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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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Cited by:
  1. James D. Hamilton & Jing Cynthia Wu, 2013. "Risk Premia in Crude Oil Futures Prices," NBER Working Papers 19056, National Bureau of Economic Research, Inc.
  2. repec:ipg:wpaper:19 is not listed on IDEAS
  3. M. J. Lombardi & I. Van Robays, 2011. "Do Financial Investors Destabilize the Oil Price?," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 11/760, Ghent University, Faculty of Economics and Business Administration.
  4. Bos Jaap & Molen Maarten van der, 2012. "A Bitter Brew? Futures Speculation and Commodity Prices," Research Memorandum 045, Maastricht University, Maastricht Research School of Economics of Technology and Organization (METEOR).
  5. Yannick Le Pen & Benoît Sévi, 2013. "Futures Trading and the Excess Comovement of Commodity Prices," Working Papers halshs-00793724, HAL.
  6. Ke Tang & Wei Xiong, 2010. "Index Investment and Financialization of Commodities," NBER Working Papers 16385, National Bureau of Economic Research, Inc.
  7. Büyükşahin, Bahattin & Robe, Michel A., 2014. "Speculators, commodities and cross-market linkages," Journal of International Money and Finance, Elsevier, vol. 42(C), pages 38-70.
  8. 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.
  9. Derek Bunn & Julien Chevallier & Yannick Le Pen & Benoît Sévi, 2014. "Fundamental and Financial Influences on the Co-movement of Oil and Gas Prices," Working Papers 2014-414, Department of Research, Ipag Business School.
  10. Yannick Le Pen & Benoît Sévi, 2011. "Macro factors in oil futures returns," Economie Internationale, CEPII research center, issue 126-127, pages 13-38.
  11. Daskalaki, Charoula & Kostakis, Alexandros & Skiadopoulos, George, 2014. "Are there common factors in individual commodity futures returns?," Journal of Banking & Finance, Elsevier, vol. 40(C), pages 346-363.
  12. 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.).
  13. Gospodinov, Nikolay & Jamali, Ibrahim, 2013. "Monetary policy surprises, positions of traders, and changes in commodity futures prices," Working Paper 2013-12, Federal Reserve Bank of Atlanta.
  14. Aytek Malkhozov & Philippe Mueller & Andrea Vedolin & Gyuri Venter, 2013. "Mortgage Hedging in Fixed Income Markets," FMG Discussion Papers dp722, Financial Markets Group.

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