Hedging Risk or Selling the Hungry Short? The Impact of Derivatives Trade on Commodity Prices

Melissa Naomi Benjovitz & Martin Christian Rannje

Student thesis: Diploma thesis

Abstract

In this paper we examine the relationship between trade with commodity derivatives and the prices of the underlying assets. For 4 selected commodities in the grains sector we specifically examine whether trade with futures contracts, can cause prices of the underlying assets to become more volatile or simply change. We do this by testing the relationships between the measures volume and open interest and monthly spot price change and volatility. During our investigation we discuss the theoretical transmission mechanisms between trade with futures contracts and the spot price market, and examine any associations between the spot and futures price. We also test for directions of causality by employing so-called “Granger tests” on our key variables. We find that there is evidence of an association between spot price volatility and trade with derivatives, but that the causal direction is uncertain. The evidence suggests that increasing transactions in the market is associated with higher levels of volatility, but that the larger the size of the total market, the lower the volatility of spot prices. The reason could be that with larger and more mature derivatives markets, producers are better able to plan and hedge and carry their supplies forward to the time where demand is highest. We furthermore find that there is no evidence of an association between the development in spot price and trade with derivatives. There is however evidence of a plausible transmission mechanism between the futures and spot market, but again it is difficult to determine the direction of causality. The paper concludes with some directions for further research

EducationsGraduate Diploma in Finance, (Diploma Programme) Final Thesis
LanguageEnglish
Publication date2012
Number of pages109