European Journal of Operational Research 155 (2004) 284–298

www.elsevier.com/locate/dsw

The efficiency of financial futures markets: Tests

of prediction accuracy
Jason Laws, John Thompson *

CIBEF, Liverpool Business School, Liverpool John Moores University, John Foster Building, 98 Mount Pleasant, Liverpool L3 5UZ, UK

Abstract

The prices of financial futures contracts can be interpreted as forecasts of the spot rates, which will apply at the final
delivery date of that contract. Financial futures contracts have been traded daily since the early 1980s and provide a
substantial bank of data to test the forecasting efficiency of such contracts. Tests are carried out to examine whether the
interest rates implied by the futures price for eurodollar and short sterling contracts are cointegrated with the final
settlement price over forecasting horizons of 1, 2 and 3 months. Similar analysis is carried out for the yen/dollar ex-
change rate futures contract. The paper then examines the forecasting performance of the three contracts over the
forecasting horizons of 1, 2 and 3 months and in particular whether the forecasts implied by the futures contract
provide better predictions than the na€ıve no-change (i.e. random walk), a vector error correction model (VECM) or an
ARIMA model.
An examination of the relative efficiency of the markets for the three markets over the three time horizons is carried
out and finally trading strategies are simulated to see whether excess profits can be achieved. In fact the results suggest
that both profits and losses would be attracted.
Ó 2003 Elsevier B.V. All rights reserved.

Keywords: Market efficiency; Financial futures; Forecasting

1. Introduction prices will reflect all available information up to

A market may be defined as efficient in the in-
formational sense 1 if the prices of the assets tra-
ded on that market instantaneously reflect all
available information. This is a strong definition
and a weaker definition contains the caveat that
*
Corresponding author.
E-mail addresses: j.laws@livjm.ac.uk (J. Laws), j.l.thomp-
son@livjm.ac.uk (J. Thompson).
1
The term ÔefficiencyÕ will be used as short hand for
informational efficiency in the remainder of the paper.
the point where the cost of acquiring additional
information is equal to the benefits derived from
that information. Efficiency will be achieved
through arbitrage between traders. Note these
definitions make no mention of the possible exis-
tence of risk premiums to compensate for the un-
doubted risk in this type of arbitrage.
Futures markets serve at least four functions:
1. competitive price discovery,
2. management of risk,
3. facilitating financing,
4. promotion of efficient resource allocation.

