Limits to Arbitrage and Hedging: Evidence from Commodity Markets
57 Pages Posted: 14 Mar 2008 Last revised: 15 Dec 2015
Date Written: January 17, 2010
We build an equilibrium model with commodity producers who are averse to future cash flow variability, and hedge using futures. Their hedging demand is met by risk-constrained speculators. Increases in producers' hedging demand (speculators' risk- capacity) increase hedging costs via price-pressure on futures, reducing producers' inventory holdings, and thus spot prices. Consistent with our model, in oil and gas data from 1980-2006 producers' default risk forecasts hedging demand, futures risk-premia and spot prices; more so when speculative activity is lower. We conclude that limits to financial arbitrage can generate limits to hedging by firms, affecting prices in both asset and goods markets.
Keywords: Corporate Hedging, Commodity Pricing, Default Risk, Incomplete Markets, Limits to Arbitrage
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