Working Paper: CEPR ID: DP10651
Authors: Suleyman Basak; Anna Pavlova
Abstract: A sharp increase in the popularity of commodity investing in the past decade has triggered an unprecedented inflow of institutional funds into commodity futures markets, referred to as the financialization of commodities. In this paper, we explore the effects of financialization in a model that features institutional investors alongside traditional futures markets participants. The institutional investors care about their performance relative to a commodity index. We find that in the presence of institutional investors prices and volatilities of all commodity futures go up, but more so for the index futures than for nonindex ones. The correlations amongst commodity futures as well as in equity-commodity correlations also increase, with higher increases for index commodities. Within a framework additionally incorporating storage, we show how financial markets transmit shocks not only to futures prices but also to commodity spot prices and inventories. Commodity spot prices and inventories go up with financialization. In the presence of institutional investors shocks to any index commodity spill over to all storable commodity prices.
Keywords: asset class; asset pricing; commodities; futures; indexing; institutions; money management; spot prices
JEL Codes: G12; G18; G29
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Institutional investors (G23) | Commodity futures prices (G13) |
| Institutional investors (G23) | Commodity futures volatilities (G13) |
| Institutional investors (G23) | Increased correlations among commodity futures (G13) |
| Institutional investors (G23) | Increased correlations between commodity and equity markets (G10) |
| Shocks to index commodities (Q02) | Spill over to all storable commodity prices and inventories (Q02) |
| Institutional investors (G23) | Higher spot prices for storable commodities (G13) |
| Institutional investors (G23) | Higher inventories for storable commodities (Q02) |
| Institutional behavior (D23) | Impact on discount factor used in pricing storable commodities (G13) |