Momentum and Mean Reversion in Futures Prices

Lee M. Dunhama
Creighton University

John M. Geppertb
University of Nebraska-Lincoln

Richard A. DeFuscoc
University of Nebraska-Lincoln

ABSTRACT

Research has documented both mean reversion and momentum is present in both spot and
futures asset prices. We show that return patterns in spot and futures prices can be consistent
with market efficiency given the cost of carry model for the futures price. We simulate the
behavior of the spot/futures price for the S&P 500 futures contract and show that shocks to the
permanent and/or temporary components in the model can result in spot and futures prices both
exhibiting momentum, both exhibiting mean-reversion, or a combination of either.

January 2009

JEL Classification: G12, G13

Keywords: Momentum, Futures, Cost of Carry, Cointegration

a
Department of Finance and Economics, 2500 California Plaza, Omaha, NE 68178. Email:
leedunham@creighton.edu. Tel: 402.280.2637. Fax: 402.280.5565.
b
Corresponding author. Department of Finance, 229 CBA, Lincoln, NE 68588-0490. Email: jgeppert1@unl.edu.
Tel: 402.472.3370. Fax: 402.472.5140.
c
Department of Finance, 230 CBA, Lincoln, NE 68588-0490. e-mail: rdefusco@unl.edu. Phone: 402-472-6763,
Fax: 402-472-5140
Momentum and Mean Reversion in Futures Prices

ABSTRACT

Research has documented both mean reversion and momentum is present in both spot and

futures asset prices. We show that return patterns in spot and futures prices can be consistent

with market efficiency given the cost of carry model for the futures price. We simulate the

behavior of the spot/futures price for the S&P 500 futures contract and show that shocks to the

permanent and/or temporary components in the model can result in spot and futures prices both

exhibiting momentum, both exhibiting mean-reversion, or a combination of either.

2
INTRODUCTION

The random walk hypothesis has a long history in finance. Research however has

documented both mean reversion and momentum is present in asset prices. For example, Fama

and French (1988) find that approximately 40 percent of the variation in 3- and 5-year returns for

size and industry portfolios is explained by mean reversion. Alternatively, price momentum was

shown in aggregate U.S. stock prices in the 1980s by Poterba and Summers (1988), and in

individual stocks prices in the 1990s by Jagadeesh and Titman (1993). Explanations for

momentum include the profit as an artifact of the construction of the winner and loser portfolios,

compensation for risk, and behavioral biases related to over- and under-reaction. Recent

research has also tested for the presence of mean reversion and momentum in futures markets.

Pirrong (2005) uses more than fifty futures contracts (agricultural, metals, interest rates and

stock) traded in North America, Europe, Asia and Australia and finds that momentum persists

even after controlling for risk. A stochastic discount factor risk adjustment reduces the

momentum profits, but does not eliminate it. Shen, Szakmary and Sharma (2007) examine 35

commodity futures markets and examine contracts for which the cost-of-carry futures/spot model

applies and contracts for which cost-carry model is less applicable. The presence of momentum

profits appears to be related to high trading volume and not the cost-of-carry model and suggests

that momentum profits in futures markets are consistent with the behavioral explanation of

Jagadeesh and Titman (2001). To date, however, no paper has examined the presence of mean-

reversion or momentum in the futures market and the corresponding behavior in the underlying

spot market.

We argue that the return patterns in both spot and futures prices can be consistent with

market efficiency given the cost of carry model for the futures price. In this paper we model the

3
futures price based on the cost-of-carry model. If the cost-of-carry is assumed to be a stationary

process, then spot and futures prices must be cointegrated and there exists a

permanent/temporary decomposition that describe the dynamics of the spot/futures system.

Using parameter estimates from Geppert (1995) for the S&P 500 futures contract, we show that

unit shocks to the permanent and/or temporary components in the model can result in spot and

futures price both exhibiting momentum, both exhibiting mean-reversion, or some combination

of either.

