THE INFORMATION FLOW AND MARKET EFFICIENCY BETWEEN THE U.S.

AND CHINESE ALUMINUM AND COPPER FUTURES MARKETS

HUNG-GAY FUNG QINGFENG WILSON LIU YIUMAN TSE*

This study examines the information flow and market efficiency between the metallurgical futures markets of the United States and China over a ten-year span from 1999 to 2009. There were structural breaks in the aluminum and copper futures price series for the New York Mercantile Exchange (NYMEX)
Liu acknowledges nancial support from the College of Business at James Madison University. Tse acknowledges the College of Business at the University of Texas and U.S. Global Investors, Inc. for nancial support. The authors thank Cathy Mai, Eric Johnson (the discussant), and the participants at the 20th annual AsiaPacic Futures Research Symposium in Hong Kong for valuable comments. *Correspondence author, One UTSA Circle, Department of Finance, College of Business, University of Texas at San Antonio, San Antonio, Texas 78249. Tel: 210-458-5314, Fax: 210-458-2515, e-mail: yiuman.tse@ utsa.edu Received August 2009; Accepted May 2010

Hung-Gay Fung is at the College of Business Administration & Center for International Studies, University of Missouri-St. Louis, Missouri, and also a Dr. Y.S. Tsiang Professor in Chinese Studies, One University Blvd, St. Louis, Missouri 63121. Qingfeng Wilson Liu is an Associate Professor of Finance, College of Business, James Madison University, MSC 0203, Harrisonburg, Virginia 22807. Yiuman Tse is a Professor of Finance and U.S. Global Investors, Inc. Research Fellow, Department of Finance, College of Business, University of Texas-San Antonio, San Antonio, Texas 78249.

The Journal of Futures Markets, Vol. 30, No. 12, 11921209 (2010) 2010 Wiley Periodicals, Inc. View this article online at wileyonlinelibrary.com DOI: 10.1002/fut.20474

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and Shanghai Futures Exchange (SHFE) between 2006 and 2008. The New York and Shanghai markets are cointegrated, indicating an equilibrium relationship between the two markets. Trading strategies are implemented to explore the error-correction process. The overall results show that U.S. and Shanghai futures prices are closely related and both markets are comparably efcient on a daily basis. The U.S. market does not appear to be more efcient than the Chinese market in incorporating information into prices. 2010 Wiley Periodicals, Inc. Jrl Fut Mark 30: 11921209, 2010

