Working Paper: CEPR ID: DP7327
Authors: Viral V. Acharya; Lars Lochstoer; Tarun Ramadorai
Abstract: We build an equilibrium model with commodity producers that are averse to future cash flow variability, and hedge using futures contracts. Their hedging demand is met by financial intermediaries who act as speculators, but are constrained in risk-taking. Increases (decreases) in producers? hedging demand (the risk-bearing capacity of speculators) increase the costs of hedging, which preclude producers from holding large inventories, and thus reduce spot prices. Using oil and gas market data from 1980-2006, we show that producers? hedging demand - proxied by their default risk - forecasts spot prices, futures prices and inventories, consistent with our model. Our analysis demonstrates that limits to financial arbitrage can generate limits to hedging by firms, affecting prices in both asset and goods markets.
Keywords: commodities; futures; hedging; limits to arbitrage
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in producers' default risk (G33) | Increase in hedging demand (G13) |
| Increase in producers' default risk (G33) | Increase in excess returns on short-term futures (G19) |
| Higher default risk (G32) | Lower inventory holdings (D25) |
| Lower inventory holdings (D25) | Depressed current spot prices (E39) |
| Increase in producers' default risk (G33) | Decrease in inventory holdings (E20) |
| Default risk of producers (G33) | Forecasting power for excess returns on short-term commodity futures (G17) |