Study of Price Discovery Process in

London Metal Exchange

Submitted by

Rajiv Mohapatra

IFMR, Chennai

Under the supervision of

Satyabrata Behera

Jr Manager (Marketing), NALCO

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Contents

Introduction to LME ................................................................................................................................. 3

Trading in LME ......................................................................................................................................... 5

LME Market and Price Data ..................................................................................................................... 6

Futures prices from the Ring ................................................................................................................ 6

Member contributed prices ................................................................................................................. 7

Futures and options prices from LMEselect .......................................................................................... 7

Open interest reports .......................................................................................................................... 7

Warehouse stocks ................................................................................................................................ 7

Additional LME market data................................................................................................................. 8

Features of Futures .................................................................................................................................. 9

Price Discovery ...................................................................................................................................... 10

Importance of Price Discovery in LME .................................................................................................... 11

Determinants of Price ............................................................................................................................ 12

Market efficiency in Futures markets ................................................................................................. 12

Theory of storage and cost-of-carry model......................................................................................... 16

Liquidity ............................................................................................................................................. 17

Price volatility .................................................................................................................................... 20

Market risk ........................................................................................................................................ 20

Market Microstructure and other aspects .......................................................................................... 20

Bibliography .......................................................................................................................................... 21

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Introduction to LME

The London Metal Exchange (LME) is the major international market for the main industrially used non-ferrous metals, namely aluminium, aluminium alloy, copper, lead, nickel, tin, zinc, and silver. It is used worldwide by producers and consumers of nonferrous metals as a centre for spot1, futures2 and options trading in these metals. The results for the spot and futures prices may erve as guidelines for allocation and hedge3 strategies involving several metal markets at different time horizons across the world.

1 Spot – A market of commodities or securities in which goods are sold for ready cash and delivered immediately i.e transactions take place on the spot. Also known as the Cash Market since cash changes hands.

2 Futures – A contract to exchange specific quantities of a commodity, not today, but at a specified date in the future, at a price that is agreed upon today.

3 Hedging – A transaction intended to protect or reduce risk from subsequent adverse price movements of a physical commodity already bought or sold.

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LME was founded in 1877. At first, only copper was traded, lead and zinc were soon added but only gained official trading status in 1920. Other metals traded extended to include aluminium (1978), nickel (1979), aluminium alloy (1992) and steel (2008). The exchange also started trading plastics in 2005.

The LME is the most important market for pricing of nonferrous metals worldwide. The total value of the trade is around $US 10.24 Trillion annually. Smaller regional markets typically participate only in spot trade of non-ferrous metals. One exception is the Shanghai Futures Exchange (SHFE), on which futures for aluminium and copper are traded primarily for the Chinese domestic market.

LME is located at 56, Leadenhall Street, London.

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Trading in LME If you want to produce, or trade aluminium or copper, or any metal listed on the LME, you can sell the metal to one of the many big warehouses of the LME, all over the world, and receive a warrant. This is a way to share the cost of these warehouses between the many industry participants and make it more efficient, to compete against other products.

The LME issues, each day, detailed figures on how many tons of each metal is in its warehouses, which helps producers and consumers make correct business decisions.

The London Metal Exchange allows members to trade internationally 24-hours a day via three trading venues: the Ring trading sessions (open-outcry), LME Select electronic trading from 1pm to 7 pm London time, and the LME 24 hour inter-office telephone market. Market data generated from trading activity is streamed live directly to licensed data distributors.

Open-outcry is the oldest and most popular way of trading on the Exchange. It is central to the process of ‘price discovery’, a term used to describe the way LME official prices are established. Prices are derived from the most liquid periods of trading; the short open-outcry ‘ring’ trading sessions, and are most representative of industry supply and demand. The official settlement price, on which contracts are settled, is determined by the last offer price before the bell is sounded to mark the end of the official ring.

Three primary functions are performed by the non-ferrous metals markets on the LME. They are

• Price Discovery Process – The settlement prices determined on the LME are used internationally as reference prices for the valuation of activities relating to non-ferrous metals.

• Risk Hedging Mechanism – The exchange provides a market where non-ferrous metal industry participants can hedge against risks arising from price fluctuations in world metals markets.

• Last Resort Delivery / Supply – LME provides appropriately located authorized warehouses to enable market participants to take or make physical delivery of approved brands of non-ferrous metals.

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LME Market and Price Data

Listed below are the different types of data provided by the LME.

Futures prices from the Ring

Market users can monitor Ring traded metals and plastics reference prices using the range of trade and price data provided by the LME direct from the trading floor.

Ring trading

• Separate bid, ask and trade prices for all futures contracts quoted outright, spread or average.

