Theory of Storage still Working!
This simple but interesting paper applies Working’s (1933) theory to six base metals traded on the London Metal Exchange (LME). Just as a quick reminder, the Theory of Storage makes two general predictions: (1) if inventory is low, spot prices will exceed futures prices (backwardation), and, (2) if inventory is low, spot price volatility will exceed futures price volatility.
The study follows Working by representing the relationship between spot and futures prices as a spread rather than in terms of a convenience yield. The spread is further modified to include interest and storage costs. Inventory data obtained from the 600 warehouses maintained by the LME is then compared to the adjusted spread of the forward curve. There is a strong relationship found between a negative adjusted spread and low levels of inventory.
The paper then modifies the annualized volatility of spot and futures base metal prices to create a measure of ‘excess volatility’. This technique isolates factors that only affect spot price. When plotted against inventory levels, spot volatility is almost always higher than futures, especially at less than 10 days inventory, supporting the theory that volatility increases toward maturity.
Data used: Both monthly and daily data, over a 28 year study period (1983-2011).
Applications: Given the clear influence of inventory over the spot-futures spread and volatility, and because inventory changes are so predictable, a model for inventory could predict spreads out to two months.
Citation: Geman, H. and Smith, W.O. (2013) ‘Theory of Storage, Inventory and Volatility in the LME Base Metals’, Resources Policy, Vol. 38, No. 1, pp. 18-28.
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