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.

Economic uncertainty, trading activity, and commodity futures volatility

“…Singleton (2014) surveys the recent literature in an attempt to explain the impact of trader activity on the behavior of energy markets, particularly crude oil futures prices, and finds futures open interest has important predictive power for crude oil prices, confirming the finding in Hong and Yogo (2012). Acharya et al (2013) consider the effect of capital-constrained speculators in a commodity futures market, where producers trade due to hedging needs and link producer default risk to inventories and prices in energy markets. They find that when speculator activity is constrained or reduced, the impact of hedging demand increases, that is, unconstrained speculator activity will assist the absorption of producer demand shocks.…”

“…As discussed further in Sections 2.2, there can be deviations from the no-arbitrage condition due to nondiversifiable risks or market frictions such as producer hedging pressure and borrowing constraints (see, e.g., Acharya et al, 2013;Cootner, 1960;Hirshleifer, 1988Hirshleifer, , 1990Keynes, 1930;deRoon, Nijman, & Veld, 2000). Further, the convenience yield associated with a commodity has features distinct from the yields on other financial contracts (see, e.g., Brennan, Williams, & Wright, 1997).…”

Causes and Implications of Shifts in Financial Participation in Commodity Markets

“…The fall in risk aversion is meant to proxy changes in the constraints facing financial investors. Indeed, in Acharya et al (2011), the risk aversion parameter is interpreted as a binding leverage ratio. Bekaert, Hoerova, & Duca, 2010 estimate that an empirical measure of risk aversion fell during the mid-2000s based on the implied volatility of share prices.…”

Arbitrage hedging in markets for the US lean hogs and the EU live pigs

“…This quotation is in line with Castelino (2000), who shows that hedging is often a vehicle to speculate and not an instrument to reduce price risks. It is also argued that the commodity futures risk premium is associated with the producer hedging demand and the capital constrained speculation (Acharya et al 2010).…”

“…Acharya et al 2010). Basically, the theory claims that "the return from purchasing the commodity today and selling it for delivery later (the so-called basis) equals the interest forgone by storing the commodity plus the marginal storage cost less the marginal convenience yield from an additional unit of inventory" (Stronzik et al 2008).…”