0377-2217/$ - see front matter Ó 2003 Elsevier B.V. All rights reserved.
doi:10.1016/S0377-2217(03)00087-0
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
To serve these functions efficiently, the futures
markets themselves must conform to the efficient
markets hypothesis; i.e. the prices must reflect all
available information. In particular futures prices
should provide unbiased predictions of the subse-
quently observed spot price. This paper looks at
one aspect of the EMH, i.e. how far futures prices
predict the subsequent spot price and, as such, is
an extension of earlier work by Holden and
Thompson (1996) and Laws and Thompson (1997,
2000).
Our analysis 2 is based on a number of different
approaches including:
1. cointegration between forward and the realized
spot price over a number of different horizons––
long-term efficiency (Section 3);
2. short-term efficiency (Section 4);
3. variance bound tests (Section 5);
4. the relative efficiency of the various markets
(Section 6);
5. comparison of the predictive power of the fu-
tures price as compared with alternative predic-
tions provided by (a) ARIMA, (b) VECM and
(c) random walk (Section 7);
6. examination whether simple-trading rules can
generate profits (Section 8);
7. conclusions (Section 9).
The futures markets examined include the 3-
month interest rate contracts for sterling (LIFFE)
and the eurodollar (CME) 3 and the dollar/yen
exchange rate contract (CME). The characteristics
of the two interest-rate contracts are very similar.
They are for 3-month interest rates and contract
prices are quoted as 100––the implied rate of in-
terest for delivery on a specific date. As an example
of the method of quoting the relevant prices, the
price of the 3-month sterling futures settlement
2
For the sake of brevity, some statistical detail is not
contained in the paper. Additional statistics can be obtained
from the authors on request. A fuller version of the paper
containing additional statistical detail is available on the web
site, CIBEF.com.
3 7
The terms ÔsterlingÕ and ÔeurodollarÕ will be used in the rest
of this paper to indicate interest rates not currencies.
285
price for the June 2000 contract was shown in the
Financial Times on 14/4/00 to be 93.590. This
implied an interest rate of 6.41% per annum. All
the contracts are subject to a quarterly cycle with
specific delivery dates 4 in March, June, September
and December each year. Each night a settlement
price is quoted. 5 A number of contracts are
available for trading at the same time. For exam-
ple there are twelve short sterling contracts avail-
able for trading at any one particular time at
LIFFE. The main dollar/yen exchange rate con-
tract is similar but the price quoted is for 100 yen.
Two main, but not mutually exclusive, models
of futures prices exist, i.e. (i) the cost-of-carry
model (see for example Brennan, 1958; or Telser,
1958) and (ii) the expectations model (see for ex-
ample Breeden, 1980; or Hazuka, 1984). Futures
prices according to the cost-of-carry model depend
on the current spot price of the ÔunderlyingÕ and
the cost of carrying stocks until the delivery period
less any marginal convenience yield obtained
through holding stocks. Typically the ÔcarryingÕ
costs would include elements such as warehousing,
insurance and interest rate charges. Arbitrage 6
should ensure that the following identity 7 holds:
F0;t ¼ S0 ð1 þ CÞ ð1Þ
where F0;t refers to the futures price quoted at time
0 for delivery at time t, S0 is the spot price at time 0
and C is the total cost for carrying the underlying
4
For example, the final trading day for the short sterling
contract is two business days prior to the third Wednesday of
the delivery month.
5
If no trades take place, an end-of-day settlement price is
fixed by the market authorities with reference to the same
contract but different delivery dates. Consequently the end-of-
day settlement price provides a good indication of the market
position irrespective of whether trading has taken place. This
caveat is not likely to be applicable to the end-of-day settlement
prices used in this study since we mainly concentrate on the
nearest contract which is normally the most heavily traded.
6
Note such arbitrage is relatively riskless since all prices are
known at time 0. There is, of course, the risk of counterparty
default.
Note for ease of exposition the formula is for one period
only and hence no discounting is involved.
286 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
from time 0 to time t net of any marginal conve-
nience yield.
In the case of financial futures contracts,
warehousing costs are virtually non-existent and
financing costs low since the contracts are highly
leveraged. This leads on to the speculative model
which suggests that the price today represents the
price of the underlying speculators expect to rule
on the delivery date. Consequently the model can
be described by
F0;t ¼ E0 ðSt Þ ð2Þ
where E0 ðSt Þ represents the spot price expected at
time 0 to rule at the time of the maturity of the
contract, i.e. time t. The definition of F0;t is the
same as for Eq. (1).
Note now, however, that the arbitrage under-
lying Eq. (2) is not risk free since the final settle-
ment price is not known at time 0. Thus the futures
price may be expected to incorporate not only the
expected spot price but also a risk premium. 8 Also
it is possible to link the two models by specifying
the marginal convenience yield in (1) to incorpo-
rate any expected profits. Nevertheless we would
expect the relative importance of carrying costs to
decline as the intrinsic value of the underlying in-
creases.
We now move on to describe the data in Section
2.
2. The data
As noted above we have concentrated on just
three futures contracts, which provide a series of
observations of the end-of-day and final settlement
prices running over a sufficient length of time. For
each contract the end-of-day settlement price is
sampled 1 month (20 days), 9 2 months (40 days),
8 10
With a risk premium (2) would be transformed to
F0;t ¼ E0 ðSt Þ  RP0 where RP0 represents the relevant risk
premium at time 0. Thus the futures price can be thought of
as a discounted expected spot price. Note also RP can be time
varying.
9 11
The data is recorded for a 5-day week.
3 months (65 days) prior to the expiration of that
contract so as to provide forecasts of the final
settlement price; i.e. the price ruling at the expi-
ration of that particular contract. For all three
contracts, the data runs from March 1987 to De-
cember 2000 (a total of 56 non-overlapping ob-
servations for each forecasting horizon).
The spot interest rates are the 3-month London
Inter-Bank Offered rates for sterling and eurodol-
lars. The spot dollar/yen exchange rate is the mid
price of the series provided by Global Treasury
Information Service. As is customary in this type
of analysis the data is in logarithmic form. The
data is obtained from Datastream.
Summary statistics of the final settlement price
for the three contracts are shown in Table 1. As far
as interest rates are concerned, the sterling interest
rates were higher on average and, as evidenced by
the standard deviation as a measure of dispersion,
displayed both greater absolute and relative vari-
ation than eurodollar interest rates. The dollar/yen
series showed lower variability than the interest
rate series as measured by the coefficient of vari-
ation. Both the interest rate series displayed posi-
tive skewness and excess kurtosis, 10 as did the
dollar/yen contract suggesting that all three series
are not normally distributed. 11 This conclusion is
only partly supported by the Jarque–Bera statistic
reported in Table 1. A caveat may be appropriate
here. This is that the Jarque–Bera test is a large
sample test and the number of observations (56)
is quite low. Finally it should be noted that the
eurodollar contract is by far most heavily traded
contract with the dollar/yen contract attracting
low trading volumes as compared with the other
two contracts.
A multivariate analysis of the degree of co-
integration between the futures prices and the final
settlement price follows in Section 3.
The short sterling series exhibits positive excess kurtosis
(i.e. it is leptokurtic) with slimmer or longer tails of the
distribution and the eurodollar and dollar/yen series both
possess negative excess kurtosis (i.e. it is platykurtic) with
shorter or fatter tails.
This is a standard result for financial time series.
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298 287

Table 1
Descriptive statistics of final settlement price (percentage per annum)
Final settlement price
Sterling Eurodollar Dollar/yen
Mean 8.78 6.13 0.0084
Standard deviation 3.52 1.73 0.0012
Coefficient of variation 0.40 0.28 0.14
Skewness 1.09 0.29 0.50
Kurtosis ()3) 0.39 )0.40 )0.13
Maximum 20.06 10.29 0.0118
Minimum 5.12 3.13 0.0065
Sample period March 1987 to December 2000 March 1987 to December 2000 March 1987 to December 2000
Number of observations 56 56 56
Volumea 5.26 m 21.85 m 0.82 m
JBb 11.44 1.16 2.37
a
Measured by total number of transactions for the contracts ending December 2000.
b
The Jarque–Bera statistic.
*
Indicates significance at the 5% level.

