DP7327 Limits to Arbitrage and Hedging: Evidence from Commodity Markets

Author(s): Viral V. Acharya , Lars Lochstoer , Tarun Ramadorai

Publication Date: June 2009

Keyword(s): Commodities , Futures , Hedging , Limits to Arbitrage

JEL(s): G12 , G13

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP7327.asp.asp

We build an equilibrium model with commodity producers that are averse to future cash flow variability, and hedge using futures contracts. Their hedging demand is met by financial intermediaries who act as speculators, but are constrained in risk-taking. Increases (decreases) in producers’ hedging demand (the risk-bearing capacity of speculators) increase the costs of hedging, which preclude producers from holding large inventories, and thus reduce spot prices. Using oil and gas market data from 1980-2006, we show that producers’ hedging demand - proxied by their default risk - forecasts spot prices, futures prices and inventories, consistent with our model. Our analysis demonstrates that limits to financial arbitrage can generate limits to hedging by firms, affecting prices in both asset and goods markets.