CAUSALITY IN FUTURES

MARKETS
HENRY L. BRYANT*
DAVID A. BESSLER
MICHAEL S. HAIGH

This study tests causal hypotheses emanating from theories of futures

markets by utilizing methods appropriate for disproving causal relation-
ships with observational data. The hedging pressure theory of futures mar-
kets risk premiums, the generalized version of the normal backwardation
theory of Keynes, is rejected. Theories predicting that the activity levels of
speculators or uninformed traders affect levels of price volatility, either
positively or negatively, are also rejected. © 2006 Wiley Periodicals, Inc. Jrl
Fut Mark 26:1039–1057, 2006

The authors are indebted to two anonymous reviewers who provided insightful comments. The first
author gratefully acknowledges the support of the Tom Slick Senior Graduate Research Fellowship
from the College of Agriculture and Life Sciences at Texas A&M University. Thanks to Todd Knarr,
whose GNU General Public Licensed “Date” class for C

was used in organizing the raw futures
data.
The views expressed in this paper are those of the authors and do not, in any way, reflect the
views or opinions of the U.S. Commodity Futures Trading Commission.
*Correspondence author, Department of Agricultural Economics, Texas A&M University, 2124
TAMUS, College Station, TX 77843-2124; e-mail: h-bryant@tamu.edu

Received July 2005; Accepted March 2006

■ Henry L. Bryant is a Research Assistant Professor in the Department of Agricultural

Economics at Texas A&M University in Texas.
■ David A. Bessler is a Professor in the Department of Agricultural Economics at Texas
A&M University in Texas.
■ Michael S. Haigh is the Associate Chief Economist with the U.S. Commodity Futures
Trading Commission.

The Journal of Futures Markets, Vol. 26, No. 11, 1039–1057 (2006)
© 2006 Wiley Periodicals, Inc.
Published online in Wiley InterScience (www.interscience.wiley.com).
DOI: 10.1002/fut.20231
1040 Bryant, Bessler, and Haigh

INTRODUCTION
It has been over 75 years since Keynes (1923/1983) proposed the theory
of “normal backwardation”—the idea that hedgers use futures markets to
transfer risk to speculators, causing futures prices to deviate from
expected future cash prices so that the speculators might be compen-
sated. Despite decades of empirical investigation, no consensus regard-
ing the validity of this theory has been reached. Two difficulties have
prevented the conclusive confirmation or rejection of the theory. First,
expected future cash prices, and therefore any risk premiums, are not
observed. Second, it is not feasible for researchers to seek the answer to
this question by experimentation. Systematic manipulation of futures
markets is not only impractical, it is also illegal.
Indeed, researchers conducting empirical work in economics and
finance generally must work with observational rather than experimental
data, and frequently are not able to observe all relevant quantities. This
makes the correct inference of causal relationships difficult at best and
impossible by some accounts—many assume that the use of controlled
experiments is the only means by which causal mechanisms can reliably
be inferred. Careful empirical researchers in these fields have thus
resigned themselves to being able to draw only rather weak conclusions.
It is said that evidence consistent with a theory is found, rather than that
a theory has been proven. Finding that two observed quantities A and B
covary might imply that either A causes B, or vice versa. Consequently,
empirical studies in economics and finance rarely unanimously support
or reject available theoretical explanations. Such is certainly the case
with research into futures markets, the subject of this article.
This situation is not unique to economics and finance—researchers
in numerous fields find themselves operating under such difficult circum-
stances. This situation has inspired recent multidisciplinary efforts to
develop a body of theory concerning the inference of causal relationships
using observational data. A subset of this literature further concerns itself
with conducting this inference when the observational data are incom-
plete. Treatments of this subject can be found in Pearl (2000) and Spirtes,
Glymour, and Scheines (2000). These methods have been adapted by
Bryant, Bessler, and Haigh (2006) for testing specific causal hypotheses.
This study conducts such tests of the normal backwardation theory and of
theories that predict that the activities of certain types of traders affect
levels of price volatility. A correct understanding of the causal mecha-
nisms that drive futures markets is obviously important for a variety of
parties—hedgers, speculators, exchange officials, and regulators.

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1041

The following section extends this brief introduction by discussing

in detail the issues investigated and their importance. The testing proce-
dure employed and the data used are then described. Finally, the analysis
is presented and some concluding remarks offered.