• Official high bid and low offer prices for futures 3 month prompt dates following each ring and kerb trading session

Daily official and unofficial prices

• Daily official cash, 3 month, 15 month and 27 month prompt date prices (where applicable) for metal futures contracts following the second morning ring trading session

• Daily official cash, month 1 and month 2 for each plastics contract • Daily official FX rates following the second morning ring trading session • Daily moving monthly average FX rates • Daily unofficial prices for all contracts following the second afternoon ring trading

session • Daily official index value available at www.lme.com/lmex.asp

Official and settlement prices are very important, as the industry use these as the basis for pricing physical contracts. All LME prices are quoted in US dollars per metric tonne.

LME contracts are traded in US$, but are cleared in US$, Sterling, Euro & Yen.

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Member contributed prices Futures pre-trade quotes from the inter-office telephone market are contributed by all the Ring Dealing Members and the majority of Associate Broker Clearing Members are input from UK and overseas offices 24 hours a day. All prices are indicative, in bid/ask pairs and in US dollars.

Futures and options prices from LMEselect

LMEselect, the LME’s electronic trading platform, is open for trading between 01.00 and 19.00 Monday to Friday. LME provides a comprehensive view of LMEselect trading including:

• Pre-trade best bid and best ask prices for all contracts traded with aggregate volume • Post trade prices with traded volume • Market depth - best five bids/offer pairs and volume for 3 month futures contracts • Open, High, Low, Last traded for the 3 month prompt date published at 19.00 each day

Open interest reports

The LME publishes a number of daily reports to inform the market of the open positions in each contract traded on the exchange.

Futures and Options Open Interest

• Market Open Interest (MOI) • Exchange Open Interest (EOI)

Member Positions

• Daily Warrant Holdings • Warrant Holdings (tomorrow and cash) • Large Position report (Futures Banding)

Warehouse stocks

The daily warehouse stock figures from LME approved warehouses are published at 09.00 each morning (London time). Stock movements are reflective of the physical supply and demand of the market. This report provides:

• Daily opening and closing stock totals

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• Daily movement in and out of warehouses and net change • Stocks totals per warehouse location • Stocks totals per metal grade (where relevant) • Reported metric tonnage

Additional LME market data

The LME also publishes a number of daily and monthly data reports produced by the LME and LCH-Clearnet4 that add value to the price data. These reports provide users with a full overview of the market and can assist them in making fully informed trading decisions.

Futures and Options Volumes

• Futures & traded options volumes reports, intra-day, end of day and previous day

Futures and Options Closing Prices (Evening Evaluations)

• Daily futures and traded options provisional and final closing prices (evening evaluation) reports

• Daily provisional and final evening evaluation exchange rates

Futures and TAPO Averages

• Official monthly average settlement prices for all contracts on the last business day of the month

• Daily notional average prices for all TAPO5 contracts • Daily monthly moving average prices for all TAPO contracts • Monthly average settlement prices for all TAPO contracts on the last business day of the

month

4 LCH Clearnet – The clearing house for LME contracts. 5 TAPO – Traded Average Price Options are monthly traded option contracts that are cash settled at expiry, based on the average of settlement prices, as soon as they become known, over the month. They are also known as Asian Options

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Features of Futures

As opposed to spot markets, deals are stuck for future action in the future markets. A future contract can be defined as a type of financial contract wherein parties agree to exchange financial instruments like securities or physical commodities for future delivery at a particular price. Future contract is a standardized contract to buy at a future date at a certain price.

Nature: Commodities in the future market can be reasonably expected to be delivered within a couple of months or so. Future market is not a ready market like a spot market. Future market does not involve primary activity and it is speculative in nature. In the future market, deals are struck at forward prices. A future contract gives the holder the obligation to buy or sell. Both parties to the contract must fulfill the contract. Here everything is in a fluid state until the security or commodity reaches the buyer’s hands and the consideration reaches the other party.

The future date is called delivery date and a final settlement date. The pre set price is called futures price. The price of the underlying asset on the delivery date is called the settlement price. Future traders are traditionally two groups - hedgers who have an interest in the commodity being traded like producers and consumers and speculators who seek to make profit by predicting market moves. There are many kinds of future contracts like Commodity market, Foreign Exchange market, Money market, Bond market Equity index etc.

Risks involved: Future market is full of risk because anything might go wrong at any stage and the transaction may become invalid or void. Stock markets all over the world are highly volatile and the value of the traded security may go down at any time. Similarly if a commodity like crude oil is traded, the happening of the future event may be subject to political equations between the two countries; unrest in a neighboring country may delay the delivery. Thus the future market does not meet the safety requirement of business. Trading in future market is not for the risk averse. It is only for those who trust others and their own luck. A very small percentage of future contracts turn to physical delivery. However there are markets like metal commodity exchanges where over 90% of the transactions take place in the futures / forward markets.