3. Long-run efficiency: Cointegration analysis be differentiated to become stationary. 12 The

3.1. Introduction
Efficiency tests can be carried out by trans-
forming Eq. (2) into
St ¼ a þ bF0;t þ et :
Long-term efficiency of a market requires the fol-
lowing four conditions to be satisfied:
1. S and F must be integrated to the same order
(this requirement is tested in Section 3.2).
2. S and F must be cointegrated otherwise S and F
will tend to drift apart over time so that inaccu-
rate forecasts are obtained (this requirement is
checked in Section 3.3 together with require-
ment 3).
3. For the cointegrating equation, the estimated
slope coefficient (i.e. b) should equal 1 and the
constant (i.e. a) 0.
4. The forecast errors should not be correlated
with any information known at the time the
forecast is made (this requirement is examined
in Section 7).
3.2. Order of integration
As is well known the order of integration is
determined by the number of times a series has to
usual method of testing for stationarity is standard
Dickey–Fuller methodology (see for example
Dickey, 1984; Dickey and Fuller, 1979, 1981).
Briefly the basic equation takes the following
form:
ð3Þ Yt ¼ / þ hYt1 þ Ut : ð4Þ
Subtracting Yt1 from both sides of (4) gives
Yt  Yt1 ¼ / þ ðh  1ÞYt1 þ Ut ð5Þ
or
DYt ¼ / þ dYt1 þ Ut :
Tests of stationarity take the form of examining
whether the coefficient d is <0, which implies that
h < 1 and the series is stationary. 13 The distribu-
tion of d is non-standard but critical values for the
test have been provided by MacKinnon (1991).
The test is also sensitive to the presence of auto-
correlation. Two methods of dealing with this
problem have been suggested. The first alters the
12
A time series is said to be ÔweaklyÕ stationary if itÕs mean,
variance and covariances remain the same over time. In this
paper the term stationary refers to Ôweakly stationaryÕ.
13
The equation was also tested to see if it was necessary to
incorporate a time trend. In all instances it was not possible to
reject the null hypothesis (i.e. that the coefficient on the time
trend was equal to 0) at the 5% level.
288 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
estimating Eq. (5) by adding lagged values of DY
until such time as autocorrelation is eliminated
(i.e. the Augmented Dickey–Fuller equation). The
second, due to Phillips and Perron (1988), alters
the test statistic.
As far as ADF approach is concerned the pro-
cedure adopted by us was to determine the lag
structure according to the Schwarz–Bayesian in-
formation criteria (Schwarz, 1978). 14 The results
from using the equation with the estimating
equation were then checked for autocorrelation. If
the LM 15 test indicated the presence of autocor-
relation then further lags of the dependent variable
were added until such time as the autocorrelation
was eliminated.
The results of this procedure provide unam-
biguous evidence that all the series are Ið1Þ and
their first differences Ið0Þ. The sole exception is for
the 2-month futures forecast of the eurodollar rate
where the ADF indicates non-stationarity for the
first difference whereas the Phillips–Perron test
indicates stationarity. In this case we have as-
sumed that the first difference series is stationary.
These results are typical for financial/commodity
price time series. A notable exception was Heaney
(1998) where the hypothesis of a unit root was
rejected for weekly data on lead commodity prices
on the London Metal Exchange.
Thus the first criterion for efficiency is satisfied
and in the following section we consider whether
the second and third criteria are met.
3.3. Cointegration
In this section we investigate whether the final
settlement price and the futures prices are cointe-
grated. Our approach is based on the vector au-
toregression (VAR) framework suggested by
Johansen (see for example Johansen, 1988; Jo-
14
The statistical package provided two other information
criteria: Akaike (1973) and Hannan and Quinn (1979). Gener-
ally the three criteria indicated the same optimum lag length but
in the majority of cases where disagreement occurred the outlier
was the Akaike criterion, which is prone to overestimate the
number of parameters (see Bascßi and Zaman, 1998).
15
Given that all the series are quarterly, the order of LM test
was 4.
hansen and Juselius, 1990). 16 The VAR can be
written in general matrix form as
X
DYt ¼ l þ CDYtkþ1 þ PYt1 þ et ð6Þ
where k is the number of variables, 2 in the case of
the tests carried out in this paper and the CDYtkþ1
represents the error correction terms.
The P matrix can be factorized into
P ¼ ab
where a specifies the speed of adjustment to the
steady state and b the cointegrating vectors.
The rank of P defines the number of cointe-
grating vectors. In the case of two variables the
maximum rank of the matrix P is 2. If the rank is
2, then St and F0;t are jointly stationary. If the rank
is 1, a single cointegrating vector exists between
the two variables. On the other hand, if the rank of
P is 0, then cointegration between will not be
present. Johansen suggests two tests to determine
the rank of P and therefore the number of coin-
tegrating vectors. These are based on the maximal
eigenvalue and the trace of the stochastic matrix.
These cointegration tests require the specification
of the number of lags in the model as represented
by Eq. (6) above. Too few lags seriously biases the
tests. On the other hand too many lags may result
in tests with low power to discriminate between the
presence and absence of cointegration (Gonzalo,
1994). 17 As before the order of the VAR was se-
lected by the Schwarz Bayesian information crite-
rion. It was also necessary to test for the existence
of a time trend in the VAR. In all cases it was not
possible to reject the hypothesis of the absence of a
time trend at the 5% level. The results are shown in
Table 2 and suggest the existence of a single co-
integrating vector over all the forecasting horizons
for the three series.
The results of estimation of the cointegration
vectors by the Johansen method suggested that,
16
Gonzalo (1994) concludes that the Johansen method of
estimating long-run relationships is more satisfactory than
OLS, NLS, principal components and canonical correlations
and that also this conclusion holds for finite samples.
17
Gonzalo (1994) suggests the consequences of overestimat-
ing the lag length are less serious than those associated with an
underestimate.
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298 289