ISSUES INVESTIGATED
The first issue investigated is the normal backwardation theory of Keynes
(1923/1983, 1930) and its extensions. Keynes theorizes that hedgers
enter the futures markets primarily to reduce the risk associated with
cash market positions. He further maintains that hedgers are generally
commodity producers, and are therefore long in the cash market and
short in the futures market. This necessarily means that speculators
must be long in the futures market, and he postulates that the current
futures price must be below the expected future cash price to induce the
speculators to bear the risk associated with those long positions. A con-
sequence of the theory as stated by Keynes, and approved by Hicks
(1939), is that futures prices are expected to display an upward trend on
average. Telser (1958) searches for such trends in the cotton and wheat
markets, and reports finding no evidence. Cootner (1960) extends the
theory by pointing out that hedgers are not necessarily commodity pro-
ducers, but may be commodity consumers as well. Thus, the net position
of hedgers as a whole might be either long or short. As such, he suggests
that the current futures price might be either above or below the expected
future cash price. The modified hypothesized phenomenon is sometimes
referred to as net hedging or hedging pressure. Cootner reports finding
evidence consistent with this hypothesis, namely that speculators appear
to be earning profits over his sample period. Cootner thus shifts the
empirical focus from searching for trends in futures prices to searching
for speculative profits and/or hedging losses in futures markets.
However, Houthakker (1957) and Rockwell (1967) note that specu-
lative profits may be due to superior forecasting ability rather than to the
collection of a risk premium. Rockwell thus recasts normal backwarda-
tion as “the return earned by a hypothetical speculator who follows a
naïve strategy of being constantly long when hedgers are net short and
constantly short when hedgers are net long” (p. 114). This then implies
that speculative profits/hedging losses are a necessary, but not sufficient
condition for the net hedging theory to hold. The analysis then must focus
on decomposing speculative profits into forecasting ability and naïve com-
ponents. Both Rockwell (1967) and Chang (1985) conduct such analyses,

Journal of Futures Markets DOI: 10.1002/fut

1042 Bryant, Bessler, and Haigh

and each finds evidence of speculative profits. Rockwell reports that

speculative profits are due to forecasting ability, however Chang reports
evidence of naïve profits as well. This approach suffers from the inherent
difficulty of dividing speculators into able and naïve groups, when fore-
casting ability is unobserved. The reliability with which this task can be
performed using aggregate data on trader positions is highly uncertain.
Further complicating matters, the available data regarding market com-
mitments contain a proportion of traders whose status (either speculator
or hedger) is unknown. In contrast to Rockwell and Chang, Hartzmark
(1987) uses a unique, highly disaggregated data set to find evidence that
hedgers earn significant positive profits on average, precluding
Rockwell’s naïve speculator from profiting. Certainly, the evidence from
these related empirical approaches to the question is mixed.
Meanwhile, another thread of the literature has developed a some-
what different perspective on the question. The theory of normal back-
wardation is presented in the context of a single asset, and the hypothesized
risk premium should therefore be due to the expected futures return and
variability of that return. Dusak (1973) and Black (1976) argue that the
question should be considered in a portfolio context. The capital asset
pricing model (CAPM) states that any risk premium should be due to the
relationship between an asset’s returns and returns on total wealth. If a
futures contract’s price changes are correlated with returns on total
wealth, then some portion of the risk of holding a futures contract is
undiversifiable (a non-zero “beta” in CAPM parlance), and a risk premium
should therefore be present (because there is a “systematic” risk). If, on
the other hand, futures price changes are independent of returns on
total wealth, then the risk of holding a futures contract should be fully
diversifiable, and no risk premium should be present. Dusak finds that
for the markets that she considers, futures price changes are independ-
ent of returns on a proxy for total wealth (the S&P 500 index), and con-
cludes that no risk premiums are present. Carter, Rausser, and Schmitz
(1983) argue that Dusak’s proxy for total wealth is inadequate, and that
it should include commodity prices. Hirschleifer (1988, 1990) argues
that the assumptions built into the standard CAPM might be inappropriate,
however, due to costs associated with futures market participation (per-
haps in the form of learning the mechanics of futures market operation)
that limit the participation of some types of investors. If this is the case,
his theoretical models show that even in the presence of a zero beta, not
all risk can be diversified away. He therefore argues that risk premiums
in futures markets could be composed of two components—the standard

