Futures Prices in a Production Economy with Investment Constraints

48 Pages Posted: 13 Sep 2005 Last revised: 20 Aug 2009

See all articles by Leonid Kogan

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Dmitry Livdan

University of California, Berkeley

Amir Yaron

University of Pennsylvania -- Wharton School of Business; National Bureau of Economic Research (NBER)

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Date Written: August 2005

Abstract

We document a new stylized fact regarding the term-structure of futures volatility. We show thatthe relation between the volatility of futures prices and the slope of the term structure of prices isnon-monotone and has a %u201CV-shape%u201D'. This aspect of the data cannot be generated by basic modelsthat emphasize storage while this fact is consistent with models that emphasize investmentconstraints or, more generally, time-varying supply-elasticity. We develop an equilibrium model inwhich futures prices are determined endogenously in a production economy in which investment isboth irreversible and is capacity constrained. Investment constraints affect firms' investmentdecisions, which in turn determine the dynamic properties of their output and consequently implythat the supply-elasticity of the commodity changes over time. Since demand shocks must beabsorbed either by changes in prices, or by changes in supply, time-varying supply-elasticity resultsin time-varying volatility of futures prices. Calibrating this model, we show it is quantitativelyconsistent with the aforementioned %u201CV-shape%u201D relation between the volatility of futures prices andthe slope of the term-structure.

Suggested Citation

Kogan, Leonid and Livdan, Dmitry and Yaron, Amir, Futures Prices in a Production Economy with Investment Constraints (August 2005). NBER Working Paper No. w11509. Available at SSRN: https://ssrn.com/abstract=775998

Leonid Kogan (Contact Author)

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Dmitry Livdan

University of California, Berkeley ( email )

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Amir Yaron

University of Pennsylvania -- Wharton School of Business ( email )

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