Measuring the impacts of cash settlement: A stochastic volatility approach

Prior to 1986, any opening position on feeder cattle futures contract must be settled with physical delivery after the last trading day. Due to dwindling commercial interests, Chicago Mercantile Exchange (CME) subsequently replaced the system with the cash settlement method. It was argued that cash...

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Bibliographic Details
Published in:International review of economics & finance 2002, Vol.11 (3), p.251-263
Main Authors: Chan, Leo, Lien, Donald
Format: Article
Language:English
Subjects:
Cash settlement
Cattle
Commodity futures
Feeder cattle futures contract
Forward exchange contracts
Futures
Futures trading
Prices
Quasi-maximum likelihood
Risk management
Stochastic models
Stochastic volatility model
Studies
Volatility
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Summary:Prior to 1986, any opening position on feeder cattle futures contract must be settled with physical delivery after the last trading day. Due to dwindling commercial interests, Chicago Mercantile Exchange (CME) subsequently replaced the system with the cash settlement method. It was argued that cash settlement would help improve the convergence between cash and futures prices and reduce the basis variability. In this paper, we adopted stochastic volatility (SV) models to investigate this conjecture. The models allow for time-varying volatility. We found strong evidence of reduction in basis and in basis variance after cash settlement. Moreover, cash settlement induced a change in the structural relationship between cash and futures prices. The futures market has become more efficient after the change in settlement methods.
ISSN:1059-0560
1873-8036
DOI:10.1016/S1059-0560(02)00112-0