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1043

systematic component, and a “residual” component that is a function of

hedging pressure. Bessimbinder (1992) finds that futures returns covary
with hedger’s net positions, and concludes that this result supports hedg-
ing pressure as a determinant of risk premiums in futures markets, con-
sistent with Hirschleifer’s model, and with the generalized concept of
normal backwardation.
In summary, risk premiums that may exist in futures markets cannot
be observed, because the expected future cash price cannot be observed.
The standard empirical practice then is to check for speculative profits,
which would be consistent with the existence of risk premiums. If spec-
ulative profits exist (the evidence on this is mixed), they must be decom-
posed into profits due to forecasting ability, which is also unobserved, and
any residual profits. The existence of residual profits is interpreted as
evidence that risk premiums are present. These premiums may be due to
systematic risk if futures price changes are correlated with returns to
total wealth. After adjusting “observed” risk premiums for systematic
risk, it is then inferred that any residual risk premium that is not due to
systematic risk may be due to hedging pressure, if measures of these two
phenomena are correlated. The path by which a researcher might find
evidence consistent with the generalized theory of normal backwardation
is so convoluted it is little wonder that no consensus has been reached. If
such evidence is found and can be believed, it is still only consistent with
the theory, the primary underlying issue of causality is never addressed.
The question is “Does the net position of hedgers cause futures price
changes and, by extension, the difference between the current futures
price and expected underlying price at the time of futures expiration?”
We reconsider this issue in an empirical framework that explicitly
addresses the issue of causality, and simultaneously allows for the existence
of relevant, but unobserved quantities. Clearly, a correct assessment of
the hedging pressure theory is important for market participants. Should
a hedger anticipate losing money on average in exchange for enjoying
reduced risk? Can speculators expect to be profitable on average by
merely taking a position opposite that of hedgers’ net position, regardless
of the depth of their market knowledge and their forecasting ability?
The second issue that we investigate is the notion that the activities
of specific types of traders are causes of levels of price volatility. The
noisy rational expectations (NRE) model of Shalen (1993), posits two
varieties of traders. Informed traders have private information regarding
market values. Uniformed speculators, on the other hand have no private
information, and attempt to extract price signals from observed futures

Journal of Futures Markets DOI: 10.1002/fut

1044 Bryant, Bessler, and Haigh

price changes. The series of these price changes is noisy, however, due to
a random liquidity demand from hedgers (buying or selling due to their
activity in the underlying market, not due to information arrival). The
uninformed speculators can then misinterpret this liquidity trading as
being motivated by information arrival, causing them to adjust their posi-
tions, resulting in increased price volatility. Increased market activity by
uniformed speculators is thus hypothesized to cause increased price
volatility.
Similarly, in the model of Stein (1987), rational, but imperfectly
informed futures speculators can (but do not necessarily) destabilize
prices. These models contrast with the rational expectations model of
Danthine (1978), in which imperfectly informed speculators stabilize
prices. More recently, the finance literature has become interested in
irrational behavior. An example of this is the model of DeLong, Shleifer,
Summers, and Waldman (1990). In their model, irrational traders drive
an asset’s price away from its fundamental value. Rational arbitrageurs’
fear that there may be a slow return to fundamental value and so limit
their activity, resulting in increased price volatility. This model is not
concerned with futures markets as such, but the underlying principals
might still apply.
Empirical evidence compiled regarding this question thus far is lim-
ited. Daigler and Wiley (1999) examine various financial futures mar-
kets, and report that the activity of futures traders who are on the trading
floor is associated with decreased price volatility, whereas the activity of
the general public is associated with increased volatility. The on-floor
traders can observe the identities of those making large trades, and are in
a position to infer the informational content of those trades. They can
therefore be thought of as informed, and the results are thus consistent
with the models of Shalen (1993) and Stein (1987). Chang, Chou, and
Nelling (2000) find that in the S&P 500 futures market, large hedging
activity is positively correlated with volatility, which is interpreted as
evidence that increased volatility causes increased hedging demand.
Wang (2002) finds that in exchange rate futures markets measures of
speculative activity and volatility are positively related, which is inter-
preted as evidence that speculators destabilize markets. Note that these
last two studies find very similar empirical evidence (price volatility
covaries with the trading activity of one particular type of trader), but
reach opposite conclusions regarding the likely direction of causality.
This highlights the attractiveness of assessing hypothesized causal rela-
tionships using methods developed specifically for such purposes.

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1045

All market participants are obviously impacted by price volatility,

and clearly should be interested in its underlying causes. Researchers
will be interested in the correct specification of empirical models, and
results inconsistent with existing theories might inspire new ones.
Regulators have displayed an interest in curbing excessive levels of price
volatility, and the success of such an endeavor necessarily depends on an
accurate assessment of its causes.