Table 2 thesis that the futures price and final settlement

Eigenvalue and trace tests for number of cointegrating vectors price were cointegrated. This is, however, a nec-
Sterling Eurodollar Yen essary but not sufficient condition for long-run
One-month forecasting horizon market efficiency. It is also necessary that a ¼ 0
Eigenvalue test and b ¼ 1 in the cointegrating equation. It was not
H0 : r ¼ 0 39.36 22.48 68.99
possible to reject the hypothesis that a ¼ 0 and
H1 : r ¼ 1 (15.87) (15.87) (15.87)
H0 : r ¼ 1 3.71 5.27 5.88 b ¼ 1 for:
H1 : r ¼ 2 (9.16) (9.16) (9.16)
(a) the sterling contract––all three forecasting ho-
Trace test
H0 : r ¼ 0 43.03 27.75 74.84 rizons,
H1 : r ¼ 1 (20.18) (20.18) (20.18) (b) the eurodollar contract––2-month forecasting
H0 : r ¼ 1 3.71 5.27 5.88 horizon only,
H1 : r ¼ 2 (9.16) (9.16) (9.16) (c) the dollar/yen contract for 1- and 2-month
forecasting horizons.
Two-month forecasting horizon
Eigenvalue test
H0 : r ¼ 0 30.35 53.42 81.62 The hypotheses that a ¼ 0 and b ¼ 1 was re-
H1 : r ¼ 1 (15.87) (15.87) (15.87) jected both separately and jointly for the other two
H0 : r ¼ 1 3.28 1.75 5.33 eurodollar contracts. In the case of the 3-month
H1 : r ¼ 2 (9.16) (9.16) (9.16) dollar/yen contract the hypotheses were accepted
Trace test separately but not jointly. 18 The rejection of effi-
H0 : r ¼ 0 33.63 55.17 86.95 ciency for the 1-month eurodollar contract is in-
H1 : r ¼ 1 (20.18) (20.18) (20.18) teresting given the acceptance of efficiency for the
H0 : r ¼ 1 3.28 1.75 5.33
2-month contract. This may be due to a significant
H1 : r ¼ 2 (9.16) (9.16) (9.16)
proportion of the transactions in the last month
Three-month forecasting horizon consisting of hedging contracts being rolled over.
Eigenvalue test Our results are roughly consistent with Kellard
H0 : r ¼ 0 30.67 76.75 19.86 et al. (1999) 19 who found that the twin hypothesis
H1 : r ¼ 1 (15.87) (15.87) (15.87) that a ¼ 0 and b ¼ 1 was not rejected for live cattle
H0 : r ¼ 1 1.70 1.99 4.11
and the dollar/DM markets and that b ¼ 1 for
H1 : r ¼ 2 (9.16) (9.16) (9.16)
Brent Crude, gas oil and soybeans over 28- and 56-
Trace test day horizons. Similarly Kavussanos and Nomikos
H0 : r ¼ 0 31.85 78.92 23.99
(1999), using similar methodology, found that
H1 : r ¼ 1 (20.18) (20.18) (20.18)
H0 : r ¼ 1 1.70 1.99 4.11 freight future prices 1 and 2 months prior to ma-
H1 : r ¼ 2 (9.16) (9.16) (9.16) turity provided unbiased forecasts (i.e. a ¼ 0 and
Note: r ¼ the number of cointegrating vectors. b ¼ 1) predictions of the realized spot price. This
The figures in brackets are the 95% critical values relevant to was not the case for future prices 3 months prior to
the test. expectation. In a similar vein, Graham-Higgs et al.
The eigenvalue and trace tests rely on asymptotic critical values (1999) found that the Australian wool futures
and therefore are not fully reliable in small samples. Reimers
market is efficient up to 6 months but no further
(1992) suggests adjusting the tests statistics by multiplying by
ðn  pkÞ=n where n is the number of observations, p is the into the future.
number of variables in the var and k is the lag order of the var.
This correction has been applied to the test statistics recorded
above. 18
Note that in all cases where the null hypotheses were
*
Indicates significance at the 5% level. rejected the values of the estimated coefficients a and b were
quite close to 0 and 1 respectively.
19
There have been a large number of studies of the
relationship between futures and spot prices with varying
for all the contracts over the three forecasting results. We concentrate on one or two for comparative
horizons, it was not possible to reject the hypo- purposes.
290 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298

Cointegration analysis examines long-run rela- Table 3

tionships and in the following section we look at Short-term efficiency tests
the relationship between the futures price and Horizon Sterling Eurodollar Dollar/yen
subsequently observed spot price over the shorter 1 month Y N N
time horizon. 2 months Y N N
3 months N N N

4. Short-term efficiency rate contract for this reason. In any case it would
not be expected that a market which was not ex-
Short-term efficiency is concerned whether de- hibiting long-run efficiency would also be short-
viations exist from the long-term equilibrium re- run efficient. For this latter reason it would be
lationship. If such deviations exist then speculative assumed that the 3-month horizon eurodollar
profit opportunities might also exist. Short-term contract would also not be short-run efficient. Eq.
efficiency can be tested through estimation of the (7) was estimated for the other contracts and the
following ECM equation: coefficients tested to see if they conform to the
X X criteria noted above. The results are recorded in
DSt ¼ a þ bi DFti;tj þ cj DStj
Table 3 and it can be seen that only the sterling
þ kðSt  Fti;t Þ1 þ Mt ð7Þ contract for 1- and 2-month horizons meets the
criteria listed above and can therefore be consid-
where i is the forecast horizon; i.e. 1, 2 and 3
ered short-run efficient.
months so that DSt is the change in S over the
These results contrast with those obtained by
forecast horizon and (St  Fti;t ) is the error cor-
Antoniou and Holmes (1996) which demonstrated
rection term. 20
(at least for their observation period September
Short-term efficiency requires:
1984 to June 1993) that the FTSE-100 futures
contract was efficient in the short run for 1 and 2
1. a ¼ 0,
months prior to maturity but inefficient for 3, 4
2. b0 ¼ c0 ¼ 1,
and 5 months prior to maturity.
3. k ¼ 1,
This implies that short-term inefficiency exists
4. all other b and c ¼ 0.
and in Section 8 we examine whether this ineffi-
ciency can be exploited to obtain excess profits.
If these four conditions are not met, then the
market is not efficient in the short run and po-
tential for profitable speculation exists. The order
5. Variance-bound tests
of the VAR dictates the form of the ECM. The
optimum order of the VARs was selected by in-
Recent years have seen extensive use of vola-
formation criteria. If the order of the VAR is 1,
tility to test the efficiency of markets (especially the
then only the error correction term appears in the
stock market) through the use of variance-bound
ECM. If the order is 2 then the variables DFtn;ti
tests. Shiller (1981) provides an exposition of the
and DStj appear in the ECM with a lag of 1. If the
simplest of these tests. The EMH implies that the
order of the VAR is more than 2, then condition 4
futures price is the optimum forecast of the sub-
above is violated and it can be seen that it was
sequently realized spot price. Hence, since the
possible to reject the hypothesis of short-run effi-
forecast error is uncorrelated with the forecast,
ciency for the 1-month horizon eurodollar interest
VarðSt Þ ¼ VarðFti;t Þ þ Varðet Þ ð8Þ
where t  i is the forecast horizon.
20
Where long-term efficiency (i.e. a ¼ 0 and b ¼ 1) was
Eq. (8) implies that VarðFti;t Þ must be less or
rejected the actual estimated values for a and b were used to equal to VarðSt Þ thus providing a test of market
estimate the error correction term. efficiency. Rejection of this inequality suggests that
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298 291

