Comparing alternative assumptions on the term structure of futures prices: Reply

Abstract

Donald Lien and Yan Wang (this issue) suggest an alternative test for different specifications of the term structure of futures prices, as used in our recently published paper in The Journal of Futures Markets. Our paper (Y. V. Veld-Merkoulova and F. A. de Roon, 2003) focuses on developing optimal hedging strategies in case sufficiently long-term futures contracts are not available (or not actively traded) on the exchange. One of the preliminary steps underlying this strategy was to compare linear and log-linear term structures of futures prices in order to choose an appropriate specification. Although this is not the main issue of our paper, it is certainly important to use the correct econometric procedure in testing alternative model specifications. The results found by Lien and Wang do not contradict our conclusion that a linear term structure of futures yields is superior to a linear term structure of futures prices. However, as we point out here, the tests suggested by Lien and Wang are not without flaws.