TESTING CAUSAL RELATIONSHIPS USING

OBSERVATIONAL DATA
As mentioned in the Introduction, treatments of the theory of causal
inference using observational data can be found in Pearl (2000) and
Spirtes, Glymour, and Scheines (2000). Hoover (2001) discusses the
application of these methods to economics. These methods are just
beginning to be adopted in economic research; efforts to date have
largely proceeded under an assumption of causal sufficiency (i.e., that
the researcher has collected observations for all variables present in
the unknown causal structure). Swanson and Granger (1997) search
for causal relationships among the variables in a vector autoregression
(VAR) to guide an appropriate Bernanke decomposition of the innova-
tion covariance matrix. Demiralp and Hoover (2003) investigate the
reliability of such a procedure. Reale and Wilson (2001) and Moneta
(2004) investigate monetary policy issues using this method. Akleman,
Bessler, and Burton (1999) investigate causal relationships among
corn exports and exchange rates using causal methods, both with
and without the assumption that all causally relevant variables are
observed. Haigh and Bessler (2004) investigate price discovery in cash
grain markets and a related transportation market, again using VAR
innovations.
The above-mentioned studies all concern exploratory searches for
causal structures among several potentially related variables. Another
use of causal inference methods is the testing of specific causal hypothe-
ses of the form H0: A causes B, as described in Bryant et al. (2006). Such
testing consists, essentially, of applying a portion of the causal inference
(CI) algorithm described in Spirtes, Meek, and Richardson (1999).
Given certain assumptions, discussed below, particular combinations of
independence relations among measured variables preclude the possibility
of A causing B, given the assumptions described below. The CI algorithm
test of H0 is carried out by testing the individual independence relations

Journal of Futures Markets DOI: 10.1002/fut

1046 Bryant, Bessler, and Haigh

among observed variables. If the correspondence between A and B is suf-

ficiently strong, a causally related test instrument C is employed in the
testing.1
Five primary assumptions underlie the CI algorithm test. First, we
assume that there are no causal cycles, wherein two variables simultane-
ously cause one another (perhaps indirectly). Second, Reichenbach’s
(1956) principle of the common cause is assumed: Two variables are sta-
tistically dependent only if one variable causes the other (perhaps indi-
rectly via other variables), or they share a common cause (or both).2
Third is the faithfulness or stability assumption, i.e., two variables that
share a common cause are assumed to not be statistically independent
due to peculiar structural parameters that result in offsetting causal
effects.3 The common cause principle and faithfulness assumption
ensure that independence relations among observed variables represent
causal relationships, and vice versa. The fourth and fifth assumptions,
linear structural relationships and normally distributed random distur-
bances, allow testing of independence relations using Fisher’s correla-
tion z-test.
Bryant et al. (2006) show that under these assumptions, either
one of two conditions may be present that require the rejection of H0: A
causes B. The first of these is a finding of rAB  0. This would result
from failing to reject H0: rAB  0 in an initial z-test. This is inherently
weak evidence for rejecting H0: A causes B, because the burden of proof
in the z-test is opposite of that which is desired. This is referred to as a
weak-basis rejection of H0: A causes B.
The second condition sufficient for rejecting H0: A causes B is find-
ing rAB  0, rAC  0, and rBC  0, for some test instrument C. For this
condition, the burdens of proof of the overall test and first two of the
three z-tests are aligned. Moreover, finding rAB  0 and rAC  0 ensures
that if A causes B, the probability of making a type 2 error in the z-test of
H0: rBC  0 should be low, as discussed in Bryant et al.. Finding rAB  0,
rAC  0, and rBC  0 constitutes a strong-basis rejection of H0: A causes B.

1
This methodology is closely related to instrumental variables methods, as discussed in Reiss
(2003).
2
A generalized version of this, the “causal Markov” assumption, underlies many causal inference
algorithms. This general version extends the basic principle to conditional statistical independence
between two indirectly causally related variables, where the conditioning is over a common cause or
mediating variable, or a set of such variables. The common cause principle is commonly accepted in
the social sciences, although it has been questioned by Cartwright (1999, pp. 69–107). See Hoover
(2001, chapter 4) for a discussion.
3
Hoover (2001, pp. 167–170) cautions that this assumption may be violated in some economic set-
tings, particularly when a policy is successful in suppressing variability in an observed quantity.

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1047

(i) (ii)

(iii)

FIGURE 1
Graphs representing causal structures in which A causes B.

The logic behind these strong-basis rejections is illustrated in Figure 1.

In each of the three causal structures (panels i–iii), A causes B is true
(hence rAB  0), and variables A and C are causally related (rAC  0). In
each case, a correspondence between B and C should be observed
because either C indirectly causes B (panel i), or because they share a
common cause (A in panel ii, L in panel iii). If no such correspondence
is observed (rBC  0), A causes B must be false. A test instrument for which
rAB  0, rAC  0, and rBC 0 are all true is referred to as an evidential
test instrument.
Monte Carlo results are presented in Bryant et al. that reveal the
degrees of confidence that can be placed in weak- and strong-basis rejec-
tions. These simulations are replicated for the present study, but using
random data sets consisting of 410 observations in each trial to precisely
match the data that we employ below. In each of 100,000 trials, a ran-
dom linear system is generated with three observed variables, between
zero and three latent common causes of pairs of observed variables, and
weak causal connections between the variables (“signal strengths”), as
described in Bryant et al. In all systems, A causes B. The observed vari-
ables of these systems are subjected to the CI algorithm test using the
recommended significance level of 0.20 in the underlying z-tests, and
the numbers of weak- and strong-basis rejections are tabulated. There
are 10,397 weak-basis rejections, and 8,468 strong-basis rejections.