Table 4 entails a comparison of the forecast provided by

Variance bounds tests the futures price with that of the best regression
Horizon Sterling Eurodollar Dollar/yen equation. The ratio of these two measures then
1 month Y N Y provides the coefficient of efficiency. More for-
2 months Y Y Y mally the regression equation takes the following
3 months Y Y Y
general form:
n 56 56 56
Y indicates that the variance bound test indicated by equation St  Sti ¼ a þ bðFti  Sti Þ
is satisfied. X
þ cj ðStj  Stij Þ
either the market is inefficient or a risk premium X
exists. Antoniou and Holmes (1996) point out that þ dj ðFtj  Ftij Þ þ et ð9Þ
testing this inequality requires the two variances to
be stationary. There is a considerable volume of where i is the forecast horizon.
evidence, apart from that discussed in this paper, The lag lengths were selected through the gen-
that financial time series are not stationary so the eral-to-specific testing procedure dropping lags,
inequality is transformed by deducting the ap- which were insignificant at the 10% level. The R2
propriate lagged spot (i.e. 1, 2 or 3 months) value values seemed quite reasonable and neither auto-
of the interest/exchange rate from both sides of Eq. correlation nor heteroscedasticity provided any
(8). 21 The inequality now being tested is cause for concern save for the 3-month eurodollar
equation where the presence of heteroscedasticity
VarðFti;t  S0 Þ 6 VarðSt  S0 Þ: ð8aÞ
was indicated.
The results are reported in Table 4. In all cases The resulting efficiency measure is then given by
except for the 1-month forecasting horizon for the
eurodollar the variance-bound tests are supported p ¼ VarðeÞ=Varðfutures price forecastsÞ:
by the data.
We now turn to examine the relative efficiency This is quite a stringent test because it compares
of the two markets in Section 6. the variance of the error term of an equation es-
timated over the whole period with the benefit of
6. Relative efficiency hindsight with the forward looking futures price.
The p values are shown in Table 5 and these are
Perfect efficiency with no departures from the relatively high and compare with figures of figures
definitions quoted in Section 1 is an illusory or recorded by Kellard et al. ranging 0.53 for live
ephemeral concept. The real question is whether a cattle to 1 for soybeans. It is also noticeable that in
market approximates efficiency. It would therefore general the sterling and dollar/yen contracts are
be interesting to derive a measure to compare the more efficient relative to the eurodollar contract.
degrees of efficiency of the two markets. One such Again we see a certain degree of inefficiency and
method of making this comparison has been sug- we examine in Section 8 whether it is possible to
gested by Kellard et al. (1999). 22 Basically this exploit this to obtain speculative profits.
In the following section we discuss another facet
of efficiency, i.e. the ability to predict future prices.
21
We tested for stationarity of the variables contained in Eq.
(8a) and found that all the variables were in fact stationary at
the 5% level with the possible exception of (F0;t  S0 ) with the Table 5
forecast horizon of 2 periods. Efficiency measures of implied futures forecasts
22
The formula given by Eq. (9) differs slightly from that used Horizon Sterling Eurodollar Dollar/yen
by Kellard et al. The maximum lag in their paper was 10
1 month 0.99 0.84 0.93
whereas ours is truncated
P to 6. AlsoP Kellard et al. specified the
2 months 0.94 0.96 0.95
lag structure on the cI and the dI to be equal to avoid
3 months 0.97 0.91 0.96
autocorrelation. This was not necessary for our data.
292 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
7. The predictive of power of futures prices
In this section we examine how well the futures
price forecasts the subsequent final settlement
price. It is useful to have some yardstick(s) against
which comparisons can be made. We use three
series for comparison: (a) an ARIMA forecast
based on Box–Jenkins methodology (see Box and
Jenkins, 1970), (b) a random walk and (c) a
VECM model. The random (RW) forecast is
simply the FSP 1, 2 and 3 months prior to expi-
ration of the contract. The ARIMA forecast was
based on a rolling 260 days prior to expiration.
There is a timing problem here. The FSP is timed
during the day whereas the daily interest rate series
refers to the end of the day. Consequently the
comparisons which are listed in Table 6a–c refer to
the FSP for the random walk and futures forecasts
but close-of-trading rates for the ARIMA fore-
casts. This should introduce very little bias.
The ARIMA forecasts are based on the fol-
lowing model:
Yt ¼ / þ a1 Yt1 þ    þ an Ytn þ b0 Ut
þ b1 Ut1 þ    þ bnUtn : ð10Þ
It was decided to drop all the Us and concentrate
on the lagged values of Y . Given the order of in-
tegration already defined for FSP the estimates
were carried out in first difference terms. Early
tests suggested that there was no stable-lag pattern
for the autoregressive component of (10) so the
number of lags was standardized as 5. The ex-
planatory power of the differenced series was
quite low with an average R2 of 0.05 suggesting
that little explanatory power was obtained over
that achieved by the random walk.
The specification of the VECM was the same as
for Eq. (6) but, in this instance, a time trend was
included. The order of the VECM was 2 in all
cases.
The criteria used to assess the quality of the
forecasts include the standard statistical measures
for assessing the accuracy for forecasts together
with the ÔCorrect Direction IndexÕ (CDI). This
latter measure indicates whether the forecast value
indicates the direction of any movement. Thus if
the forecast value is above the current value, this
indicates a rise in the variable. This is a particu-
larly useful indicator because very often the di-
rection of the change is more important than the
magnitude of the change. The mean 23 error is also
a useful, but often neglected, statistic since it il-
lustrates any bias in the forecast. The mean ab-
solute error overcomes the problem associated
with the mean error of errors being cancelled out
by errors of the same magnitude but opposite sign.
The root mean square error penalizes large fore-
cast errors. The Theil inequality coefficient (Theil,
1966) is useful becomes it is a pure number free of
units of measurement. A value of 0 indicates per-
fect forecasts. Details of the comparisons are
shown in Table 6.
For the four types of forecast (i.e. futures price,
ARIMA, RW and VECM) every forecast is un-
biased on the mean-error criteria for all three
contracts. As far as the sterling forecasts are con-
cerned, the futures price provides the best forecast
for all the criteria except for the mean error. The
CDI is always significantly different from the
random value of 50% and is far superior in this
respect to the ARIMA forecast and also the RW
forecast. 24 This latter is by definition equal to 0
since it forecasts no change. As far as the RW,
ARIMA and VECM forecasts, there is little to
choose between them. This is perhaps not sur-
prising given the low level of predictive power of
the ARIMA equations over and above the random
walk.
Generally speaking all the forecasts for the eu-
rodollar contract are slightly superior to those for
the sterling interest rate except for the CDI crite-
rion. Again for most criteria the eurodollar futures
price provides a superior forecast to that generated
by the ARIMA, RW and VEDM processes. It is
also noticeable that the CDI is only significantly
different from 0.5 for the 3-month horizon in the
case of both the futures and ARIMA forecast.
23
Holden and Peel (1990) suggest the mean error is the best
indicator of bias.
24
These results mirror earlier studies of dollar interest rates
(Batchelor, 1994; Belognia, 1987) where predictive accuracy was
of the order of 55%.
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298 293

