Limits to Arbitrage and Hedging: Evidence from Commodity Markets

Acharya, Viral V.; Lochstoer, Lars A.; Ramadorai, Tarun

Purchase - $8 CEPR Subscribers Download

Add Paper to My Library

Limits to Arbitrage and Hedging: Evidence from Commodity Markets

CEPR Discussion Paper No. DP7327

57 Pages Posted: 15 Jul 2009

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management

Tarun Ramadorai

Imperial College London; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

There are 6 versions of this paper

Date Written: June 2009

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 Classification: G12, G13

Suggested Citation: Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Lochstoer, Lars A. and Ramadorai, Tarun, Limits to Arbitrage and Hedging: Evidence from Commodity Markets (June 2009). CEPR Discussion Paper No. DP7327, Available at SSRN: https://ssrn.com/abstract=1433923