Journal of Futures Markets DOI: 10.1002/fut

1048 Bryant, Bessler, and Haigh

Therefore, in the results that follow strong-basis rejections are at approx-

imately the 9% level of confidence, whereas weak-basis rejections are at
approximately the 19% level.4

DATA
We analyze eight futures markets: Chicago Board of Trade (CBOT) corn,
New York Mercantile Exchange (NYMEX) crude oil, Chicago Mercantile
Exchange (CME) Eurodollar deposits, New York Commodity Exchange
(COMEX) gold, CME Japanese Yen, New York Board of Trade (NYBOT)
coffee, CME live cattle, and the CME S&P 500. Weekly observations for
all data over the interval March 21, 1995, through January 8, 2003, are
used. We construct three types of data series for use in the analysis:
(a) those related to trader activity and positions, (b) those related to
futures prices and trading volume, and (c) seasonal harmonic series.
The Commodity Futures Trading Commission (CFTC) requires cer-
tain exchange members and futures commission merchants (i.e., bro-
kers) to file daily reports with the Commission. Those reports show the
futures positions of traders that hold positions above reporting levels set
by CFTC regulations (referred to as “reportable positions”). Each trader
is classified as being either commercial or noncommercial, with com-
mercial traders being those engaged in hedging activity. Ederington and
Lee (2002) caution that this distinction is not always entirely accurate,
and our data regarding trader type are thus noisy. Henceforth, we refer to
reportable commercial positions as being those of large hedgers, to
reportable noncommercial positions as being those of large speculators,
and to nonreportable positions as being those of small traders. The data
collected as of each market’s close on each Tuesday are released to the
public in the CFTC’s Commitments of Traders (COT) report, generally
on the following Friday. The data is used in two ways. First, the net posi-
tion of large hedgers (LH Net Position) is calculated as the number of
open long futures positions minus the number of open short futures
positions held by large hedgers. Second, the aggregate level of activity of
each trader type (LH Activity, LS Activity, and ST Activity for large
hedgers, large speculators, and small traders, respectively) is calculated as
the sum of their open long and short futures positions. These three vari-
ables, at any point in time, sum to twice the level of open interest in the

4
The confidence level for weak-basis rejections is the proportion of trials in which either type of
rejection occurred, which we round up to the next integer percentage.

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1049

market. Some adjustments to the COT data are necessary. Before 1998,
corn futures positions are measured in thousands of bushels, rather than
number of contracts (each contract calls for delivery of 5,000 bushels).
We therefore divide all corn COT data prior to 1998 by five so that the
related data series we use are measured in consistent units over the sam-
ple period. The size of the cash settlement called for by the S&P 500
futures contract was halved in late 1997, and we therefore multiply all
S&P 500 COT data prior to the change by two, to make our measures of
trader positions consistent with the current contract specification. In the
crude oil and coffee markets, observations for the COT series are miss-
ing for September 11, 2001, and are linearly interpolated.
The Commodity Research Bureau provides daily price data for indi-
vidual deliveries for each market, and Primark Datastream provides the
corresponding volume data. A continuous futures price-level series
(Nearby) is constructed for each market using weekending observations
of the futures contract nearest to expiration. Weeks that run Wednesday
through Tuesday are used in constructing all price, volume, and volatili-
ty series to correspond to the COT data. A nearby weekly returns series
(Return) is also constructed using weekly returns series for each individ-
ual delivery. Thus, no observations in our Return series are constructed
using price-level observations from two different deliveries (as would be
the case if one simply constructed a return series using a previously con-
structed nearby levels series). A weekly total volume series (Volume) was
constructed for each market by summing the total trading volume for all
deliveries for each day. A measure of futures price volatility (Volatility)
was constructed by taking the log difference between the high and low
prices for each week for the nearby contract.
Finally, weekly observations of two annual seasonal harmonic vari-
ables are used in the analysis, defined as

b
2pTime
Annual Sin  sina
52

and

b
2pTime
Annual Cos  cosa
52

where Time is a linear time trend. These exogenous harmonic series are
used to account for the possibility of seasonal influences on the various
endogenous variables.

