Limits to Arbitrage and Hedging: Evidence from Commodity Markets
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
Lars A. Lochstoer
Columbia Business School - Finance and Economics
University of Oxford - Said Business School; University of Oxford - Oxford-Man Institute of Quantitative Finance; Centre for Economic Policy Research (CEPR)
CEPR Discussion Paper No. DP7327
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.
Number of Pages in PDF File: 57
Keywords: Commodities, Futures, Hedging, Limits to Arbitrage
JEL Classification: G12, G13working papers series
Date posted: July 15, 2009
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