Benefits of futures market: As far as the futures market in metal production is concerned, the producers have a guarantee for payment and quality risk is avoided. It promotes storage and warehousing facilities and logistics facilities. It also increases the bargaining power of the producers and enables decision on the scale of production and the time of sale.

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Price Discovery Price Discovery refers to the dynamics whereby future and cash (spot) markets attempt to identify permanent changes in transaction prices. Price Discovery is two things – the differential reaction of the different markets to new information, and the rate at which the new information is incorporated into price.

Price discovery is the central aspect of financial markets. The relatively efficient price signals that prevail in the marketplace are important for enhancing productive efficiency and economic growth through superior capital allocation. These signals also facilitate the ability of relatively uninformed investors to make suitable portfolio choices.

Semi-strong form market efficiency precludes the possibility of earning excess returns on current public information, so if markets demonstrate this efficiency, the time lag in both of these two must be sufficiently small to prevent economically significant excess returns.

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Importance of Price Discovery in LME Importance of the price discovery process in LME and other commodity markets are as follows

• Commodities are traded in highly developed future markets. • In the metals sector 90% of the transactions take place in the forward/future markets. • The LME quoted price is the world wide reference price and the common. • It is important to quantify the price discovery role of metals futures.

A more accurate view of futures prices for metals is of particular interest to participants in industries reliant on the production or consumption of metals, such as miners, smelters, refiners, rolling mills, extrusion plants, metals merchants and fabricators. Energy providers, banks, investment funds and, to some extent, speculators, are also active participants in metals futures markets.

At a macroeconomic level, commodity prices play an important role in the economy of many countries. Developing economies are particularly reliant on commodity production in the generation of national income. A greater understanding of the relationship between futures and spot prices has important policy implications for commodity dependent nations for key indicators such as exchange rates, inflation and economic growth.

Fig 1: Volumes traded in commodity and index future markets

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Determinants of Price

Macroeconomic variables such as aggregate demand, industrial production, inflation, exchange and interest rates are common determinants of all commodity prices. The changes in these variables can affect commodity prices in two ways: directly, when they modify current commodity demands and supplies; and indirectly, when they alter expectations about future supplies and demands, and, therefore, the current demand for storage.

Besides the age-old economics laws of supply and demand, empirical research involving non-ferrous metals and pricing of spot and futures markets can be classified into four broad areas:

1. Market efficiency; 2. The theory of storage and cost-of-carry model; 3. Liquidity; 4. Price volatility; 5. Market risk; 6. Market microstructure and other aspects of metals markets.

Market efficiency in Futures markets

When money is put into the stock market, it is done with the aim of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or beat, the market. However, market efficiency - championed in the Efficient Market Hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.

There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". Weak EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. Semi-strong EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. Strong EMH additionally claims that prices instantly reflect even hidden or "insider" information.

Derivative securities like futures and options enhance price discovery by pricing a static payoff pattern that represents the value of an otherwise dynamic investment strategy. They are expected to increase the flow of information into the market resulting in better price discovery of the underlying asset.

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Contrary to widespread belief that future prices are unilaterally derived from underlying stock prices, evidence suggests that futures markets are likely to be informative about the future movement of stock prices. Both futures and spot markets induce non-trivial cumulative responses in themselves. Studies have suggested a strong evidence of bi-directional causality (or feedback) between futures and spot indexes. In most commodity markets a futures shock causes a small change in the spot index, but interestingly, a spot index shock appears to induce a very large response in the futures contract. This ‘over-reaction’ of futures to underlying index shocks and increased volatility in futures prices will have consequences for, among other things, hedging, arbitrage strategies and margin requirements. However, in LME, the future price changes lead spot price changes in cash markets more often than the reverse due to the fact that in metals sector 90% of the transactions take place in the forwards / future markets.

The conclusion that spot index leads futures is in line with the hedging argument, while the fact that futures contracts lead to stock price changes indicates that the futures market is an important venue for information-based trading.

According to the asymmetric information-based theory, the informed traders would trade in options and futures based on their private information which would convey useful signals to the other market participants resulting in an impact (positive or negative) on the price of underlying stock. Investors who do not possess the specific information about the future price movement can use these predictors for deciding upon their trading strategies. Even the sophisticated investors can explore these estimates and further refine their trading strategies with more informational inputs. Thus, the role of futures in price discovery is clearly visible in the results.

Also, due to the bi-directional causality or feedback in spots and futures explained earlier, the future and spot prices are cointegrated implying that it is not possible to make profits in the long run trading futures and taking positions in the underlying commodity, hence reducing the opportunity of Arbitrage6.

The scatter plot diagram to illustrate the correlation between the Spot and 15 month futures of some volume traded metals in LME are given below. This reveals the information present in markets and efficient price discovery process.