Journal of Futures Markets DOI: 10.1002/fut

1050 Bryant, Bessler, and Haigh

ANALYSIS
We begin by investigating the stationarity of each series. A priori, the effi-
cient market hypothesis gives us strong reason to suspect that the
Nearby series may contain a unit root, however, we have no such
grounds for suspicion with respect to the remaining series. Indeed, it
would seem rather implausible to believe that LH Net Position, for
example, might drift off toward infinity. All data, save the seasonal har-
monic series, are subjected to Augmented Dickey-Fuller (ADF) tests,
with the results given in Table I. We find that for seven of the eight
Nearby series we cannot reject the null hypothesis of nonstationarity,
confirming our initial suspicion. We therefore use the Return series for
all markets in the causal analysis that follows (we use the Return series
even with the live cattle market, as we wish to keep the interpretation of
the results consistent across markets). For the remaining series
(Volatility, Volume, LH Activity, LS Activity, ST Activity, and LH Net
Position), we generally reject the null hypothesis that each series con-
tains a unit root. Given (a) our prior expectations as discussed above,
(b) the well-established fact that ADF tests have low power against
plausible alternatives (see, for example, DeJong, Nankervis, Savi, &
Whiteman, 1992), and (c) our desire to use consistent types of series
(i.e., levels or differences) across markets, we proceed to use the levels
series for all variables other than Return.
Following other studies that have applied causal inference methods
to time series data (Demiralp & Hoover, 2003; Haigh & Bessler, 2004;
Moneta, 2004; Reale & Wilson, 2001; Swanson & Granger, 1997), we

TABLE I
Results of Augmented Dickey-Fuller Testsa

LH LS ST LH Net
Commodity Nearby Return Volatility Volume Activity Activity Activity Position

Corn 2.73 (1)
19.59 (0)
6.53 (2)
11.49 (0)
3.70 (1)
4.10 (0)
3.42 (1)
3.94 (1)
Crude oil 2.03 (1)
21.66 (0)
15.53 (0)
6.65 (3) 2.30 (13)
3.54 (0) 1.76 (9)
4.78 (1)
Eurodollars 0.24 (0)
19.07 (0)
6.67 (2)
5.44 (3) 2.60 (13) 2.81 (16)
3.79 (1)
4.01 (0)
Gold 0.02 (0)
19.20 (0)
14.17 (0)
12.91 (0)
3.47 (0)
4.23 (1)
3.38 (2)
4.33 (1)
Japanese yen 2.25 (0)
18.49 (0)
5.97 (3) 2.08 (12)
4.17 (13)
5.48 (0)
7.73 (0)
5.81 (1)
Coffee 2.69 (3)
21.39 (0)
9.50 (1)
14.11 (0)
3.72 (0)
4.55 (0)
4.89 (1)
5.90 (1)
Live cattle
3.82 (0)
17.95 (1)
6.78 (2)
14.25 (0) 1.96 (0)
4.96 (1)
4.77 (10)
3.30 (1)
S&P 500 0.24 (1)
24.26 (0)
8.91 (1) 1.71 (12) 1.97 (14)
3.18 (13) 1.92 (14)
3.45 (0)

a
The null hypothesis is that the series listed in the row and column intersection has a unit root. We reject this hypothesis if
the ADF test statistic is less than the critical value 3.13 (10%) given in Fuller (1976). Both an intercept and a time trend
were included in the tests. The optimal lag length given in parenthesis was chosen using the Schwarz (1978) information
criterion.

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1051

filter the series for each market through a vector autoregression (VAR).
Conducting tests of causal hypotheses over the innovations emanating
from VARs ensures that contemporaneous causality is tested and that
the results are not confounded by correlation between contemporaneous
and lagged observations. For each of the eight markets, a VAR is estimated
that includes the Return, Volatility, Volume, LH Activity, LS Activity, ST
Activity, and LH Net Position. An optimal lag length of one is selected in
all eight markets using Schwarz (1978) information criterion. All testing
that follows is conducted using the VAR innovations for these seven
series, as well as the deterministic series Annual Sin, and Annual Cos.
There are 410 observations for each series.
The hypothesis that LH Net Position causes Returns and, by exten-
sion, risk premiums, is tested for each of the eight markets, using
the seven other variables as test instruments. Results are presented in
Table II. In all markets, the correlations between the innovations to LH
Net Position and Returns are significant; there are no weak-basis rejec-
tions. For Corn and Crude Oil, we are unable to reject the hypothesis,
based on the available test instruments. For the remaining six markets
markets, however, we find strong bases for rejecting the hypothesis.

