Asymmetric Arbitrage and the Pattern of Futures Prices

Abstract

Since Keynes first argued that backwardation was the normal state of affairs on futures markets, there have been several theoretical explanations for its existence. In particular, Fort and Quirk have shown that the "Houthakker effect" can lead to a backwardation equilibrium. In this paper, we consider another argument for backwardation suggested by Houthakker, namely, asymmetric arbitrage. Our conclusions are generally negative, despite its intuitive appeal. Specifically, in a world with an equal number of short and long hedgers, with identical utility functions and densities over cash and futures prices, if the futures market is a forward market, then in a rational expectations framework, asymmetric arbitrage has no effect on the pattern of futures (or cash) prices. If we are dealing with a true futures market, under the above assumptions, arbitrage will act to encourage short hedging and to discourage long hedging only under some restrictive conditions. Moreover, further quantitative restrictions must be imposed in order to derive a backwardation equilibrium under asymmetric arbitrage.