Limits to Arbitrage and Hedging: Evidence from Commodity Markets

Abstract

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