Limits to Arbitrage and Hedging: Evidence from Commodity Markets

Abstract

Motivated by the literature on limits-to-arbitrage, we build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases (decreases) in producers' hedging demand (speculators'risk-capacity) increase hedging costs via price-pressure on futures, reduce producers'inventory holdings, and thus spot prices. Consistent with our model, producers'default risk forecasts futures returns, spot prices, and inventories in oil and gas market data from 1980-2006, and the component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to …nancial arbitrage generate limits to hedging by producers, and a¤ect both asset and goods prices. risk-capacity) increase hedging costs via price-pressure on futures, reduce producers' inventory holdings, and thus spot prices. Consistent with our model, producers'default risk forecasts futures returns, spot prices, and inventories in oil and gas market data from 1980-2006, and the component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to …nancial arbitrage generate limits to hedging by producers, and a¤ect both asset and goods prices.

Commodity index trading and hedging costs

“…1 Our results are complementary with that of Acharya, Lochstoer, and Ramadorai (2013), who find that increased hedging demand leads to greater returns to long futures positions, or equivalently, a higher price for hedging.…”

“…First, like Acharya, Lochstoer, and Ramadorai (2013), we focus on the determinants of the cost of hedging. This focus seems appropriate, since a key function of commodity futures markets is to allow firms to hedge their inherent risk.…”

“…Instead, these models are based upon the dichotomy between hedgers and speculators [see, for instance, Acharya, Lochstoer, and Ramadorai (2013), Lux (1995), Shiller (2003) and Shleifer and Summers (1990)]. CITs behave differently.…”

Learning in the Oil Futures Markets: Evidence and Macroeconomic Implications

“…3 For instance, Hamilton and Wu (2014) Buyuksahin et al (2008) argue that increased market activity by commodity swap dealers, hedge funds, and other financial traders, has helped link crude oil futures prices at different maturities. Acharya et al (2013) emphasize limits to arbitrage and their effects on spot and futures prices in commodity markets. In their environment, speculators face capital constraints in commodity markets, which limits commodity producers' ability to hedge risk and is reflected in commodity prices.…”

Commodities, Financialization, and Heterogeneous Agents

“…For example, Singleton (2013) shows that the NYMEX WTI crude oil price peaked (at about 140 USD per barrel) around August 2008. Other studies providing detailed analyses with similar tendencies in commodity trading activities and price dynamics include Casassus and Collin-Dufresne (2005), Gorton and Rouwenhorst (2006), Hong and Yogo (2009), Acharya, Lochstoer, and Ramadorai (2013), and Gorton, Hayashi, and Rouwenhorst (2013).…”