions Futures Adjusted Macro Economic & Financial Indicators Inflation Targeting

Commodity and Financial Futures Markets

Submitted By: Okan Aybar, ETU20111319 10

Convenience Yield vs Macro Data and Price Levels

Convenience Yield Open Positions Futures Adjusted Macro Economic & Financial Indicators Inflation Targeting

Commodity and Financial Futures Markets

Futures Price: Spot Price + Carry Cost + Convenience Yield (Expectation)

Stepanek et al. (2011) Convenience yield in general has predictive power on the inventory volume / turnover and future spot prices. Gospodinov and Ng., (2011 Concluded that individual and aggregate convenience yields of different portfolios of commodities may explain commodity prices and futures prices may contain information about future economic conditions Brennan (1958) Convenience yields are negatively correlated with inventories. Dinçerler et al. (2005) Convenience yields are conversely related to inventories Paper Claim

Submitted By: Okan Aybar, ETU20111319 11

Open Positions Data vs Commodity Prices

Scrimgeour (2010) Commodity Prices are in strong co-relation with Monetary Policies as he found that every 10 basis points increase in interest rates cause commodity prices to fall by 0.5%. (Pankki 2011) Described a model, based on speculative positions in the futures markets, which does a good job in forecasting the oil price one year forward. (Hamilton et al. 2012) We reviewed evidence that positions in crude oil contracts imputed from the reported agricultural holdings could help predict crude oil futures returns. (Basu et al. 2006) Concluded that the CFTC data can be used to construct reliable signals that tell a portfolio manager when to switch from equities into commodities and vice-versa. Paper Claim

Submitted By: Okan Aybar, ETU20111319 12

Research Questions

• CAN CONVENIENCE YIELD AND OPEN POSITIONS DATA BE

EFFECTIVELY EMPLOYED TOGETHER TO ANTICIPATE THE FUTURE SPOT PRICES AND POSSIBLE DEMAND AND SUPPLY SHOCKS?

• HOW CAN THE BEST PORTFOLIO OF FUTURES CONTRACTS, WHOSE

CONVENIENCE YIELD AND OPEN POSITIONS, EXPLAINING THE HEADLINE INFLATION, BE CONSTRUCTED?

• TO WHAT LEVEL OF ACCURACY CAN THE PROPOSED PORTFOLIO

ANTICIPATE THE INFLATION?

• HOW EFFECTIVELY CAN INFLATION TARGETING CENTRAL BANKS

IMPROVE THEIR POLICY MAKING PROCEDURES IF THEY WERE TO ADOPT THE METHODOLOGY THAT WILL BE PROPOSED TO ANTICIPATE THE UNDERLYING INFLATION IN G7 COUNTRIES?

Submitted By: Okan Aybar, ETU20111319 13

Rationale

It is important to spot inflation pressures correctly to successfully define moneytary policy. Effects of economic indicators and inflation on monetary policy and commodity prices have been the focus for monetary policy makers. Yet only few studies have been done to define the interaction between the commodity prices and economic indicators which contain ex ante data. If expectations components of futures prcies and open positions data are statistically linked with economic indicatrors, then economic indicators may be forecasted correctly thereby allowing the central bankers to act proactively. Although similar studies have been done, there is no academic paper that studied adjustment of economic indicators with expectations component of futures prices and open position data to reconstruct forecasts of economic indicators. This thesis aims to achive to deifne a methodology that the central banks may use in the future to successfully set monetary policies based on accurate forward looking indicators rather than lagged indicators.

