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Limits to Arbitrage and Hedging: Evidence from Commodity Markets

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

Abstract

Motivated by the literature on limits-to-arbitrage, we build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases (decreases) in producers' hedging demand (speculators' risk-capacity) increase hedging costs via price-pressure on futures, reduce producers' inventory holdings, and thus spot prices. Consistent with our model, producers' default risk forecasts futures returns, spot prices, and inventories in oil and gas market data from 1980-2006, and the component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to financial arbitrage generate limits to hedging by producers, and affect both asset and goods prices.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16875.

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Date of creation: Mar 2011
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Publication status: published as “Limits to Arbitrage and Hedging: Evidence from Commodity Markets” with Lars Lochstoer and Tarun Ramadorai, forthcoming, Journal of Financial Economics.
Handle: RePEc:nbr:nberwo:16875

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Cited by:
  1. Yannick Le Pen & Benoît Sévi, 2011. "Macro factors in oil futures returns," Economie Internationale, CEPII research center, issue 126-127, pages 13-38.
  2. 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.
  3. 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).
  4. 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.
  5. Ke Tang & Wei Xiong, 2010. "Index Investment and Financialization of Commodities," NBER Working Papers 16385, National Bureau of Economic Research, Inc.
  6. 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.).

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