Chicago wheat
Chicago wheat remains the preeminent instrument for price discovery.

MILWAUKEE — While the Euronext Paris milling wheat futures contract has become a credible and sometimes preferred contract for hedgers, Chicago wheat remains the preeminent instrument for price discovery, according to a recently published research study.

A comparison of Chicago and Paris wheat contracts was the subject of a study, “Estimating the Location of World Wheat Price Discovery,” published in the October issue of the American Journal of Agricultural Economics. Researchers were Joseph P. Janzen, an assistant professor at Montana State University, and Michael K. Adjemian, a research agricultural economist at the Economic Research Service of the U.S. Department of Agriculture.

Applying high-frequency data and market microstructure methods, the researchers concluded that the Chicago Mercantile Exchange market accounted for 80% of price discovery during the 10-year period ending in 2015. Over the period, the percentage fell from about 91% to 75%.

Setting the stage for their exploration of what has changed in world wheat futures markets, the researchers provided background on the declining position of the United States in world wheat markets.

“The United States has historically been a major wheat producer and the largest wheat exporter,” they said. “However, two concurrent trends suggest that the prominence of the United States in world wheat markets is not assured.”

The first of these trends is the declining U.S. share of world wheat trade, dating back to the early 1980s when the United States accounted for more than 40% of global wheat exports, Mr. Janzen and Mr. Adjemian said. By contrast, they cited March U.S. Department of Agriculture forecasts ranking the United States as the fifth-largest producer (8.4% of global production), lagging the European Union, China, India and Russia, and the second-largest exporter (15.1%) behind Russia.

The export share loss has mirrored growth from former Soviet Union countries — Kazakhstan, Russia and Ukraine (K.R.U.), the authors noted, adding the K.R.U. exports are expected to reach 27% of world trade by 2025.

Coincident with the K.R.U. emergence has been the growth of a Paris wheat futures contract (formerly called the MATIF wheat contract), which more closely tracks supply/demand fundamentals of the K.R.U. and the E.U., the authors said.

“Futures exchanges located in the United States have been the world’s deepest and most liquid agricultural commodity markets with frequent transactions occurring between a large number of buyers and sellers,” the authors said. “This market liquidity is thought to provide more efficient and timely price discovery. Accordingly, traders of a given commodity tend to congregate at the most liquid exchange where trading is frequent and price discovery is best.”

At the same time, they noted that in some cases increased hedging effectiveness may be as or more valuable to hedgers than greater liquidity. It is this tradeoff that has allowed futures contracts in Kansas City and Minneapolis to thrive in the shadow of the larger Chicago contract and which also has helped the Paris Euronext milling wheat contract to grow.

Open interest in the Paris Euronext wheat contract was negligible (less than 10,000 contracts per day) in 2005 but has grown rapidly and steadily since. Paris open interest eclipsed Minneapolis is 2008 and has widened its gap above the U.S. contract since. From 2013 to 2015, Paris wheat trading volume was in line with Kansas City wheat and in 2015 was not far behind Chicago (recent open interest was 317,000 contracts in Paris versus 478,000 in Chicago).

“Traders may prefer the Paris market for a number of reasons, including hedging effectiveness, trading hours, and the currency in which trades are denominated,” the authors said. “If they act on their private information in the Paris market, price movement in Paris will increasingly lead price changes in other wheat markets. Instead of the Paris market acting as a complement to U.S. markets, establishing the price differential for wheat delivered in Europe relative to the United States, the Paris market may also substitute for U.S. markets in establishing the world benchmark value of wheat.”

As the Paris wheat contract has gained a firmer footing and U.S. wheat production and trade have diminished in importance, questions have emerged over whether the United States futures market remains the preeminent location of price discovery.

The authors cited a French grain trader’s claim that “the market is not done in Chicago anymore. Prices of the European continent have taken the leadership of the world wheat market.”

It was to test this claim that the authors sought to objectively measure the degree to which the Chicago wheat futures contract exhibits price leadership, whether new wheat price benchmarks are complements or substitutes and whether the diminished share of U.S. exports is a driver of how large a role U.S. futures markets play in price discovery.

To test shifts in price discovery, the researchers used high-frequency transaction price data for the three U.S. wheat contracts plus Paris Euronext. This approach was chosen over another common price discovery measurement tool — vector error correction models.

“Existing research cited above suggests that futures prices rapidly incorporate new information into existing prices,” the researchers said. “In the context of our study, this implies that daily futures price data aggregate over important price discovery dynamics.”

Data from the four markets covered in the study spanned Jan. 1, 2005-Dec. 31, 2015.

Using both “information share” and “information leadership share” measurements, the researchers estimated Chicago wheat futures were responsible for about 80% of price discovery during the study period.

Still, a fairly abrupt decline in the Chicago market’s share of price discovery emerged after the middle of 2010, and since then, “price discovery has become more diffuse between U.S. and European markets,” the researchers said.

“There are more days (than pre-2010) where the Paris market makes up a larger share of price discovery,” they said.

Also over the course of the study period, price shocks to the market became increasingly “contemporaneously correlated,” the researchers said.

This change, they said, likely was because “the Paris market began responding more quickly to common shocks to the fundamental value of wheat.”

The extreme K.R.U. region drought in 2010 and subsequent export ban may have been a catalyst for change in trading expertise in Paris, perceptions of the Paris contract or both.

“Our results suggest that the Paris market may more closely track supply and demand conditions in Europe and K.R.U.,” the researchers said.

Trading hours may factor into perceptions, the researchers said, suggesting that traders with market-moving information may be drawn to trade in the market open in Paris rather than the less active and liquid U.S. overnight trading session.

While trading hours appeared to be a significant factor in terms of price discovery, the role of trading volume was less clear. Looking at the Kansas City and Minneapolis markets versus Paris, the smaller U.S. markets also had a price discovery share four times higher than the European market.

Later, though, the researchers pointed out that U.S. markets are “tightly arbitraged with respect to common wheat market shocks.”

That the Paris market generates a significant share of price discovery during times of day that U.S. markets are thinly-traded or closed was another major finding, but the researchers said Chicago does not generate significantly more price discovery on trading days featuring a limit market move.

“Price limits, as imposed by the Chicago exchange, do not significantly constrain price discovery,” they added.

Price discovery rarely occurs in overnight trading sessions, the researchers said, hypothesizing that “informed trading is concentrated during regular business hours.”

 “We find a positive correlation between the share of trading volume and the share of price discovery, but the level of correlation suggests that other, likely unobservable factors are important determinants of the price discovery share,” the researchers said. “The incidence of supply and demand shocks that link each market to the fundamental value common to all types of milling-quality wheat may be a more important determinant of price discovery than the absolute level of trading volume. For producers, merchants, and end-users interested in hedging, this result may be useful in informing hedging activity depending on the exposure of these firms to supply-and-demand shocks of particular origins and navigating the tradeoff between market liquidity and hedging effectiveness inherent in choosing a trading venue for risk management.”