Options-Based Forecasts of Futures Prices in the Presence of Limit Moves

This analysis examines a simultaneous estimation option-based approach to forecast futures prices in the presence of daily price limit moves. The procedure explicitly allows for changing implied volatilities by estimating the implied futures price and the implied volatility simultaneously. Using 15 years of futures and futures options data for three agricultural commodities, we find that the simultaneous estimation approach accounts for the abrupt changes in implied volatility associated with limit moves and generates more accurate price forecasts than conventional methods that rely on only one implied variable. Introduction In order to protect investors' equity against contract default, some futures exchanges impose voluntary daily price limits within which trades may occur. Once the futures price has increased (decreased) to the upper (lower) bound, no trading at higher (lower) prices is possible until the futures price reverses back into the permissible range, or until the next trading day when new limits are set. Whenever trading is ceased, the futures price stops reflecting the market's assessment of the " true " price of the contract. The futures market becomes informationally inefficient because investors are prevented from incorporating publicly available information into prices. Yet, since limit moves are generally associated with the arrival of new information and the resolution of great amounts of uncertainty, knowing the new " true " price level during this particular time is especially critical for investors and has important consequences for efficient derivative pricing and effective hedging decisions. Options markets can provide an alternative way to obtain the subsequent futures price, even when the underlying contract has stopped trading. The traditional approach involves inserting the last recorded non-limit futures and options prices in a theoretical options pricing formula such as Black's (1976) model and solving for the implied volatility. At the halt of trading in the underlying futures, this volatility estimate can be used together with a current options price to obtain an implied futures price. The implied price reflects investors' assessment of what the " true " futures price would be if no price limits were in place. However, this traditional approach can result in inaccurate price estimates because the implied volatility is assumed to remain constant when trading is halted. Empirical research has shown that the arrival of new information alters the amount of uncertainty that investors expect to be resolved until option expiration and results in significant changes of the options implied volatility We propose and …