Limits to Arbitrage and Hedging: Evidence from Commodity Markets

57 Pages Posted: 15 Jul 2009

See all articles by Viral V. Acharya

Viral V. Acharya

New 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. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management

Tarun Ramadorai

Imperial College London; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 6 versions of this paper

Date Written: June 2009

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.

Keywords: Commodities, Futures, Hedging, Limits to Arbitrage

JEL Classification: G12, G13

Suggested Citation

Acharya, Viral V. and Lochstoer, Lars A. and Ramadorai, Tarun, Limits to Arbitrage and Hedging: Evidence from Commodity Markets (June 2009). CEPR Discussion Paper No. DP7327. Available at SSRN: https://ssrn.com/abstract=1433923

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Lars A. Lochstoer

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Tarun Ramadorai

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

HOME PAGE: http://www.tarunramadorai.com

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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