Limits to Arbitrage and Hedging: Evidence from Commodity Markets
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.
We thank Nitiwut Ussivakul, Prilla Chandra, Arun Subramanian, Virendra Jain, Krishan Tiwari and Ramin Baghai-Wadji for excellent research assistance, and seminar participants at the AFA 2010, ASAP Conference 2007, Columbia University, EFA 2009 (winner of Best Paper on Energy Markets, Securities and Prices Award), Princeton University, the UBC Winter Conference 2008, David Alexander, Sreedhar Bharath, Patrick Bolton, Pierre Collin-Dufresne, Joost Driessen, Erkko Etula, Gary Gorton, Jose Penalva, Helene Rey, Stephen Schaefer, Tano Santos, Raghu Sundaram and Suresh Sundaresan for useful comments. We are grateful to Sreedhar Bharath and Tyler Shumway for supplying us with their naive expected default frequency data. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
“Limits to Arbitrage and Hedging: Evidence from Commodity Markets” with Lars Lochstoer and Tarun Ramadorai, forthcoming, Journal of Financial Economics. citation courtesy of