Limits to Arbitrage and Hedging: Evidence from Commodity Markets
57 Pages Posted: 10 Sep 2013
Date Written: January 2010
Motivated by the literature on limits-to-arbitrage, we build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases (decreases) in producers' hedging demand (speculators' risk capacity) increase hedging costs via price-pressure on futures, reduce producers' inventory holdings, and thus spot prices. Consistent with our model, producers' default risk forecasts futures returns,spot prices, and inventories in oil and gas market data from 1980-2006, and the component of the commodity futures risk premium associated with producer hedging demand rises when speculative activity reduces. We conclude that limits to financial arbitrage generate limits to hedging by producers, and affect both asset and goods prices.
Suggested Citation: Suggested Citation