Financialization and speculators risk premia in commodity futures markets

J.M. Keynes coined the term normal backwardation, a situation where a futures price for a particular expiry month is less than the expected spot price for that month. He argued hedgers pay speculators a risk premium, giving rise to normal backwardation. We study the behavior of commodity futures before and since financialization of the markets, which started about 20 years ago. We find the poor returns to managed futures in recent years are likely due to the impact of financialization and the associated outside money suppressing the futures risk premium.     

Limits to arbitrage and hedging: Evidence from commodity markets

We build an equilibrium model of commodity markets in which speculators are capital constrained, and commodity producers have hedging demands for commodity futures. Increases in producers' hedging demand or speculators' capital constraints increase hedging costs via price-pressure on futures. These in turn affect producers' equilibrium hedging and supply decision inducing a link between a financial friction in the futures market and the commodity spot prices. Consistent with the model, measures of producers' propensity to hedge forecasts futures returns and spot prices in oil and gas market data from 1979 to 2010. 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 equilibrium commodity supply and prices.     

Nonlinear relationship between crude oil price and net futures positions: A dynamic conditional distribution approach

This study examines the dynamic relationship between crude oil prices and net futures positions using a dynamic conditional density that can take account of time-varying bimodality. The shape of conditional density is modeled directly by specifying functional coefficients. We find that when the crude oil price is on the rise (decline), speculators tend to take long (short) positions to make profits and hedgers tend to take short (long) positions to cover the risk in the physical market. On the other hand, speculators have a positive effect on the price whereas hedgers have a negative effect. Therefore, when the price is on the rise (decline), speculators tend to push it up (pull it down) while hedgers tend to pull it down (push it up). This effect becomes stronger in the recent period. Moreover, the sharp increase of the crude oil price can be explained by speculating and hedging behavior through conditional higher-order moments.     

Futures Commitments and Exchange Rate Volatility

It is commonly suggested that certain groups of futures traders, such as speculators and small traders, exacerbate cash market volatility. Empirical research on the subject has been conducted in context of the relationship between price volatility and futures volume or open interest and fails to satisfactorily resolve such an issue. This paper examines the relationship between exchange rate variability and futures trading activity in the context of disaggregated open interest. The data and techniques employed allow for more specific inferences regarding which group of traders contribute to exchange volatility. The results suggest that while 'typical' levels of futures commitments are not destabilizing, surges in the level of commitments of large speculators and small traders causes exchange rate volatility. The actual release of the commitment-of-traders data, however, has no impact on spot prices.     

Profitability of return and sentiment-based investment strategies in US futures markets

Our study adds to the literature by providing initial evidence on the interaction between short-horizon return predictability and investors’ sentiment by traders’ types on US commodity futures market. We find that the short-term contrarian profit is more associated with an increase rather than a decrease in hedgers’ sentiment. However, the interaction between lagged return and past change in speculators’ sentiment illustrates that the short-term contrarian profit is more associated with a decrease rather than an increase in sentiment. Based on behavioral finance theories, we conclude that hedgers behave like irrational traders while speculators behave like rational ones. Using Chou et al. (2007) decomposition, our results confirm the obtained relations between change in trader's sentiment and the overreaction. By expanding this decomposition, we find that the winners’ portfolio tends to more overreact with futures specific information. Also, the cross-autocorrelation between winners and losers and between losers and winners can represent another source of contrarian profits.     

Time series momentum

We document significant “time series momentum” in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for one to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets. Examining the trading activities of speculators and hedgers, we find that speculators profit from time series momentum at the expense of hedgers.     

Information, Trading Demand, and Futures Price Volatility

We examine the relation between futures price volatility and trading demand by type of trader in the Standard & Poor's (S&P) 500-stock index futures market. We find that volatility covaries negatively with signed speculative demand shocks but is positively related to signed hedging demand shocks. No significant relation between volatility and demand shocks for small traders is found. Our results suggest that changes in positions of large hedgers destabilize the market, whereas changes in positions of large speculators stabilize volatility. Consistent with models with asymmetrically informed traders, we find that large speculators are likely to possess superior forecasting ability, large hedgers behave like positive feedback traders, and small traders are liquidity traders.     

