Price Discovery in Commodity Futures and Cash Markets with Heterogenous Agents

SOAS Department of Economics Working Paper Series, No 213

25 Pages Posted: 21 Apr 2019

Date Written: November 01, 2018

Abstract

The paper develops a price discovery model for commodity futures markets that accounts for two forms of limits to arbitrage caused by transaction costs and noise trader risk. Four market regimes are identified: (1) effective arbitrage, (2) transaction costs but no noise trader risk, (3) no transaction costs but noise trader risk and (4) both transaction costs and noise trader risk. It is shown that commodity prices are driven by both market fundamentals and speculative trader positions under the latter two regimes. Further, speculative effects spill over to the cash market under regime (3) but are confined to the futures market under regime (4). The model is empirically tested using data from six grain and soft commodity markets. While regime (4) is rare and short lived, regime (3) with some noise trader risk and varying elasticity of arbitrage prevails.

Keywords: commodity futures, index investment, price discovery, speculation

JEL Classification: D84, G13, Q02, Q11

Suggested Citation

van Huellen, Sophie, Price Discovery in Commodity Futures and Cash Markets with Heterogenous Agents (November 01, 2018). SOAS Department of Economics Working Paper Series, No 213, Available at SSRN: https://ssrn.com/abstract=3357467

Sophie Van Huellen (Contact Author)

SOAS University of London ( email )

Thornhaugh Street
Russell Square
London, WC1H 0XG
United Kingdom

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