TABLE II
Causal Inference (CI) Algorithm Test Results for H0: LH Net
Position Causes Returnsa

LH Net Position
and Returns
innovation CI algorithm Evidential test
Market correlation test result instrument(s)

Corn 0.7170* Cannot reject —

Crude oil 0.6281* Cannot reject —
Eurodollars 0.2266* Strong-basis rejection LH Activity, LS Activity,
ST Activity, Annual Cos
Gold 0.6180* Strong-basis rejection LH Activity, LS Activity
Japanese yen 0.6205* Strong-basis rejection Annual Cos
Coffee 0.6994* Strong-basis rejection LS Activity
Live cattle 0.3267* Strong-basis rejection LH Activity, ST Activity
S&P 500 0.1852* Strong-basis rejection LH Activity

a
LH Net Position is the number of long contracts minus the number of short contracts held by large hedgers in
each market. Returns is the series of log changes in the prices of the nearby futures contracts. Correlations are
calculated using 410 innovations from a vector auto-regression. An * denotes that a correlation coefficient is sig-
nificant at the 20% level using Fisher’s z-test. Negative correlations between LH Net Position and Returns are
consistent with aggregate speculative profits when large hedgers are net long (and inconsistent with speculative
profits when they are net short), which is true for a majority of observations in the sample for markets other than
crude oil, coffee, and live cattle. Weak-basis rejections of H0: LH Net Position causes Returns are at the 19%
level, while strong-basis rejections are at the 9% level. Evidential test instruments are variables that are corre-
lated with LH Net Position but not with Returns, and therefore constitute strong-basis rejections of H0.

Journal of Futures Markets DOI: 10.1002/fut

1052 Bryant, Bessler, and Haigh

Based on the Monte Carlo results described above, these rejections are
at approximately the 9% level. These rejections are generally based on
the information provided by the levels of activity of the different trader
types, although the seasonal series Annual Cos is evidential for
Eurodollars and the Japanese Yen. For half of these six strong rejections,
multiple evidential test instruments are present, further strengthening
the result. No pattern to these results regarding contract type (financial vs.
commodity, cash-settled vs. physical delivery) is apparent.
On balance, this evidence suggests that for most markets, either
Return causes LH Net Position or they share a common cause (or both).
The former possibility would reflect a simple price response on the part
of large hedgers. For example, if large hedgers of a commodity are pre-
dominately producers or merchants, an increase in price would, on average,
motivate them to produce additional quantities or to release stocks. This
in turn would cause them to adjust their futures market positions.
Although more mundane than the theory of normal backwardation, this
explanation is nonetheless perfectly consistent with economic intuition.
The results further imply that hedgers need not expect to lose
money on average in exchange for reduced price risk. This is in accord
with Hartzmark (1987). These results also call into question the wisdom
of speculative trading strategies that are predicated on the assumption
that the futures returns can be predicted using COT data.
Either of the CFTC’s large speculator reporting group or nonreport-
ing group might be thought to correspond to the “uninformed specula-
tors” that are hypothesized to cause futures price volatility, and we there-
fore employ both groups for testing. The hypothesis that LS Activity
causes Volatility is tested, using the seven other variables as test instru-
ments, with results reported in Table III. For the crude oil and live cattle
markets, the innovations for LS Activity and Volatility are not significantly
correlated, and we therefore weakly reject the hypothesis at the 19%
level. For the remaining markets, these innovations are significantly pos-
itively correlated in two cases (consistent with the theories of Shalen,
1993, and Stein, 1987) and negatively so in four cases (consistent with
Danthine, 1978). For the Japanese yen, we are not able to reject the null
hypothesis using the available test instruments. For the remaining
five markets, we strongly reject the hypothesis at the 9% level, with evi-
dential test instruments in all five including the activity levels of the
other trader types.
The hypothesis that ST Activity causes Volatility is tested with
results presented in Table IV. This hypothesis is weakly rejected for corn,
crude oil, Eurodollars, and coffee. For the remaining four markets, the

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1053

TABLE III
Causal Inference (CI) Algorithm Test Results for H0:
LS Activity Causes Volatilitya

LS Activity and
Volatility
innovation CI algorithm Evidential test
Market correlation test result instrument(s)

Corn 0.0654* Strong-basis rejection LH Activity, ST Activity

Crude oil 0.0629 Weak-basis rejection —
Eurodollars 0.0680* Strong-basis rejection ST Activity, LH Net Position
Gold 0.1561* Strong-basis rejection LH Activity
Japanese yen 0.0956* Cannot reject —
Coffee 0.1369* Strong-basis rejection LH Activity, ST Activity,
Annual Cos
Live cattle 0.0158 Weak-basis rejection —
S&P 500 0.0936* Strong-basis rejection LH Activity

a
LS Activity is the sum of the long and short contracts held by large speculators in each market. Volatility
is the log difference between the highest and lowest trade prices each week in the nearby contract.
Correlations are calculated using 410 innovations from a vector auto-regression. An * denotes that a correla-
tion coefficient is significant at the 20% level using Fisher’s z-test. Weak-basis rejections of H0: LS Activity
causes Volatility are at the 19% level, while strong-basis rejections are at the 9% level. Evidential test instru-
ments are variables that are correlated with LS Activity but not with Volatility, and therefore constitute strong-
basis rejections of H0.

