Hedging Pressure and Speculation in Commodity Markets

Abstract

We propose a micro-founded equilibrium model to examine the interactions between the physical and the derivative markets of a commodity. This model provides a unifying framework for the hedging pressure and storage theories that comprises four types of traders: short and long hedgers, both of which operate on all markets; speculators who operate only on the futures market; and spot traders. We provide the necessary and sufficient conditions on the fundamentals of this economy for a rational expectation equilibrium to exist, and we show that it is unique. The model shows a variety of behaviors at equilibrium that can be used to analyze price relations for any commodity. The regimes are determined by basic characteristics of the commodity under consideration as well as by the present and expected supply conditions on the physical market. Further, through a comparative statics analysis, we precisely identify the losers and winners in the financialization of the commodity markets. Therefore, this paper clarifies the political economy of regulatory issues, like speculators' influence on prices.

Keywords: Equilibrium model; commodity; speculation; regulation; futures markets

JEL Classification: D4, G13, Q02