INTRODUCTION Commodity markets experienced exceptional price hikes and volatility between 2006 and 2008. During this period, energy, metallurgic, agricultural, and other commodities reached unprecedented price levels, causing concerns about the effectiveness of commodity markets. Theorists in finance generally cite two reasons for this phenomenon: rapidly growing demand for these commodities in emerging economies such as China and India, as well as rampant speculation and arbitrage trading activities in derivative markets (Henriques, 2008; Ruggiero, 2008). Both may have important effects on the pattern of information ows across nancial markets. A number of studies have documented a recognized information ow pattern from larger, more liquid, and efcient markets such as that of the United States to others that are less liquid and less efcient. Eun and Shim (1989), Fung, Leung, and Xu (2003), Ghosh, Saidi, and Johnson (1999), Kwan, Sim, and Cotsomitis (1995), and Xu and Fung (2005), among others, have demonstrated the central role that U.S. nancial markets play in global nancial markets and the dominance of U.S. nancial markets in information ows across countries. Nevertheless, as recent commodity market turmoil is largely attributable to factors from emerging economies and from speculation activities that rely on the speculators ability to obtain relevant information quickly to help make their trading decisions, one would expect the nancial markets in these emerging economies to play an increasingly important role in cross-border information ows. This study uses two important futures contracts (those for aluminum and copper) that are listed on both the U.S. and Chinese exchanges (specically, the NYMEX and the SHFE) to examine patterns of information flow before and after this recent period of high volatility. Although some studies examine information ows across nancial futures markets (e.g. Fung, Leung, & Xu, 2001) and between precious metals futures markets (e.g. Xu & Fung, 2005), few studies have focused on metallurgical futures. Aluminum and copper are important commodities for both the United States and China (Hunt, 2004). The United States is the largest consumer of aluminum, with China following
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closely behind. In copper, however, China has been the worlds largest consumer in recent decades due to demand from large infrastructure projects as China transitions to a market-oriented economy. Examining the futures contracts for these two metals sheds light on how information ows across markets between the two large economies, which is important in light of their substantial demand for these commodities. The Perron (1997) model applied to the futures data for aluminum and copper in each of the two markets (U.S. and China) shows statistically signicant structural breaks in all four futures price series during the volatile period of 20062008. The data are divided into two periods based upon the date when the break occurred for each of the commodities. Subsample 1 is composed of the series of prices for the time before the breaks occurred and Subsample 2 refers to the period after the breaks occurred, for each of the two metals. The information ow between the two countries is examined by a vector error correction model (VECM). The model incorporates a long-run equilibrium error correction term to address the long-term cointegrating relationships between the series. Trading strategies based on the cointegrating relationships between the futures price series are used to examine possible changes in the level of market efciency in these two futures contracts. Finance theories on market efciency consider the presence or absence of signicant trading prots to be an indicator of the level of market efficiency. The hypothesis of market efficiency assumes that there are no statistically signicant prots from trading several related price series, because any divergence in prices from a long-term equilibrium is supposedly short-lived and temporary. Arbitrage activities are expected to close any signicant gaps quickly enough to foreclose the possibility of consistent long-term trading prots. Many prior studies have used simulated trading to examine market efciency. For example, Johnson, Zulauf, Irwin, and Gerlow (1991) use a protmargin trading rule to investigate the market efciency of soybean, soybean oil, and soybean meal futures (i.e. the crush spread). They nd that nearby futures price spreads are more efcient than distant ones, indicated by the different levels of trading prots. McKenzie and Holt (2002), studying the market efciency of live cattle, hog, corn, and soybean meal futures markets, suggest that the four futures markets exhibit pricing efciency in the long run accompanied by some short-run pricing biases. Fung, Liu, and Tse (2008) nd signicant improvements in the efciency of the Dow Jones Industrial Average futures and exchange-traded fund markets between 1998 and 2004. The overall results show that the U.S. and Shanghai futures markets are closely related and that both markets efciently incorporate information on a daily basis. Neither market dominates the other in informational efficiency.
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Trading prots generated by strategies based on the error correction process are generally small. DATA AND STRUCTURAL BREAKS Chinas futures markets were established in the early 1990s, and the SHFE was formed by merging a number of smaller futures exchanges in 1998. The daily futures data were obtained from the SHFE and Commodity Systems, Inc. (CSI). The SHFE sample was matched with the NYMEX aluminum and copper daily futures data for the period between May 14, 1999 and May 13, 2009, a sample period of exactly ten years.1 Table I provides detailed specications of the four futures contracts. This study uses front futures contract prices, which roll over five days before contract expiration.2 Because of time-zone differences, daily settlement prices of SHFE futures contracts precede those of NYMEX futures for the same day. As the futures contracts are denominated in different currencies and have different standard contract sizes, all futures price units are converted to U.S. dollars per pound using concurrent exchange rates obtained from the Oanda Corporation (www.oanda.com/convert/fxhistory). The trading volume of aluminum is larger in the United States (on average, 161,110 contracts daily) than in China (79,763 contracts daily) in our study. However, with regard to copper futures contracts, the Chinese market appears to have a higher average daily trading volume (on average, 157,699 contracts daily vs. 84,453 contracts daily in the U.S. market). The Perron (1997) model examines the stationarity of the time series and tests possible structural breaks in the data. The model assumes that the timing of possible changes in both the intercept and slope is not fixed a priori, but occurs gradually, depending on the correlation structure of the noise. The optimal break time, Tb, is estimated using a recursive approach to minimize the t-statistic for testing a 1 in the following ordinary least-squares regression: yt m ayt1 uDUt dD 1 Tb 2 t gDTt bt a ci yti et
i1 k

(1)

where DUt 1(t Tb); D(Tb)t 1(t Tb 1), and DTt 1(t Tb)t with 1() as the indicator function. The number of lags, k, is selected using a general-tospecic recursive procedure to ensure that the coefcient on ytk is signicant while the coefcient on ytk1 is not signicant based on the t-statistics.
1

The aluminum and copper futures contracts are traded in the COMEX division under NYMEX. Thus, some articles refer to these contracts as COMEX futures. We call them NYMEX futures here. 2 There is typically low open interest and high price volatility during the last several trading days.
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TABLE I

Futures Contract Specications

Contract Size
44,000 pounds $0.0005 per pound ($22.00 per contract) 7:50 a.m.1:15 p.m. Mon.Fri. (Open Outcry) 6:00 p.m. Sundays through 5:15 p.m. Fridays (Electronic) 9:00 a.m. to 11:30 a.m., 1:30 p.m. to 3:00 p.m. January to December Four consecutive months

Futures Contract (Ticker Symbol) Tick Size Trading Hours* Contract Months

Exchange

Last Trading Day

The third-to-last business day of the delivery month. The 15th day of the delivery month (postponed if a legal holiday)

NYMEX Aluminum Futures Contract (AL)

New York Mercantile Exchange (NYMEX)

SHFE Aluminum Futures Contract (AL)

Shanghai Futures Exchange (SHFE)

5 tons

RMB10 per ton

NYMEX Copper Futures Contract (HG)

New York Mercantile Exchange (NYMEX)

25,000 pounds

$0.0005 per pound ($12.50 per contract)

9:00 a.m.2:30 p.m. Mon.Fri. (Open Outcry) 6:00 p.m. Sundays through 5:15 p.m. Fridays (Electronic) 9:00 a.m. to 11:30 a.m., 1:30 p.m. to 3:00 p.m.