Submitted By: Okan Aybar, ETU20111319 14

Methodology

1 & 3 Technique to understand that food and energy have relevant effects on inflation and that food prices have significant second round effects. Used regression to estimate spread regressions to generate forecast of the oil price Gregorio (2012) Alquist and Kilian (2010) Regression 1 An error correction model that considers the deviation of the current state from its long-run relationship and feed the found relationship in to the short-run dynamics, to explore if the long-run relationship between spot and futures prices provides information about the future changes in spot and futures prices Capolla (2008) Vector Error Correction Model 1 & 2 An estimation framework of oil prices that tend to have different character of risk premiums depending on different periods. Pankki (2008) Bayesian Vector Auto Regressive Modeling 1 Commodity prices can be used as signal for informing macroeconomic policy for possible actions in South Africa Causality to find observable long run relationships between energy prices and currency exchange rates. Found there is strong link between commodity prices and consumer price index Ocran and Biekpe (2007) Kıymaz and Perdue (2009) Verheyen (2010) Granger Causality Answ Found What? Who Used? Methodology

Submitted By: Okan Aybar, ETU20111319 15

Methodology (continued)

3 & 4 To investigate the implications of increased input prices, higher price support rates for corn, and higher price support rates for wheat on resource use, output, and income for individual commodities. Daryll and Earl (1972) Simulation Testing 2 Is a computational approach of portfolio

• ptimization applicable to broad range of

portfolio models employed by the investment community? (Perold 1984) Large Scale Mean Variance Portfolio Optimization 2 To explain the consumer price index, long- term behavior of consumer price index based

• n the amount of money supply.

Cronin (2010) Forecast Error Variance Decomposition based on Vector Auto Regression Ans Found What? Who Used? Methodology

Submitted By: Okan Aybar, ETU20111319 16

Methodology (continued)

Number Crunching Experiment Positivism Objectivist Simulation Testing Number Crunching Experiment Positivism Objectivist Large Scale Mean Variance Portfolio Optimization Number Crunching Experiment Positivism Objectivist Forecast Error Variance Decomposition based

• n

Vector Auto Regression Number Crunching Experiment Positivism Objectivist Regression Number Crunching Experiment Positivism Objectivist Vector Error Correction Model Number Crunching Experiment Positivism Objectivist Bayesian Vector Auto Regressive Modeling Number Crunching Experiment Positivism Objectivist Granger Causality Methods Methodology Theoretical Perspective Epistemology Study

Submitted By: Okan Aybar, ETU20111319 17

Potential Findings

• Futures prices and convenience yields are good reflectors of

expectations and are good predictors of future spot prices.

• Commodities are in close relationship with macro-economic

indicators as well as headline and core inflation.

• Individual futures contracts may be analyzed by their convenience

yield and open position data to find the best portfolio of contracts that may be forecasted.

• Thanks to multivariate analysis and portfolio composition models, a

portfolio of futures contracts may be constructed and analyzed to see if their convenience yield and open positions contain hidden forward-looking information about how macro-economic indicators and inflation may evolve.

• It is also expected to find a methodology that would be proposed for

G7 countries to define commodity futures price and open positions data ruled monetary policy.

Submitted By: Okan Aybar, ETU20111319 18

Schedule

M

• n

t h s

T A S K

1 2 3 4 5 6 7 8 91 01 11 21 31 41 51 61 71 81 92 02 12 22 32 42 52 62 72 82 93 03 13 23 33 43 53 6 Id e a G e n e r a t io n L ite r a t u r e R e s e a r c h R e s e a rc h P r

• p
• s

a l C

• n

d u c t E x p e r im e n t s W r it e u p D a t a D a ta E n t ry a n d T a b u la t io n A n a ly s e R e s u lts W r it e u p S e c tio n F in a l D r a f t

• f C
• m

p le te T h e s is

Submitted By: Okan Aybar, ETU20111319 19

Conclusion

• The literature that has been studied indicated strong ties between inflation

and macro-economic data.

• If commodities are further investigated, academia and practitioners may find

that there is more information hidden in the commodity futures prices.

• This thesis will focus on to finding a procedure to extract forward-looking

information from convenience yield and open positions data and use the findings to adjust economic indicators and inflation data that central banks use in their decision making models.

• It is expected that this thesis will contribute to the scientific knowledge of

monetary policymaking and therefore it will be a valuable piece of study.

Submitted By: Okan Aybar, ETU20111319 20

End of Presentation Thanks for listening