A shadow price is created when any asset’s price changes are influenced by the changes in price of another asset. The influence may be so strong as to completely govern the shadow’s price changes. For example, an exchange-traded fund (ETF) may have its value determined by futures on a single commodity, a situation that permits little independent price movement of the ETF, aside from the price changes of the underlying commodity.
Other shadow prices may be less controlled by the related asset. Silver traditionally has been linked to gold, and its price tends to shadow gold over the long-term but with wide variations because of the larger volatility of silver vs. gold. Other pairs exhibiting shadow pricing are live cattle and lean hogs, and corn and soybeans. Agricultural commodities are connected by common markets for their products, similar structures of costs and profits, and all are affected by climate as well as shifts in the import/export of them.
Economic competition is one reason for shadow pricing. This is as close-to-home as your local supermarket and as far-reaching as international currency markets. A country may allow its currency to gain value with respect to other currencies, but eventually either will permit or force it to fall to restore economic competitiveness.
Examples of loose and strong shadow pricing of currencies are shown on “Currency ETF warfare” (below). The Swiss monetary authorities have decreed that the Swiss franc should not be stronger than 1.20 vs. the euro, and thus the franc is trending in an almost perfect shadow of the euro. However, an increasing separation is noted in August 2014 leading into September as the euro declined with respect to the Swiss franc and the Swiss fought back. On Sept. 15 the franc/euro ratio was 1.2105.
The British pound was permitted to gain in relative value until the need to compete forced a decline to accompany the euro’s drop starting in July 2014. From that point, through the summer and into September, the pound joined the battle, falling almost 8% from July 1 through Sept. 15 compared with the change for the euro and Swiss franc of approximately 6%. As a result of the brawl, the Dec. 2014 dollar index (an innocent bystander, 73% of which is determined by the three currencies) was forced to rise 5.56% between July 1 and Sept. 15.
Forex traders should be able to profit from currency warfare as long as the announced or perceived determination by each central bank to maintain price control is in effect. During this period, normal economic variations in price are temporarily set aside while the battle goes on.
A shadow price may be created by an ETF that is based on the values of more than one commodity. In this case, an artificial “senior asset” price may be computed based on the formula followed by the sponsors of the ETF or ETN (exchange-traded note). An example of this scenario is the agriculture ETN known as COW. The price of COW is determined by the approximate ratio of 61% live cattle futures and 39% lean hog futures.
The percentages may be used to create the virtual asset (COW’s avatar), COMBO. “COW and COMBO” (below) shows that price changes for COMBO shadow the underlying futures prices contained in COW. Short-term variations due to cattle and lean hogs not being perfectly correlated permit spread trades. COW is at times above or below COMBO in its cumulative percentage price changes, but COW cannot separate from its shadow for long. The two eventually cross paths.
The spread suggested on “COW and COMBO” on March 18, 2014, would have the trader taking a long position in live cattle and lean hogs in approximately a two-to-one ratio, and at the same time selling short an equivalent amount of the ETN COW. A reverse trade is noted for Aug. 21, with a long position in COW and short COMBO.