Limits to Arbitrage and Hedging: Evidence from Commodity Markets
51 Pages Posted: 9 Mar 2009 Last revised: 8 Jan 2013
Date Written: January 8, 2013
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 producershedging demand or speculatorscapital constraints increase hedging costs via price-pressure on futures. These in turn affect producersequilibrium 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 producerspropensity 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
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