Current month and next 23 consecutive months January to December

The third-to-last business day of the delivery month. The 15th day of the delivery month (postponed if a legal holiday)

SHFE Copper Cathode Futures Contract (CU)

Shanghai Futures Exchange (SHFE)

5 tons

RMB10 per ton

Sources: NYMEX Web site at www.nymex.com and SHFE Web site at www.shfe.com.cn, September 2009.

*The trading hours are based on local time, i.e., Eastern Standard Time for NYMEX and Beijing Time for SHFE respectively. Beijing Time leads Eastern.

Daylight Saving Time by 12 hr and leads Eastern Standard Time by 13 hr; therefore, there are no overlapping oor trading hours between the two exchanges.

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TABLE II

Perron Unit Root Tests

Independent Variable
NYAL Price level

Yt1
0.990 (3.99)a 0.292*** (14.89)a 0.993 (3.37)a 0.016*** (13.80)a 0.991 (3.77)a 0.099*** (13.58)a 0.992 (3.98)a 0.182*** (13.06)a

DUt
0.118*** (4.44) 0.180*** (4.44) 89.423*** (3.04) 307.064*** (4.34) 8.588*** (4.07) 117.366*** (5.49) 167.869*** (4.09) 2,136.721*** (5.08)

DTt
0.057*** (4.50) 0.079*** (4.29) 0.043*** (3.11) 0.137*** (4.27) 0.004*** (3.90) 0.052*** (5.44) 0.078*** (3.89) 0.955*** (5.05)

Break Point Jan. 22, 2008 1 difference of price SHAL Price level
st

Break Point Nov. 19, 2007 1 difference of price NYCO Price level
st

Break Point Mar. 7, 2006 1 difference of price SHCO Price level

st

Break Point Feb. 27, 2006 1 difference of price

st

Note. The Perron (1997) test procedure is conducted by tting the following model to the price level and rst differences of the futures price series:
k

Yt aYt1 uDUt gDTt dD (Tb ) t m bt a ci Yti et

i1 a

t-statistic for testing the null hypothesis that the coefcient of Yt1 equals 1. The asymptotic critical values for a are 5.57, 5.08, and 4.82 at the 0.01, 0.05, and 0.10 condence levels respectively. *** denotes signicance at 1% level. t-statistics are in parentheses.

Table II reports the test results for structural breaks and unit roots. The futures price series for NYMEX aluminum (NYAL), SHFE aluminum (SHAL), NYMEX copper (NYCO), and SHFE copper (SHCO) do not reject, at the price level, the null hypothesis that there is a unit root, while their rst differences reject the null at the confidence level of 0.01, suggesting that they are all integrated at order one, or I(1). In addition, the coefficients for DUt and DTt are all significant at the confidence level of 0.01, which indicates the presence of statistically signicant structural breaks within the sample period. The recursive testing procedures further find the dates of the
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Price (US$)

Break Points

Price (US$)

Break Points

FIGURE 1

The data series and structural break points. Note: NYAL and SHAL are the price series of nearby aluminum futures contracts traded at Shanghai Futures Exchange and New York Mercantile Exchange respectively. NYCO and SHCO are those of nearby copper futures contracts at the two exchanges. The sample periods are from May 14, 1999, to May 13, 2009. Structural breaks are found on January 22, 2008, November 19, 2007, March 7, 2006, and February 27, 2006, for NYAL, SHAL, NYCO and SHCO price series, respectively.

breaks to be January 22, 2008, November 19, 2007, March 7, 2006, and February 27, 2006, for NYAL, SHAL, NYCO, and SHCO futures price series, respectively.3 Figure 1 presents the four series and indicates the approximate dates of the structural breaks in the entire sample. The break dates of the two aluminum series are close to each other, as are those for the two copper series. Not surprisingly, the structural breaks appear to be located just before a sharp spike in the prices and volatility, and they are all during the period of commodity market turmoil between 2006 and the rst half of 2008.
3

The fact that the structural breaks for the two SHFE series precede those for the two NYMEX series is interesting and provides evidence that the Chinese market may lead the U.S. market in some ways. When the same procedures are applied to the aluminum and copper futures series from the London Mercantile Exchange, the break dates are identical to those of the NYMEX series.
DOI: 10.1002/fut

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TABLE III

Descriptive Statistics of Daily Futures Returns

NYAL SHAL NYCO SHCO

Subsample 1: May 14, 1999Nov. 16, 2007

Mean Median Variance Kurtosis Skewness 3.66E04 0 1.75E04 5.84** 0.49** 2.19E04 0 7.26E05 4.87** 0.01