I. MODEL

The model is based on the cointegration implications of a cost-of-carry, spot/futures

framework. In the cost-of-carry model, the spot and futures series are related by the following:

(1)

where F is the futures’ price, S is the spot price, c is the cost-of-carry and (T-t) is the time to

maturity of the futures contract. The cost-of-carry is the sum of the interest rate corresponding to

the horizon of the contract, the storage costs and convenience yield. The cost-of carry is

assumed to be a stochastic, but stationary series. Taking the natural log of equation (1) results in

the (log) spread futures /spot relationship:

f s c T t

f s c T t (2)

where lower case letters are the natural log of their uppercase counterparts. Given the

assumption about the stationary of the cost-of-carry, if the futures and spot prices have a unit

root, equation (2) implies that the log futures and spot prices are cointegrated with cointegrating

vector (1,-1). Cointegration has numerous implications for the joint behavior of two series.

4
Stock and Watson (1988) and Hylleberg and Mizon (1989) prove that if two series are

cointegrated then there must be a permanent/transitory decomposition for the two series.

Following Geppert (1995) we decompose the spot and futures prices into the sum of shared

permanent and transitory components. The spot and futures prices are described by the system:

s a p a τ (3)

f b p b τ (4)

p p u (5)

τ ατ v (6)

where p is the shared permanent component that follows a pure random-walk, and τ is the

shared transitory component that follows an AR(1) process with |α| 1. The loadings on the

permanent and transitory components are given by a , a , b and b .

Since momentum and mean reversion can be described in terms of the autocorrelations of

the price changes for the two series, the expressions for Δs and Δf implied by the system in

equations (3)-(6) are shown in equation (7) and equation (8) below (the derivations are given in

the Appendix):

Δs a u f s a ∑∞ α v (7)

Δf b u f s b ∑∞ α v (8)

Engle and Granger (1987) also show that when two series are cointegrated, there exists an error-

correction representation for the system. The error correction representation is evident in

equations (7) and (8). The spot and futures prices share the shocks to the permanent component

through u . The cointegrating relationship is f s . The cointegrating relation

corresponds to the equilibrium and each series responds to the deviations from the relationship

5
with adjustment speeds and for the spot and futures changes. The

remaining terms ∑∞ α v can generate complex patterns in the autocorrelations.

Geppert (1995) fits the permanent/transitory structure to five different futures contracts

and finds that the estimates for a and b were essentially identical within each spot/futures pair.

Imposing the restriction that b a to our model we get:

τ f s (9)

Δs a u f s a ∑∞ α v

Δf b u f s b ∑∞ α v

where equation (9) is from the Appendix. Substituting f s from the cost-of-carry

cointegrating relation equation (2) into equation (9), we find that:

τ b a f s c T t (10)

Finally, substituting equation (10) into equations (7) and (8) yields:

Δs a u c T t 1 a ∑∞ α v (11)

Δf b u c T t 1 b ∑∞ α v (12)

We simulate equations (11) and (12) and demonstrate that depending on the correlations between

the transitory and permanent shocks u and v , and the speed of adjustment , we can

generate momentum or mean-reversion in futures and spot price changes. The simulation is

described in the next section.

6
II. ESTIMATION AND SIMULATION

The model’s parameters are estimated in the permanent/transitory representation. As an

illustration of the system dynamics, we use the S&P 500 index and its corresponding futures

contract. Using parameters from Geppert(1995) the system becomes1:

s p 0.1764τ
f p 0.98τ
p p u
τ 0.57τ v

We simulate the error-correction version of the model because momentum and mean reversion

are best viewed in terms of the properties of Δs and Δf . With the above parameters the error-

correction system becomes:

Δs u 0.22 f s 0.1764 ∑ 0.57 v (13)

Δf u 1.22 f s 0.98 ∑ 0.57 v (14)

In equations (13) and (14), we set the starting value of the log spot price to 1 since the starting

value is arbitrary. Assuming that the market starts in equilibrium, the cointegrating relation

imposes that the starting value of the log futures price is also set to 1. To simulate the values for

the term ∑∞ α v we set the number of lags to be equal to 4. A longer lag structure would

allow for a richer set of dynamics, but we find that four lags are sufficient to accommodate

momentum and mean reversion.

a. Impulse Responses

Momentum and mean reversion are time series features of a series. We can best illustrate

the behavior of the futures/spot system by tracing out its response to the model’s underlying

1
In this note, we do not separately estimate the model’s parameters. We borrow the coefficient estimates from
Geppert (1995).

