Hedging vs. speculative pressures on commodity futures returns

This study introduces a non linear model for commodity futures prices which accounts for pressures due to hedging and speculative activities. The linkage with the corresponding spot market is considered assuming that a long term equilibrium relationship holds between futures and spot pricing. Over the 1990-2010 time period, a dynamic interaction between spot and futures returns in five commodity markets (copper, cotton, oil, silver, and soybeans) is empirically validated. An error correction relationship for the cash returns and a non linear parameterization of the corresponding futures returns are combined with a bivariate CCC-GARCH representation of the conditional variances. Hedgers and speculators are contemporaneously at work in the futures markets, the role of the latter being far from negligible. In order to capture the consequences of the growing impact of financial flows on commodity market pricing, a two-state regime switching model for futures returns is developed. The empirical findings indicate that hedging and speculative behavior change across the two regimes, which we associate with low and high return volatility, according to a distinctive pattern, which is not homogeneous across commodities.