6 Arbitrage – The process by which traders make profits by exploiting price differential between markets i.e buying from low price markets and selling in high price markets

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Spot versus 15month aluminium prices

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Theory of storage and cost-of-carry model

An agent who is buying or selling a contract in the futures market for a commodity undertakes to receive or deliver the commodity at a certain time in the future, based on a price determined today. In this context, it is reasonable to expect that a long run price relationship between the futures contract price and the underlying commodity spot price exists.

The cost-of-carry model (COC) uses a no-arbitrage argument by factoring in the carrying costs involved in holding an underlying asset until maturity. For commodity futures contracts, the underlying asset is the physical commodity. Carrying costs within models of commodity futures pricing include interest costs, a risk premium for holding stocks, and storage costs net of convenience yield. Convenience yield is the return due to holding inventory or stocks. This return accrues to an agent or firm because holding stocks of a commodity may reduce transactions costs involved with frequent deliveries of an input in a firm’s production process, or may provide the flexibility to meet unexpected demand. The cost-of carry argument justifies the futures price as being equal to the current spot price minus net carrying costs.

Zinc spot versus 15-month price levels

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Liquidity

This refers to the volume or amount of stocks that are traded on a daily basis. Some stocks are traded regularly, while others are only traded a few times a day. The volume of trading witnessed in the option and stock market has also been found relevant in understanding the price discovery function. Volume provides information about the quality of trader’s information, which cannot be deduced from the price statistic.

The stocks and indexes that have large trading volumes will have narrower bid-ask spreads7 than those that are infrequently traded. When a stock has a low trading volume, it is considered illiquid because it is not easily converted to cash. As a result, a broker will require more compensation for handling the transaction, accounting for the larger spread.

Currently, there are futures contracts available in the London Metal Exchange for 3 month, 15 month and 27 month maturity. While attempting to decipher the price-volume relationship, liquidity becomes an important issue. The three month futures contracts are the most liquid.

7 Bid Ask spread – The bid price is the amount that a buyer is willing to pay for a particular security; the ask price is the amount that a seller wants for that security - it is always a little higher than the bid price. The difference between the bid and ask prices is called the bid-ask spread. In futures markets the price difference between two prompt dates is called the spread which may be in contango or backwardation

Contango – If the price for delivery on an earlier date is lower than the price for a later date

Backwardation – If the price for delivery on an earlier date is greater than that for a more forward date

Figure 1:Aluminium spot 3-month and 15-month forward future offer prices

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Figure 2:Copper spot 3-month and 15-month future offer prices

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Figure 4: Lead spot settlement 3 month and 15 month lead prices

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Price volatility

Volatility usually increases during periods of rapid market decline or advancement. At these times, the bid-ask spread is much wider because market makers want to take advantage and profit from the change. When securities are increasing in value, investors are willing to pay more, giving market makers the opportunity to charge higher premiums. When volatility is low and uncertainty and risk are at a minimum, the bid-ask spread is narrow.

Market risk

The risk premium hypothesis presumes the risk and return relationship commonly proposed for other asset markets is applicable to futures markets. It states that, under market efficiency and rational expectations, the futures price is equal to the expected spot price plus a risk premium. However, the expected risk premium is frequently not a measurable or observable.

Market Microstructure and other aspects

Market microstructure implies the details of the many ways in which exchange occurs in markets. Market microstructure research examines the ways in which the working process of a market affects trading costs, prices, volume, and trading behaviour. The microstructure of the securities market (as that of other markets) is impacted by the information available during the price discovery process, that is information such as how keen the seller and buyer are to dispose of or possess the share, repectively, the market sentiment (is it going through a bull or bear phase) as well as the liquidity (how keen are other market players to acquire the share) and transactions costs. The effects on price can be through the following factors:

• Transaction costs - The higher the transaction cost, the lower is the liquidty of a particular share. Typically, high volumes do not occur when the transaction costs are high.

• Company and market variables - The price of the security is also determined by information about the company as well as the sector in which the company operates.

• Information and disclosure - Market information and transparency also impact the price of shares. For instance, if a particular share is known to be purchased by a big investor or the management of the company buys back some of its shares or big mutual funds disclose that they have a heavy exposure in one share, then individual market participants too try to acquire shares in that company. Some owners of the shares might decide to sell their stock at a higher price to take advantage of the demand.

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Bibliography Joshua Turkington and David Walsh, “Price Discovery and Causality in Australian Futures market”, 1999 Grossman, “An Analysis of the Implications of Stock and Future Price volatility of program trading and dynamic hedging strategies”, 1988 Blume et al,”Market Statistics and Technical Analysis: The Role of Volume”, 1994 London Metal Exchange www.lme.com Investopedia www.investopedia.com