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Limits to arbitrage and hedging: Evidence from commodity markets

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

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.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 109 (2013)
Issue (Month): 2 ()
Pages: 441-465

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Handle: RePEc:eee:jfinec:v:109:y:2013:i:2:p:441-465
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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