Subsample 1: May 14, 1999Feb. 24, 2006

8.32E04 5.59E04 2.23E04 4.48** 0.29** 7.58E04 4.61E04 1.18E04 2.94** 0.09

Subsample 2: Jan. 23, 2008May 13, 2009

Mean Median Variance Kurtosis Skewness t -test Two-Sample for Means between Subsamples F-test Two-Sample for Variance between Subsamples 1.13E03 0 4.15E04 3.34** 0.55** 1.25 8.38E04 7.11E04 2.29E04 2.42** 0.47** 1.19

Subsample 2: Mar. 8, 2006May 13, 2009

3.27E04 5.56E04 8.25E04 3.96** 0.20** 0.45 1.72E04 0.00E 00 4.66E04 2.61** 0.06 0.69

0.42**

0.32**

0.27**

0.25**

Note. SHAL and SHCO are SHFE futures price series converted to US dollars/lb with contemporaneous US$/RMB exchange rate. ** denotes signicance at the 5% level.

COINTEGRATION RESULTS Because of the structural breaks, data are divided into two subsamples to examine possible changes in time-series properties before and after the breaks. For aluminum futures, the rst subsample is May 14, 1999 to November 16, 2007 (i.e. from the beginning date of the data series to the date of the earlier of the two structural breaks for aluminum), while the second subsample is between January 23, 2008 and May 13, 2009 (i.e. between the later date of the two structural breaks for aluminum, and the ending date of the data series). Similarly, the two subsamples for copper futures are from May 14, 1999, to February 24, 2006, for the rst period, and from March 8, 2006, to May 13, 2009, for the second period. Table III reports the descriptive statistics for the four futures contracts daily returns in each of the two subsamples. Although the differences in mean returns between the subsamples for all four futures price series are not statistically signicant, the differences in the variances are signicant. As reported in the
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last panel of the table, the second subsample exhibits signicantly higher variance, consistent with higher observed uctuations after the structural breaks. The kurtosis is moderately smaller in the second subsample. As the futures price series are all I(1) processes (i.e. they are integrated at order one as indicated in Table II) and are related through the same underlying commodity, it is important to test whether a linear combination of them constitutes a long-run equilibrium, using the multivariate cointegration tests developed in Johansen (1988), Johansen et al. (1991), and Johansen and Juselius (1990). Because of the time-zone difference, this study applies the tests both to the same-day prices (i.e. NYALt vs. SHALt, and NYCOt vs. SHCOt) and different-day prices (i.e. NYALt1 vs. SHALt, and NYCOt1 vs. SHCOt).4 Table IV presents the Johansen likelihood ratio statistic, lTrace, and an alternate statistic, the maximal eigenvalue or lMax, from the tests. For all the pairs of price series, the null hypothesis that r 0, or that there is no cointegrating relationship between the price series, is rejected at the condence level of 5%. But the null hypothesis that r 1 cannot be rejected by either the trace or the max statistic, suggesting that one stationary linear combination (i.e. r 1) constitutes a long-run equilibrium of the price relations. For the two subsamples for New York and Shanghai, respectively, the normalized b vectors (i.e. the cointegration vectors calculated by the model) are (1, 1.439) and (1, 1.506) between NYALt and SHALt, (1, 1.437) and (1, 1.498) between NYALt1 and SHALt, (1.133, 1) and (1.086, 1) between NYCOt and SHCOt, and (1.129, 1) and (1.088, 1) between NYCOt1 and SHCOt. VECTOR ERROR CORRECTION RESULTS A VECM is used to investigate the information flow between the U.S. and Chinese futures markets. Changes in log futures prices in the New York (NY) and Shanghai (SH) futures contracts, rNYt and rSHt, are specied as a vector of their own lags (i.e. the home-market lags) and the other markets return lags (i.e. the cross-market lags) with an error correction term in the following two models. Model 1 does not account for the time-zone difference between the New York and Shanghai market. Model 1: No adjustment for non-synchronous trading NYt w0 w1SHt z1,t
4

(2)

There is a 12-hour difference between Eastern Daylight Saving Time (NYMEX) and Beijing Time (SHFE), and a 13-hour difference between Eastern Standard Time and Beijing Time. Thus, between the same-day prices, SHALt and SHCOt precede NYALt and NYCOt by about half a day. Similarly, between the differentday prices, NYALt1 and NYCOt1 lead SHALt and SHCOt by about half a day.
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TABLE IV

Johansen Cointegration Tests

lTrace 95% Null Hypotheses Alternative Hypotheses lTrace Critical Value lMax lMax 95% Critical Value

