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Limits to Arbitrage and Hedging: Evidence from Commodity Markets

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  • Acharya, Viral V.
  • Lochstoer, Lars
  • Ramadorai, Tarun

Abstract

We build an equilibrium model with commodity producers that are averse to future cash flow variability, and hedge using futures contracts. Their hedging demand is met by financial intermediaries who act as speculators, but are constrained in risk-taking. Increases (decreases) in producers’ hedging demand (the risk-bearing capacity of speculators) increase the costs of hedging, which preclude producers from holding large inventories, and thus reduce spot prices. Using oil and gas market data from 1980-2006, we show that producers’ hedging demand - proxied by their default risk - forecasts spot prices, futures prices and inventories, consistent with our model. Our analysis demonstrates that limits to financial arbitrage can generate limits to hedging by firms, affecting prices in both asset and goods markets.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7327.

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Date of creation: Jun 2009
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Handle: RePEc:cpr:ceprdp:7327

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Keywords: Commodities; Futures; Hedging; Limits to Arbitrage;

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Citations

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Cited by:
  1. Lombardi, Marco J. & Van Robays, Ine, 2011. "Do financial investors destabilize the oil price?," Working Paper Series 1346, European Central Bank.
  2. Celso Brunetti & David Reiffen, 2011. "Commodity index trading and hedging costs," Finance and Economics Discussion Series 2011-57, Board of Governors of the Federal Reserve System (U.S.).
  3. repec:dgr:umamet:2012045 is not listed on IDEAS
  4. Ke Tang & Wei Xiong, 2010. "Index Investment and Financialization of Commodities," NBER Working Papers 16385, National Bureau of Economic Research, Inc.
  5. Ekeland, Ivar & Lautier, Delphine & Villeneuve, Bertrand, 2013. "A simple equilibrium model for a commodity market with spot trades and futures contracts," Economics Papers from University Paris Dauphine 123456789/11383, Paris Dauphine University.

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