Further evidence on the relationship between spot and futures prices

Based on a theoretical model, Tiltonet al. (2011) concluded that spot and futures prices should be highly correlated during periods of strong contango and much less correlated during periods of weak contango and backwardation. More recently, Gulley and Tilton (2014) found empirical support of this hypothesis for copper data during the period of 1994–2011. In this note, we show that Gulley and Tilton's findings can be rationalized by the theory of storage, as periods of contango and backwardation can be singled out by the sign of the interest-adjusted basis (i. e., storage cost rate minus convenience yield). Our estimation results for the six base metals of the London Metal Exchange show that a stronger association between futures and spot returns during periods of high stocks (i.e., positive interest-adjusted basis) holds only contemporaneously. Indeed, Granger causality, especially from futures to spot returns, may take place regardless of stock levels.