Panel 1: Between NYALt and SHALt

Subsample 1: May 14, 1999Nov. 16, 2007: r0 r0 r1 r1 Based on r 1, the normalized b vector is: NYAL SHAL 1 1.4390 Subsample 2: Jan. 23, 2008May 13, 2009: r0 r0 r1 r1 Based on r 1, the normalized b vector is: NYAL SHAL 1 1.5055 16.89*** 0.89 10.60 2.71 17.78*** 0.89 13.31 2.71

14.58*** 0.66

10.60 2.71

15.24*** 0.66

13.31 2.71

Panel 2: Between NYALt1 and SHALt

Subsample 1: May 14, 1999Nov. 16, 2007: r0 r0 17.47*** r1 r1 0.90 Based on r 1, the normalized b vector is: NYAL SHAL 1 1.4371 Subsample 2: Jan. 23, 2008May 13, 2009: r0 r0 18.65*** r1 r1 0.76 Based on r 1, the normalized b vector is: NYAL SHAL 1 1.4976 10.60 2.71 18.37*** 0.90 13.31 2.71

10.60 2.71

19.41*** 0.76

13.31 2.71

Panel 3: Between NYCOt and SHCOt

Subsample 1: May 14, 1999Feb. 24, 2006: r0 r0 r1 r1 Based on r 1, the normalized b vector is: NYCO SHCO 1.1333 1 Subsample 2: Mar. 8, 2006May 13, 2009: r0 r0 r1 r1 Based on r 1, the normalized b vector is: NYCO SHCO 1.0861 1 49.53*** 1.95 10.60 2.71 56.17*** 1.95 13.31 2.71

34.12*** 1.44

10.60 2.71

35.57*** 1.44

13.31 2.71

Panel 4: Between NYCOt1 and SHCOt

Subsample 1: May 14, 1999Feb. 24, 2006: r0 r0 r1 r1 Based on r 1, the normalized b vector is: NYCO SHCO 1.1291 1 Subsample 2: Mar. 8, 2006May 13, 2009: r0 r0 r1 r1 Based on r 1, the normalized b vector is: NYCO SHCO 1.0883 1 37.10*** 1.94 10.60 2.71 44.04*** 1.94 13.31 2.71

26.38*** 1.57

10.60 2.71

27.95*** 1.57

13.31 2.71

Note. Johansen (1988), Johansen et al. (1991), and Johansen and Juselius (1990) multivariate cointegration tests are used to examine the cointegrating relations. Two likelihood ratio test statistics, lTrace and lMax, are reported along with their 95% critical values. The statistics include a nite sample correction based on Reimers (1992). *** denotes signicance at the 1% level.

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rNY,t aNY cNY z1,t1 a bNY rNY,ti a dNY rSH,tj eNY,t

i1 k j1 k

(3) (4)

rSH,t aSH cSH z1,t1 a bSH rNY,ti a dSH rSH,tj eSH,t

i1 j1

The residuals, z1,t, from regression (2) are the error correction terms used in the VECM (3) and (4). Model 2 adjusts for the different time zones of the two markets. In particular, the model uses the closing price of the U.S. market at day t 1 with the closing price of the Chinese market at day t in Equation (2) and modifies Equation (4) correspondingly. No adjustment is required for Equation (3). Model 2: Adjustment for nonsynchronous trading NYt1 w0 w1SHt z2,t rSH,t aSH cSH z2,t1 a bSHrNY,t1i a dSHrSH,tj eSH,t
i1 j1 k k

(2a) (4a)

Each univariate equation of the VECM (3), (4), and (4a) uses a maximum likelihood estimation with the residuals following a GARCH(1,1) process.
2 2 2 eit N (0, s2 it ); sit vi aieit1 bisit1,

where i NY or SH.

(5)

Two dummy variables, Monday and Friday, are included to control the day of the week effects. Table V presents the VECM results of aluminum futures. Before the structural break, in Subsample 1, Model 1 shows that both the error correction terms are signicant in the US Equation (3), 0.01 (t-value 2.48) and in the Chinese Equation (4), 0.007 (t-value 3.44), indicating a bidirectional error correction process between the two markets. The table also indicates signicant short-term causality from the price in the New York market on day t 1 to the price in the Shanghai market on day t, with a coefficient of 0.192 (t-value 14.48), but not in the reverse direction. The latter result may show that the U.S. market is more informationally efcient than the Chinese market. However, after correcting for the non-synchronous trading effect in Model 2, as reported in the last two columns of the table, this causality drops considerably, with a coefcient of 0.037. Moreover, the coefcient of the error correction term in the Shanghai Equation (4a) also decreases to 0.003 (t-value 1.34). Signicant GARCH effects are observed in both markets. For Subsample 2, Model 1 also indicates a short-term causality from the price in the New York market on day t 1 to the price in the Shanghai market
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TABLE V

Vector Error Correction Model: Aluminum Futures

No Adjustment for Nonsynchronous Trading: Use NYt and SHt NY Coefcient t-stat SH Coefcient t-stat Adjustment for Nonsynchronous Trading SH Coefcient t-stat