Table 6 Table 6 (continued)

Forecasting performance (panels A–C: 1-, 2- and 3-month Sterling Eurodollar Dollar/yen
forecasting horizon respectively)
Correlation coefficient
Sterling Eurodollar Dollar/yen Futures 0.990 0.974 0.931
Panel A AR 0.985 0.976 0.933
Mean error RW 0.984 0.967 0.933
Futures 0.078 0.036 )0.148 (104 ) VECM 0.983 0.973 0.903
AR 0.073 )0.012 )0.174 (107 )
TheilÕs inequality coefficient (1966)
RW 0.034 )0.023 )0.106 (107 )
Futures 0.055 0.061 0.054
VECM 0.005 0.006 )0.589 (107 )
AR 0.061 0.063 0.054
Mean absolute error RW 0.062 0.077 0.052
Futures 0.238 0.178 0.248 (103 ) VECM 0.066 0.069 0.068
AR 0.278 0.207 0.236 (103 )
CDI
RW 0.249 0.197 0.245 (103 )
Futures 66.07 50.00 30.36
VECM 0.317 0.216 0.265 (103 )
AR 50.00 53.21 57.14
RMS RW 0 0 0
Futures 0.373 0.271 0.311 (103 ) VECM 53.57 58.93 48.21
AR 0.409 0.346 0.304 (103 )
RW 0.397 0.413 0.309 (103 ) Panel C
VECM 0.459 0.303 0.343 (103 ) Mean error
Futures )0.012 )0.061 )0.250 (104 )
Correlation coefficient
AR )0.010 0.031 )0.245 (104 )
Futures 0.995 0.988 0.965
RW )0.116 )0.067 0.441 (104 )
AR 0.992 0.979 0.966
VECM )0.051 0.026 0.249 (106 )
RW 0.992 0.974 0.965
VECM 0.989 0.984 0.958 Mean absolute error
Futures 0.588 0.400 0.435 (103 )
TheilÕs inequality coefficient (1966)
AR 0.746 0.422 0.455 (103 )
Futures 0.039 0.043 0.037
RW 0.650 0.437 0.416 (103 )
AR 0.045 0.055 0.036
VECM 0.719 0.433 0.618 (103 )
RW 0.043 0.065 0.037
VECM 0.050 0.048 0.041 RMS
Futures 0.930 0.570 0.576 (103 )
CDI
AR 1.095 0.566 0.605 (103 )
Futures 69.64 51.79 44.64
RW 1.024 0.656 0.558 (103 )
AR 46.43 48.21 60.71
VECM 1.048 0.590 0.812 (103 )
RW 0 0 0
VECM 25.0 55.36 55.36 Correlation coefficient
Futures 0.964 0.944 0.889
Panel B AR 0.946 0.953 0.886
Mean error RW 0.948 0.937 0.892
Futures 0.056 0.0004 )0.671 (104 ) VECM 0.950 0.948 0.821
AR )0.008 0.015 )0.655 (104 )
TheilÕs inequality coefficient (1966)
RW )0.047 )0.039 )0.219 (104 )
Futures 0.099 0.089 0.068
VECM )0.064 )0.008 )0.709 (107 )
AR 0.120 0.089 0.072
Mean absolute error RW 0.112 0.103 0.066
Futures 0.368 0.278 0.333 (103 ) VECM 0.115 0.093 0.096
AR 0.414 0.293 0.328 (103 )
CDI
RW 0.385 0.288 0.315 (103 )
Futures 67.86 64.29 39.29
VECM 0.441 0.294 0.420 (103 )
AR 53.57 64.29 62.50
RMS RW 0 0 0
Futures 0.518 0.386 0.454 (103 ) VECM 55.36 57.14 46.43
AR 0.558 0.401 0.456 (103 ) *
Indicates value significantly different from zero at the 5%
RW 0.564 0.487 0.439 (103 ) level of significance.
VECM 0.601 0.436 0.571 (103 )
294 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
In contrast to the other two contracts, the
dollar/yen futures price is not generally the best
forecast. For the 1-month horizon, the ARIMA
forecast generally across most criteria provides the
best performance whereas for the 2- and 3-month
horizons, the random walk performs the best. It is
also noticeable the futures price gives little or no
indication of the direction of future changes in the
exchange rate as the CDI statistic is always lower
than the random value of 50% at the 5% level and
significantly so in the case of the 2-month fore-
casting horizon. Possibly this is caused by inter-
vention in the foreign exchange market by the
authorities. Neely (2000) reported that interven-
tion by the US authorities (mainly in the DM and
Yen markets) over the period 1973:04 to 1998 as
follows:
average (absolute) monthly intervention 355
million dollars,
maximum monthly intervention 6735 million
dollars (purchase of foreign currency),
minimum monthly intervention )3413 million
dollars (sales of foreign currency).
On the reasonable assumption that intervention
was leaning against the wind, this would provide
an adequate explanation, in the case of the dollar/
yen series, of the relatively good performance of
the random walk for 2- and 3-month forecasting
horizons and the ARIMA for the 1-month fore-
casting horizon as well as the poor performance of
the futures price as far as the CDI criterion is
concerned.
Finally it should also be seen that, as would be
expected, the performance of all contracts tend to
deteriorate as the forecasting horizon lengthens.
Kavussanos and Nomikos (1999) also found
that, for 1-, 2- and 3-month horizons, the freight
futures prices provided a better prediction of the
spot price than the other models considered (i.e.
vector error correction (VECM), ARIMA, ran-
dom walk and exponential smoothing models)
with the sole exception that the VECM provided a
marginally better forecast for the 1 month horizon.
We also examined the forecast errors for the
futures contracts. In all cases these were station-
ary. For efficiency, it is also necessary that these
errors do not contain any information, which is
correlated with the forecast at the time the forecast
is made. We therefore regressed the forecast error
with up-to-4 of its own lagged values. For the
three futures forecasts over the three time hori-
zons, the F value of the estimating equation was
never significant though, in the case of the 2-
month eurodollar futures forecast, the F statistic
verged on significance (P value 0.054). It was also
noticeable that only two of the individual coeffi-
cients were significantly different from zero at the
customary 5% level (two lags for the 1-month
horizon for the dollar/yen and three lags for the
eurodollar 2-month horizon).
8. Simulated trading
In the previous sections we have identified areas
where the markets are less then fully efficient but
the acid test for efficiency is whether excess profits
can be made from trading rules. The term excess
profit implies profits that are persistently above the
level associated with the risk associated with that
direction of trading. Whether the level of profits is
excess or not is a matter of judgement and could be
the subject of considerable controversy.
In this paper the scope for trading is provided
by the coexistence of two forecasts of the prices
likely to exist in the future. Our trading rule is to
take a position and hold that to the expiration of
the futures contract. Clearly this is more reason-
able for the 1-month forecasts than those for 2 or 3
months. Nevertheless these are included for com-
parison purposes. The precise trading rules 25 are
as follows:
(1) If the ARIMA or VECM interest-rate
forecast exceeds the futures rate forecast plus the
trading cost then our prediction is that the futures
rate will rise in the future. The predicted rise in the
interest rate is equivalent to predicting a fall in the
25
This is the same rule adopted by Kellard et al. (1999) but
for 1-month forecasts only. This rule could be easily altered to
(a) permit trading only when the profit exceeds trading cost by a
fixed margin and (b) to increase the intensity of trading by
permitting more than one trade if the profit margin is above a
certain level(s).
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298 295