TABLE IV
Causal Inference (CI) Algorithm Test Results for H0:
ST Activity Causes Volatility a

ST Activity and
Volatility
innovation CI algorithm Evidential test
Market correlation test result instrument(s)

Corn 0.0053 Weak-basis rejection —

Crude oil 0.0053 Weak-basis rejection —
Eurodollars 0.0218 Weak-basis rejection —
Gold 0.2026* Strong-basis rejection LH Activity
Japanese yen 0.1007* Strong-basis rejection Annual Cos
Coffee 0.0538 Weak-basis rejection —
Live cattle 0.0894* Strong-basis rejection LH Activity, LS Activity,
LH Net Position
S&P 500 0.1414* Strong-basis rejection LH Activity

a
ST Activity is the sum of the long and short contracts held by small traders in each market. Volatility is the log
difference between the highest and lowest trade prices each week in the nearby contract. Correlations are
calculated using 410 innovations from a vector auto-regression. An * denotes that a correlation coefficient
is significant at the 20% level using Fisher’s z-test. Weak-basis rejections of H0: ST Activity causes Volatility
are at the 19% level, while strong-basis rejections are at the 9% level. Evidential test instruments are
variables that are correlated with ST Activity but not with Volatility, and therefore constitute strong-basis
rejections of H0.

Journal of Futures Markets DOI: 10.1002/fut

1054 Bryant, Bessler, and Haigh

innovations are significantly correlated, again with mixed signs (three

positive, one negative). For these four markets we strongly reject the
hypothesis, with other trader types’ activity levels again proving eviden-
tial in most cases.
Weighed across the eight markets and the two hypotheses regarding
Volatility, these results suggest that these trader types’ activity levels do
not cause volatility (either positively or negatively) as posited by the
above-mentioned theories. These empirical results also stand in contrast
to the causal conclusions that Daigler and Wiley (1999) and Wang
(2002) draw from similar data. We therefore conclude that generally,
futures price volatility causes the activity levels of traders other than
large hedgers, or that these phenomena share a common cause (or both).
This latter possibility would be consistent with a competing theoretical
explanation for the observed correlation between trading activity levels
and price volatility. In the mixture of distribution hypothesis advanced by
Clark (1973) and Tauchen and Pitts (1983), a variable rate of informa-
tion arrival is presumed to cause both. This competing theory might be
tested in future research if a suitable measure of the putative cause can
be devised.
Like the evidence with regard to Returns, these results again call
into question to the usefulness of COT data in formulating successful
speculative strategies. Any policies aimed at curbing futures price volatil-
ity by discouraging the participation of specific trader types are unlikely
to prove successful.

CONCLUSIONS
In this article, we test hypothesized causal relationships in futures mar-
kets. To this end, we apply methods that have been developed in the
causality literature for inferring causal relationships from observational
data, even in the presence of unobserved, causally related quantities.
Such an approach is highly attractive, considering that most research in
empirical economics and finance is conducted under such conditions.
We strongly reject for most markets a hypothesis associated with the
generalized theory of normal backwardation, wherein hedgers transfer a
risk premium to speculators in exchange for risk-bearing services. We
also generally reject theories predicting that the levels of activity of par-
ticular types of traders affect levels of price volatility, either positively or
negatively, in futures markets. Roughly, half of these rejections are
strongly based, at a 9% level of confidence, while others are weakly based
at a 19% level.

Journal of Futures Markets DOI: 10.1002/fut

 Causality in Futures Markets 1055

There exists an abundance of causal hypotheses related to deriva-

tives markets that might be tested. Is the level of futures trading activity
a cause of price volatility in the underlying cash market? Are cross-
market volatility correlations caused by a contagion effect (volatility
“spillovers”), or simply due to fundamental developments that have
impacts in multiple markets? Any number of hypotheses regarding infor-
mation transmission and price discovery might be investigated. Various
microstructure theories regarding the causes of bid-ask spread magnitudes
and liquidity provision might be addressed. Such issues offer a fertile
ground for future research.

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