Subsample 1: May 14, 1999Nov. 16, 2007. Constant 0.0002 zt1 0.0100 NYt1 0.0574 NYt2 0.0469 SHt1 0.0151 SHt2 0.0347 Mon 0.0013 Fri 0.0003 GARCH Residuals v 0.0773 a 0.0926 b 0.8666 Constant 0.0003 0.0437 zt1 NYt1 0.0554 NYt2 0.0996 0.0304 SHt1 SHt2 0.1753 Mon 0.0030 Fri 0.0032 GARCH Residuals v 2.9848 a 0.1169 b 0.1229 0.41 2.48** 1.70 1.56 0.34 0.79 1.44 0.39 3.11*** 3.96*** 26.98*** 0.18 2.08** 0.81 1.49 0.32 2.09** 0.88 1.01 9.84*** 2.01** 1.51 0.0001 0.0070 0.1971 0.0192 0.0044 0.0193 0.0012 0.0001 0.0702 0.0961 0.8960 0.0006 0.0038 0.2980 0.0471 0.0355 0.0953 0.0125 0.0171 0.0113 0.1709 0.8445 0.54 3.44*** 14.48*** 1.38 0.15 0.75 3.56*** 0.35 3.47*** 6.18*** 56.39*** 0.78 0.35 9.12*** 1.26 0.49 1.66 0.89 0.96 1.16 2.86** 19.11*** 0.0001 0.0030 0.0367 0.0172 0.0583 0.0194 0.0010 0.0000 0.0063 0.1242 0.8784 0.0008 0.0181 0.0046 0.0733 0.1016 0.1619 0.0008 0.0015 0.0330 0.1524 0.8409 0.56 1.34 2.73** 1.22 1.88 0.68 2.86** 0.04 2.74 6.95 54.63*** 0.65 1.19 0.11 1.65 1.35 2.12** 0.37 0.77 0.91 2.29** 13.67***

Subsample 2: Jan. 23, 2008May 13, 2009

Note. *, **, and *** denote signicance at the 10%, 5%, and 1% condence levels, respectively.

on day t with a coefficient of 0.298 (t-value 9.12), but not in the reverse direction. Similar to the results from Subsample 1, for Model 2 with adjustment for the nonsynchronous trading problem, the coefcient drops to 0.0046. Both subsamples show that the U.S. market does not dominate the Chinese markets in informational efciency. Both markets are efcient in incorporating information on a daily basis. Table VI shows the results for the copper futures contracts in the New York and Shanghai markets. In Subsample 1, the coefcients of the error correction term in the New York and Shanghai markets are comparable, 0.029 and 0.024, respectively, although the rst one is not statistically signicant, as
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TABLE VI

Vector Error Correction Model: Copper Futures

No Adjustment for Nonsynchronous Trading: Use NYt and SHt NY Coefcient t-stat SH Coefcient t-stat Adjustment for Nonsynchronous Trading SH Coefcient t-stat

Subsample 1: May 14, 1999Feb. 24, 2006 Constant 0.0004 zt1 0.0293 NYt1 0.0470 NYt2 0.0326 SHt1 0.0528 SHt2 0.0308 Mon 0.0011 Fri 0.0013 GARCH Residuals v 1.4284 a 0.0492 b 0.3120 Constant 0.0004 zt1 0.0432 NYt1 0.1051 NYt2 0.0511 0.1260 SHt1 SHt2 0.0897 Mon 0.0012 Fri 0.0009 GARCH Residuals v 0.2929 a 0.0616 b 0.9023
Note.

0.52 1.44 1.12 0.80 1.02 0.52 0.60 0.88 19.05*** 2.31** 16.95*** 0.28 1.41 1.72* 0.91 1.63* 1.61 0.40 0.29 2.17** 3.18*** 25.88***

0.0001 0.0242 0.4386 0.1224 0.2428 0.0256 0.0019 0.0005 0.0058 0.0448 0.9486 0.0002 0.0428 0.4547 0.1368 0.1032 0.0323 0.0009 0.0020 0.0588 0.1013 0.8832

0.60 3.92** 30.14*** 6.15*** 7.75*** 1.26 4.26*** 0.94 3.56 5.43 101.42 0.23 2.90** 17.20*** 4.19*** 2.33** 1.04 0.59 1.33 1.93* 2.97** 25.03***

0.0001 0.0047 0.0046 0.0129 0.0007 0.0258 0.0020 0.0001 0.0092 0.0419 0.9515 0.0001 0.0026 0.0186 0.0470 0.1428 0.0187 0.0011 0.0019 0.2362 0.1395 0.8122

0.39 0.58 0.23 0.57 0.02 0.80 3.41* 0.09 3.91*** 8.00*** 161.58*** 0.07 0.14 0.53 1.30 2.72** 0.37 0.50 1.01 25.40*** 4.04*** 28.33***