7
shocks. Figure 1 shows the response of the spot and futures prices to a unit shock in the

permanent component. Both the spot and futures prices rise immediately and fully adjust to the

unit shock. Both the spot and futures prices stay at the new equilibrium price of 2 because the

shock is permanent. The spot and futures have the same price because of the cointegrating

relation. The pattern of response to the shock would imply neither momentum nor mean-

reversion in the prices. This would classic random-walk behavior.

Figure 2 shows the response of the system to a unitary shock to the transitory component,

v . The response to a transitory shock has a noticeably different dynamic than the response to a

permanent shock. First, the futures price increases by nearly the full value of the shock (the

coefficient in equation (19) is 0.98, but the response decays at a rate of 0.57 and effectively

returns to the initial value after six periods. The spot price has a similar pattern but doesn’t

increase as much initially. The spot price’s response also effectively returns to its initial value

after six periods. Both the spot and futures prices would exhibit mean-reversion under this case.

A third possible scenario is that market experiences simultaneous permanent and transitory

shocks. Figure 3 gives the case when the permanent and transitory shocks are positively

correlated. The key feature here is that the system initially rises above the permanent shock

(greater than 1 above the initial value) and then decays down to the initial value plus the

permanent shock. Here again, the spot and futures prices would exhibit mean-reversion under

this case.

The final scenario is that the market experiences simultaneous permanent and transitory

shocks and the two shocks are negatively correlated. Figure 4 shows the impulse response

functions for this case. Initially, the futures contract price exhibits virtually no response. The

futures price then steadily increases and finally converges to the long run response equal to the

8
initial value plus the permanent shock. The spot price follows a similar pattern although its

initial response is much greater. The scenario in Figure 4 results in momentum in the spot and

futures prices.

b. Discussion

Figures 1 to 4 illustrate that a simple cost-of-carry model for the futures and spot price

results in dynamics that can accommodate momentum, mean-reversion or random walk behavior

in these prices. The determining feature of the price behavior is the correlation between the

permanent and transitory shocks. All three return patterns (momentum, mean-reversion or

random walk behavior) are consistent with market efficiency in the sense of no arbitrage between

spot and futures prices. The basic results from the model follow from the permanent/transitory

structure in the futures/spot relation. Lack of arbitrage ties the futures and spot prices together

by equation (1). The only other necessary condition for a permanent/transitory structure is

cointegration between the futures and spot prices and there is wide evidence that this condition

holds.

9
III. CONCLUSION

We show that a simple cost-of-carry model and cointegration between the spot and futures

prices, results in a futures/spot system that can produce momentum and mean-reversion

behavior. The model does not require over- or under- reaction to generate the price behavior;

market are efficient in the sense of no arbitrage between spot and futures prices. While the

permanent/transitory model given above can accommodate a wide range of futures price

behavior, we are conducting more research to relate the model’s parameters to market features.

For example, what economic features do the permanent and transitory components capture?

What determines differing speeds of adjustment across different commodities or assets? This

model provides a very rich environment for understanding when we would expect momentum,

mean-reversion or random walk behavior in futures markets.

10
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Futures Markets 11, 577-589.

