Price discovery under model uncertainty

Abstract

In this study, we empirically investigate whether or not the conventional belief that new information about fundamental value is revealed in the futures market ahead of the spot market is applicable to four important storable energy commodities, oil, gasoline, heating oil and natural gas. Taking into account regime-switching model parameters derived from a sound economic model, our Bayesian analysis clearly shows significant heterogeneity in the futures market's contribution to price discovery across commodities and time periods. This indicates that valuable information about the underlying price is also revealed in the spot market. We also develop a new price discovery measure that can be applied to regime switching error correction models. Our simulation results demonstrate the superior performance of the new measure compared to extant alternatives.