Subsample 2: Mar. 8, 2006May 13, 2009

*, **, and *** denote signicance at the 10%, 5%, and 1% condence levels, respectively.

indicated by their t-statistics (1.44 and 3.92, respectively). Consistent with the results of aluminum, the table reports signicant short-term causality from New York to Shanghai as indicated by a coefcient of 0.438 (t-value 30.14), but not from Shanghai to New York. Adjusting for different time zones, Model 2 again shows that this causality is induced by nonsynchronous trading with the coefcient declining to 0.019. Similar results occur for Subsample 2. The overall results of the VECM in both the aluminum and copper markets show that the U.S. and Chinese markets are informationally efcient on a daily basis. Neither the U.S. nor the Chinese market Granger causes the other.
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TRADING SIMULATIONS The cointegration relationships displayed in Table IV suggest that there is a long-term equilibrium for the spreads in the futures price series, while the VECM analysis in Table V further conrms the importance of the error correction term in the cross-market analysis.5 The spread has a significant meanreverting tendency toward a long-term equilibrium value, which may provide potentially lucrative trading opportunities for futures traders. That is, traders can employ a buy-low-and-sell-high strategy to capture the disequilibrium pricing, implying that traders can take a long position of the spread when it drops below the long-run equilibrium and then offset it when the spread widens to the equilibrium. However, traders can take a short position when the spread rises above the long-run equilibrium and then offset it when the spread narrows to the equilibrium. If the futures markets in the U.S. and China markets are efcient enough, traders should be able to fully incorporate this information into their trading behavior, such that no one can take advantage of it to generate a large, meaningful trading prot, net of transaction costs. The less efcient the underlying markets are, the more trading prots can be obtained from such trading transactions. Thus, the profitability level of trades could serve as an indicator of market efciency. For aluminum futures, the trading strategy is to long (short) the spread by buying (selling) one New York contract and selling (buying) four Shanghai futures contracts when the spread is below (above) the long-run equilibrium by a certain level, and then to close the positions by conducting offsetting trades when the spread reverts to the long-run equilibrium.6 For copper futures, the trading strategy is to long (short) the spread by buying (selling) four New York contracts and selling (buying) nine Shanghai futures contracts when the spread is below (above) the long-run equilibrium.7 Transaction costs are incurred when positions are opened or closed. Consistent with other trading simulation studies, the trading rules consider two types of transaction costs for futures contract: slippage costs and brokerage fees. Slippage cost is typically two price ticks per round trip, which translates into $44 for NYAL, $25 for NYCO, and RMB100 for both SHAL and SHCO. For brokerage fees, the lowest fee for online futures trading is $0.95 per contract
5

For instance, the spread between NYAL and SHAL in Subsample 1 is NYAL1.439*SHAL, as the corresponding cointegration vector is (1, 1.439). 6 As Table I shows, one NYAL futures contract is for 44,000 pounds of aluminum and one SHAL contract is for 5 metric tons of aluminum. One metric ton equals 2,204.6 pounds. Therefore, one NYAL contract is approximately equivalent to four SHAL contracts in terms of size. 7 One NYCO futures contract is for 25,000 pounds of aluminum and one SHCO contract is for ve metric tons of aluminum. Therefore, four NYCO contracts are approximately equivalent to nine SHCO contracts in terms of size.
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(www.mbtrading.com) for NYAL and NYCO, which is equivalent to $1.90 per contract per round trip. With regard to SHFE futures, the lowest brokerage fees are RMB10 per contract per trade for SHAL and 0.04% of contract value for SHCO (www.gold-futures.cn). Thus, the sum per round trip of these two types of transaction costs for trading one futures contract is $45.90 for NYAL, $26.90 for NYCO, RMB120 for SHAL, and RMB100 plus 0.04% of contract value for SHCO. These transaction costs are deducted from trading prots in our trading simulations. Trading Triggers and Results The trading simulations are based on the cointegration vectors in Table IV. Trading is triggered when the spread, as dened by the cointegration vector, deviates from the long-term equilibrium (i.e. when the spread equals zero) by more than 0.1, 0.2, and 0.3 times its standard deviation, de. The detailed trading rules are as follows. Long positions: For aluminum futures, long the spread by buying one NYAL contract and selling four SHAL futures contracts. For copper futures, long the spread by selling four NYCO futures contracts and buying nine SHCO contracts. The long positions are taken when et Xde (6)

where et is the deviation of the spread from 0, X is alternatively 0.1, 0.2, and 0.3, and de is the standard deviation of et. The long positions are closed when et goes above zero. Short positions: For aluminum futures, short the spread by selling one NYAL contract and buying four SHAL futures contracts. For copper futures, short the spread by buying four NYCO futures contracts and selling nine SHCO contracts. The short positions are taken when et Xde (7)

