Building a Model
A model can be created to explain or forecast price changes. Most models explain rather than forecast. Explanatory models analyze sets of data at concurrent times, that is, they look for relationships between multiple factors and their effect on price at the same moment in time. They can also look for causal, or lagged relationships, in which prices respond to other factors after one or more days. It is possible to use the explanatory model to determine the normal price at a particular moment. Although not considered forecasting, any variation in the actual market price from the normal or expected price could present trading opportunities.
Methods of selecting the best forecasting model can affect its credibility An analytic approach selects the factors and specifies the relationships in advance. Tests are then performed on the data to verify the premise. Many models, though, are refined by fitting the data, using regression analysis or shotgun testing, which applies a broad selection of variables and weighting to find the best fit. These models do not necessarily forecast but are definitely using perfect hindsight. Even an analytic approach that is subsequently finetuned could be in danger of losing its forecasting qualities.
The factors that comprise a model can be both numerous and difficult to obtain. The change in value of the U.S. dollar and the volatility of interest rates have had far greater influence on price than normal fundamental factors for many commodities.
Models that explain price movements must be constructed from the primary factors of supply and demand. A simple example for estimating the price of fall potatoes’ is where P is the average price of fall potatoes received by farmers; PPI is the Producer Price Index; S is the apparent domestic free supply (production less exports and diversions); D is the estimated deliverable supply; and a, b, and c are constants determined by regression analysis.
This model implies that consumption must be constant (i.e., inelastic demand); demand factors are only implicitly included in the estimated deliverable supply Exports and diversion represent a small part of the total production. The use of the PPI gives the results in relative terms based on whether the index was used as an inflator or defiator of price.