price of the futures contract. Hence the trading
rule is to sell one contract.
(2) Conversely if the ARIMA or VECM fore-
cast is less than the implied futures rate by more
than the trading cost, then the trading rule gives a
signal to buy one futures contract.
(3) In the case of the dollar/yen exchange rate
contract, the rule is quite simple and the inverse of
the interest rate contracts. If, after allowance for
the trading cost, the ARIMA or VECM interest-
rate forecast exceeds the futures rate forecast then
a contract should be bought. Conversely if, after
allowance for the trading cost, the ARIMA or
VECM interest-rate forecast is less than the fu-
tures rate forecast then a contract should be
sold.
(4) The simulated trade takes place at the rates
ruling at the close of the day following the fore-
cast. Hence the trades could have been made at the
quoted prices.

Table 7
Simulated trade profits (panel A–C: 1-, 2- and 3-month horizon)
Sterling (£) Eurodollar ($) Dollar/yen ($)
Panel A
Total profit )3370 ()5060) 950 (170) 11,740 ()1980)
Maximum profit on one trade 1400 (1090) 1200 (2880) 7980 (7980)
Minimum profit on one trade )2180 ()2180) )1400 ()1400) )7890 ()7890)
Maximum cumulative profit 1990 (140) 3180 (2180) 20,980 (17,580)
Minimum cumulative profit )3370 ()5060) 0 ()3170) )7190 ()7780)
No. No. No.
Transactions 32 (36) 33 (34) 33 (39)
Sales 17 (22) 19 (19) 19 (21)
Profitable trades 15 (15) 16 (13) 21 (22)

Sterling (£) Eurodollar ($) Dollar/yen ($)

Panel B
Total profit 1640 (1820) 4050 (590) )11,250 ()57,050)
Maximum profit on one trade 1610 (1610) 2650 (2650) 11,160 (9700)
Minimum profit on one trade )1160 ()1230) )1750 ()2200) )23,630 ()23,630)
Maximum cumulative profit 5930 (4540) 11,050 (930) 1290 ()6540)
Minimum cumulative profit )830 ()2250) 150 ()2500) )34,360 ()70,810)

No. No. No.

