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Limits to Arbitrage and Hedging: Evidence from Commodity MarketsViral V. AcharyaNew 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. LochstoerColumbia Business School - Finance and Economics Tarun RamadoraiUniversity of Oxford - Said Business School; University of Oxford - Oxford-Man Institute of Quantitative Finance; Centre for Economic Policy Research (CEPR) June 2009 CEPR Discussion Paper No. DP7327 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 producersÂ’ 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 producersÂ’ 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, G13 working papers seriesDate posted: July 15, 2009Suggested CitationContact Information
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