Conrad, J., Kaul, G., 1998. An anatomy of trading strategies. The Review of
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Geppert, John, 1995, “A statistical model for the relationship between futures contract hedging
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Gorton, Gary B., Hayashi, F., Rouwenhorst, K.G., 2007, “The fundamentals of commodity futures
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Grundy, B.D., Martin, J.S., 2001, “Understanding the nature of the risks and the source of the
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Pirrong, Stephen, 2005, “Momentum in futures markets,” Working paper, Bauer College of
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12
 Figure 1
Single Unit Shocks to the Permanent Components
Impulse Response

0.22 0.1764 0.57

1.22 0.98 0.57

2.2

2
Spot or Futures Price 

1.8

1.6

1.4 Spot
Futures
1.2

0.8
1 2 3 4 5 6 7 8 9
Periods 

Figure 1 shows the response of the spot and futures prices to a unit shock in the
permanent component. Both the spot and futures prices rise immediately and
fully adjust to the unit shock. Both the spot and futures prices stay at the new
equilibrium price of 2 because the shock is permanent. The spot and futures
have the same price because of the cointegrating relation.

13
 Figure 2
Single Unit Shock to the Transitory Component
Impulse Response

0.22 0.1764 0.57

1.22 0.98 0.57

2.2

2
Spot or Futures Price 

1.8

1.6

1.4 Spot
Futures
1.2

0.8
1 2 3 4 5 6 7 8 9
Periods

Figure 2 shows the response of the spot and futures prices to a unit shock in the
transitory component. The futures price increase by nearly the full value of the
shock but the response decays and effectively returns to the initial value after six
periods. The spot price has a similar pattern but doesn’t increase as much
initially. The spot and futures prices would exhibit mean-reversion in this case.

14
 Figure 3
Unit Shocks to the Permanent and Transitory Component and
Positive Correlation between and
Impulse Response

Δs u 0.22 f s 0.1764 0.57 v

Δf u 1.22 f s 0.98 0.57 v

3.3

2.8
Spot or Futures Price 

2.3

Spot
1.8
Futures

1.3

0.8
1 2 3 4 5 6 7 8 9
Periods

Figure 3 gives the case when the permanent and transitory shocks are positively
correlated. The key feature here is that the system initially rises above the
permanent shock (greater than 1 above the initial value) and then decays down to
the initial value plus the permanent shock. The spot and futures prices would
exhibit mean-reversion under this case.

15
 Figure 4
Unit Shocks to the Permanent and Transitory Component and
Negative Correlation between and
Impulse Response

0.22 0.1764 0.57

1.22 0.98 0.57

2.2

2
Spot or Futures Price

1.8

1.6

1.4 Spot

1.2 Futures

0.8
1 2 3 4 5 6 7 8 9

Periods

Figure 4 gives the case when the permanent and transitory shocks are negatively
correlated. The key feature here is that the system initially rises above the
permanent shock (greater than 1 above the initial value) and then decays down to
the initial value plus the permanent shock. The spot and futures prices would
exhibit momentum under this case.

16
 Appendix

In this appendix we derive the dynamics of the times series system relating spot and futures
prices.

s a p a τ (A.1)

f b p b τ (A.2)

p p u (A.3)

τ ατ v (A.4)

Cointegrating Vector

1. Multiply equation (A.1) by Æ

s a p a τ

s b p a τ

2. Subtract s b p a τ from equation (A.2) to get

f s b a τ

f s τ

τ f s

τ f s

3. Lag s a p a τ to get s a p a τ

Subtract s a p a τ from s a p a τ (equation A.1)

Δs a Δp a τ a τ

17
4. substitute p p u (equation A.3) in for Δp

Δs a u a τ a τ

5. Substitute in τ f s into

Δs a u a τ a τ to get

Δs a u a τ f s

6. From τ ατ v (equation A.4)

τ ∑∞ α v

7. Substitute τ ∑∞ α v into

Δs a u a τ f s to get

Δs a u f s a ∑∞ α v

The process for the change in the spot price has a permanent component equal to a u . It has an

error correction component f s with speed of adjustment equal to .

The process fro f follows a similar process:

Δf b u f s b ∑ αv

18