Transactions 42 (43) 42 (39) 43 (46)
Sales 22 (26) 17 (18) 17 (24)
Profitable trades 19 (19) 25 (21) 22 (21)

Sterling (£) Eurodollar ($) Dollar/yen ($)

Panel C
Total profit )3090 ()480) 8330 (5900) 37,790 ()91,560)
Maximum profit on one trade 1810 (1810) 3030 (2980) 11,880 (11,950)
Minimum profit on one trade )3030 ()3030) )4530 ()3930) )29,060 ()29,490)
Maximum cumulative profit 2650 (6450) 8330 (5900) 58,450 ()2740)
Minimum cumulative profit )3230 ()480) )4700 ()5700) 3940 ()101,080)
No. No. No.
Transactions 48 (50) 50 (51) 54 (55)
Sales 22 (26) 25 (20) 19 (24)
Profitable trades 21 (24) 26 (28) 31 (23)
Figures in brackets show corresponding figures for trades based on VECM.
296 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
(5) Sutcliffe (1997) identifies the cost of trading
the FTSE-100 futures contract as 0.116% for a
round trip including two commissions and the
spread between the bid and offer rate. It is likely
the costs of trading interest and exchange rate
contracts will be of a similar nature. However,
since our strategy is to buy and hold, we have re-
duced the cost so as to include only one commis-
sion. The trading cost is therefore specified as 0.1%
or £500 per transaction for the sterling contract. A
similar cost was applied to the eurodollar interest
and dollar/yen exchange rate futures contract so
that the total cost per transaction came to £500 for
all contracts.
The results of the trade are shown in Table 7
with the transaction cost being incorporated into
the profit calculations. The trades include both
purchases and sales with sales tending to be more
numerous than purchases for the 1-month fore-
casting horizon and less numerous for the 2- and
3-month forecasting horizons. The overall profit-
ability is summarized below:
One month forecasting horizon
(a) Losses incurred on the sterling contract for
both methods of forecasting (i.e. ARIMA
and VECM).
(b) Very small profits were obtained on the euro-
dollar contract for both methods of forecast-
ing (i.e. ARIMA and VECM).
(c) For the dollar/yen contract profits could be
made if ARIMA forecasts were used as the
basis of trading but not in the case of VECM
forecasts.
Two month forecasting horizon
(a) For the sterling and eurodollar contracts prof-
its would be obtained whichever forecasting
method was used. Only in the case of the euro-
dollar ARIMA forecast would the level of
profits be significant.
(b) For the dollar/yen contract a substantial loss
was incurred whichever forecasting method
was used.
Three month forecasting horizon
(a) Losses were incurred for both methods of fore-
casting for the sterling contract and VECM
forecasts for the dollar/yen contract. The loss
was substantial in the latter case.
(b) Profits were obtained in all other cases and
these were substantial in the case of the euro-
dollar contract (both forecasts) and the dol-
lar/yen (ARIMA forecast).
Further points about the overall profitability
are:
1. For all contracts the cumulative profit was neg-
ative at some time throughout the sample pe-
riod except in the cases of (a) the 1-month
eurodollar forecasting horizon (zero profit),
(b) eurodollar 2-month ARIMA forecast
(small profit $150) and (c) dollar/yen 3-month
ARIMA forecast (significant profit of $3940).
2. Individual trades showed substantial profits as
well as losses.
3. The ARIMA forecasts generally performed bet-
ter than the VECM forecasts.
Kellard et al. (1999) also reached a similar con-
clusion for simulating trade with a 56-day forecast
horizon. After allowance for trading costs, profits
were obtained during December 1991 and October
1994. However in one sub-period a loss was in-
curred and they also concluded that the Ôsmall size
of the average return and the large variance suggest
a substantial risk-return trade-off Õ.
In conclusion to this section, the outlay for
trading a single contract is quite low on the other
hand the total profit at the end of the period also
seems quite low given the length of the period and
the degree of risk associated with the trading rule.
Whether these profits are excessive is, as noted
earlier, a matter of judgement.
9. Conclusions
We have examined the sterling and eurodollar
futures markets for efficiency. Our conclusions for
this sample period can be summarized as follows:
1. For horizons of 1, 2 or 3 months, the futures
price and the subsequently realized spot rate
are cointegrated for the three contracts.
 J. Laws, J. Thompson / European Journal of Operational Research 155 (2004) 284–298
2. The sterling contract meets the conditions nec-
essary for efficiency imposed on the constant
and slope coefficients in the case of 1-, 2- and
3-month forecasting horizons. This is not the
case for the eurodollar market where the condi-
tion is only met for the 2-month forecasting ho-
rizon or the dollar/yen contract where condition
is only met for the 1- and 2-month forecasting
horizons.
3. Only the sterling futures market exhibits short-
term efficiency and then solely for 1- and 2-
month forecasting horizons.
4. Variance bounds requirements for efficiency are
satisfied for all three futures markets with the
sole exception of the 1-month forecasting hori-
zon for the eurodollar futures market.
5. An examination of the relative efficiency of the
three futures markets, reveals that, whilst the
level of relative efficiency is high for all markets,
the sterling market is relatively more efficient
than the either eurodollar or dollar/yen futures
markets.
6. For all the forecasting horizons, the interest-
rate futures price tends to provide a superior
forecast of the subsequent spot price as com-
pared with the random walk, VECM or AR-
IMA forecasts. This is not the case for the
dollar/yen exchange rate futures contract.
7. The futures forecast errors are both stationary
and uncorrelated with past errors.
8. During this period, both profits and losses
could be made through the use of a simple trad-
ing rule. The presence of significant losses sug-
gests that the risk/profit trade off is substantial
and, in general, losses would be incurred if al-
lowance were made for the existence of a risk
premium.
This leaves the efficiency of the three markets as
an open question. As usual the empirical evidence
is ambiguous but we would argue that nevertheless
it is sufficient to indicate ÔapproximateÕ efficiency in
these three markets.
Acknowledgements
The authors are grateful for helpful comments
provided by Professors C. Dunis and K. Holden.
297
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