ARE INTEREST RATES NECESSARY FOR TEMPORAL COINTEGRATION? EVIDENCE FROM THE LONDON METAL EXCHANGE (LME)

This study examines the long run relationship between 1-day and 3-month futures prices for five metals at the London Metal Exchange (LME) and further investigates the role of interest rates in this relationship. A battery of stationarity tests and cointegration tests are applied to a simple cost of carry model, which contains the interrelationship between prices of the same commodity for delivery at two different dates and the cost of carry term. Results provide strong evidence that 1-day and 3-month metals futures prices are cointegrated and that interest rates are not needed to find this cointegration. These findings are confirmed in an analysis of the truncated sample period of 1979-1984 when the interest rates were highly volatile. Our finding calls into question the role of interest rates in the cointegration of temporal spreads, such as their proposed role in cash-futures cointegration, and seems to at odds with the cost of carry theory. To examine this anomaly, a further analysis of a quadvariate cointegration is conducted and results show that cointegration exists for 1-day and 3-month metals futures prices, 3-month interest rates and physical storage costs. These findings are consistent with Working's cost of carry theory.