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Limits to arbitrage and hedging: Evidence from commodity markets

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

Abstract

We build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases in producers' hedging demand or speculators' capital constraints increase hedging costs via price-pressure on futures. These in turn affect producers' equilibrium hedging and supply decision inducing a link between a financial friction in the futures market and the commodity spot prices. Consistent with the model, measures of producers' propensity to hedge forecasts futures returns and spot prices in oil and gas market data from 1979 to 2010. 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 equilibrium commodity supply and prices.

Suggested Citation

  • Acharya, Viral V. & Lochstoer, Lars A. & Ramadorai, Tarun, 2013. "Limits to arbitrage and hedging: Evidence from commodity markets," Journal of Financial Economics, Elsevier, vol. 109(2), pages 441-465.
  • Handle: RePEc:eee:jfinec:v:109:y:2013:i:2:p:441-465
    DOI: 10.1016/j.jfineco.2013.03.003
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    More about this item

    Keywords

    Commodity markets; Futures pricing; Hedging; Limits to arbitrage;

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • Q49 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Other

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