NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Futures Prices in a Production Economy with Investment Constraints

Leonid Kogan, Dmitry Livdan, Amir Yaron

NBER Working Paper No. 11509
Issued in August 2005
NBER Program(s):   AP

We document a new stylized fact regarding the term-structure of futures volatility. We show that

the relation between the volatility of futures prices and the slope of the term structure of prices is

non-monotone and has a “V-shape”'. This aspect of the data cannot be generated by basic models

that emphasize storage while this fact is consistent with models that emphasize investment

constraints or, more generally, time-varying supply-elasticity. We develop an equilibrium model in

which futures prices are determined endogenously in a production economy in which investment is

both irreversible and is capacity constrained. Investment constraints affect firms' investment

decisions, which in turn determine the dynamic properties of their output and consequently imply

that the supply-elasticity of the commodity changes over time. Since demand shocks must be

absorbed either by changes in prices, or by changes in supply, time-varying supply-elasticity results

in time-varying volatility of futures prices. Calibrating this model, we show it is quantitatively

consistent with the aforementioned “V-shape” relation between the volatility of futures prices and

the slope of the term-structure.

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Published: Leonid Kogan, Dmitry Livdan and Amir Yaron. Journal of Finance, 2009, vol. 64, issue 3, pages 1345-1375

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