Close the short positions when et falls below zero. Table VII reports the trading simulation results for the aluminum futures in the two subsamples. The average duration for completing the long trades ranges for the first subsample from 23 to 43 days with an average return of 0.611.21%. For the second subsample, the duration becomes shorter than the earlier period, suggesting the price adjustment process is faster. However, the average return in this period is slightly higher (ranging from 0.88 to 1.63%) than for the rst period. Note that the return volatility of this period is also higher than that of the earlier period.
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TABLE VII

Simulated Trading Results: Aluminum Futures

Trigger X # of Trades Avg Duration (days) Avg Return
0.61% 1.02% 1.21% 0.88% 1.02% 1.63% 0.38% 0.55% 0.75% 1.43% 1.93% 2.47%

Standard Deviation
1.11% 1.34% 1.49% 2.02% 2.02% 2.38% 0.96% 1.07% 1.15% 2.35% 2.75% 2.91%

Long trades in Subsample 1: May 14, 1999Feb. 24, 2006 0.1 37 22.95 0.2 24 33.58 0.3 18 42.61 Long trades in Subsample 2: Mar. 8, 2006 May 13, 2009 0.1 13 4.85 0.2 12 5.08 0.3 9 5.67 Short trades in Subsample 1: May 14, 1999Feb. 24, 2006 0.1 48 21.10 0.2 35 28.26 0.3 30 31.87 Short trades in Subsample 2: Mar. 8, 2006May 13, 2009 0.1 14 11.07 0.2 9 16.11 0.3 7 19.43

Note. Long and short positions are established in accordance with the trading rules described in the text. A position is closed by executing the opposite trades when the spread reverts to zero.

The short trade results for Subsample 1 are similar to the long trade results. There are few points to be made. First, the returns are lower than the long trade results, implying lower prot potential for this trading rule. Second, higher returns in the second period are accompanied by higher standard deviations, conrming the return-risk tradeoffs. Finally, the second period trading duration is again shorter than that of the rst period. The trading simulations for the copper futures are presented in Table VIII. All the trading returns are substantially smaller than those for aluminum. The returns are less than 1%, except for the longs in Subsample 2, which have an average return of 1%. Similar to the aluminum results, the trading duration of the second period is shorter than that of the rst period, indicating that the markets reflect information faster. The higher returns in Subsample 2 are accompanied by higher standard deviations, conrming the return-risk tradeoffs.8 CONCLUSIONS This study examines the transmission of information between the U.S. and Chinese aluminum and copper futures markets over a ten-year span from 1999
8

If the roll-over costs of the transactions for new contracts are included, the prots (returns) will be lower than those reported.
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TABLE VIII

Simulated Trading Results: Copper Futures

Trigger X # of Trades Avg Duration (days) Avg Return
0.26% 0.27% 0.30% 1.00% 1.23% 1.23% 0.33% 0.46% 0.48% 0.79% 0.70% 0.82%

Standard Deviation
0.87% 0.88% 0.93% 2.22% 2.35% 2.35% 0.88% 0.96% 0.96% 1.59% 1.62% 1.63%

Long trades in Subsample 1: May 14, 1999Nov. 16, 2007 0.1 86 8.81 0.2 70 10.39 0.3 59 11.75 Long trades in Subsample 2: Jan. 23, 2008May 13, 2009 0.1 58 5.86 0.2 47 6.91 0.3 38 8.13 Short trades in Subsample 1: May 14, 1999Nov. 16, 2007 0.1 84 8.75 0.2 62 11.35 0.3 53 12.79 Short trades in Subsample 2: Jan. 23, 2008May 13, 2009 0.1 65 5.40 0.2 60 5.63 0.3 55 5.93

Note. Long and short positions are established in accordance with the trading rules described in the text. A position is closed by executing the opposite trades when the spread reverts to zero.

to 2009. It is important to understand these market characteristics because they can help investors and portfolio managers formulate successful international investment and asset allocation strategies. They also help producers and multinational corporations design effective hedging and risk management policies to use in these markets. Structural breaks are found in the data series that all fall within the recent high-volatility period in commodity markets. The data are divided into two periods defined by the breaks. Differences in means for the daily returns of the price series are not signicant between the subsamples, but the differences in variance are, due to the signicantly higher uctuations in aluminum and copper prices after the structural breaks. The VECM shows that the New York and Shanghai markets are cointegrated and both markets are comparably efcient in incorporating information. Trading strategies are used to explore the error correction process between the two markets. The trading results show that the trading returns are small (less than 1%), except for some cases during the volatile Subsample 2 period. The overall results show that U.S. and Shanghai futures prices are closely related and both markets are efficient on a daily basis for both periods. Furthermore, the U.S. market is not superior to the Chinese market in informational efciency.
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Journal of Futures Markets

DOI: 10.1002/fut

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