Limits to Arbitrage and Hedging: Evidence from Commodity Markets

Abstract

We build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases in producers’hedging demand or speculators’capital constraints increase hedging costs via price-pressure on futures. These in turn affect producers’equilibrium hedging and supply decisioninducing a link between a fi…nancial friction in the futures market and the commodity spot prices. Consistent with the model, measures of producers’propensity to hedge forecasts futures returns and spot prices in oil and gas market data from 1979-2010. The component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to fi…nancial arbitrage generate limits to hedging by producers, and affect equilibrium commodity supply and prices.

Keywords: commodities, hedging, limits to arbitrage, oil and gas, futures

JEL Classification: G12, G13, G14, G32