A continuous time equilibrium model of forward prices and futures prices in a multigood economy

This paper is a theoretical investigation of equilibrium forward and futures prices. We construct a rational expectations model in continuous time of a multigood, identical consumer economy with constant stochastic returns to scale production. Using this model we find three main results. First, we find formulas for equilibrium forward, futures, discount bond, commodity bond and commodity option prices. Second, we show that a futures price is actually a forward price for the delivery of a random number of units of a good; the random number is the return earned from continuous reinvestment in instantaneously riskless bonds until maturity of the futures contract. Third, we find and interpret conditions under which normal backwardation or contango is found in forward or futures prices; these conditions reflect the usefulness of forward and futures contracts as consumption hedges.     

A Model of Financialization of Commodities

We analyze how institutional investors entering commodity futures markets, referred to as the financialization of commodities, affect commodity prices. Institutional investors care about their performance relative to a commodity index. We find that all commodity futures prices, volatilities, and correlations go up with financialization, but more so for index futures than for nonindex futures. The equity‐commodity correlations also increase. We demonstrate how financial markets transmit shocks not only to futures prices but also to commodity spot prices and inventories. Spot prices go up with financialization, and shocks to any index commodity spill over to all storable commodity prices.     

What is going on in the oil market?

Conclusion In this article, we propose a consistent view on the recent oil-price history based on fundamental data and economic theory. We sum up: After the turn of the century three major stylized shocks have hit market. First, the demand curve has shifted fight outwards, mainly driven, as extensively reported in the media, by sustained growth in China and other Asian Countries. Second, supply disruptions in countries with low extraction costs (Iraq and Venezuela) have shifted the supply curve to the left. Third, we show that speculators adjust their inventories in order to take advantage of predictable price fluctuations and play themselves a major role in the price formation. Optimal storage theory implies that aggregate inventories are negatively related to the oil price and positively to the volatility of supply and demand shocks. We provide evidence that the political events in the last years have increased volatility and induced the inventory curve to shift right outwards. We analyze in a graphical framework the interaction of all these shocks and conclude that speculators have caused the oil price to overshoot in the short run its long-run fundamental value. However, this is not at all attributable to market failure or the harmfulness of speculators. In fact, the opposite is true. Speculators have in general a dampening effect on the oil price. The record oil price in the very recent history is partly a consequence of speculators maintaining or building-up inventories to cope with the supply and demand shocks to come. Hence, high prices represent a short-term toll for future price stability. It follows from our analysis that the oil price is expected to fall towards its long-term mean, provided that no further shocks hit the economy and, critically, the oil supply. As we saw, this prediction is consistent with the observed prices in the futures markets. Also in terms of future price volatility, the outlook is rather upbeat. The increased inventory levels held by speculators will cushion the spot market against fluctuations in natural supply and demand and limit the degree to which the currently high underlying volatility will translate into higher price volatility. We would like to thank Manuel Ammann, Bernd Brommundt, Stephan Kessler, Ralf Seiz, Michael Verhofen, Hemrich von Wyss, and two anonymous referees for helpful comments We are particularly indebted to Sergej Peisotchenko at United Energy System (UES) of Russia and Jan Gjerde at Shell for clearing us up on technical aspects of oil production     

Speculators,commodities and cross-market linkages

We use a unique, non-public dataset of trader positions in 17 U.S. commodity futures markets to provide novel evidence on those markets' financialization in the past decade. We then show that the correlation between the rates of return on investible commodity and equity indices rises amid greater participation by speculators generally, hedge funds especially, and hedge funds that hold positions in both equity and commodity futures markets in particular. We find no such relationship for commodity swap dealers, including index traders (CITs). The predictive power of hedge fund positions is weaker in periods of generalized financial market stress. Our results support the notion that who trades helps predict the joint distribution of commodity and equity returns. We find qualitatively similar but statistically weaker results using a proxy for hedge fund activity based on publicly available data.     

Futures Commitments and Commodity Price Jumps

We examine the relationship between the commitments of three of the largest groups of futures traders and the abnormal price movements in five agricultural commodities. The general evidence suggests that the commitments of futures traders have been increasing over time, whereas the frequency of price jumps have not. Regression results indicate a negative relationship between price jumps and the commitments of speculators and small traders. There is also evidence of a negative relationship between the number of speculators and cash market volatility, consistent with a host of speculation-based theories.     

Cross‐Asset Speculation in Stock Markets

In practice, heterogeneously informed speculators combine private information about multiple stocks with information in prices, taking into account how their trades influence the inferences of other speculators via prices. We show how this speculation causes prices to be more correlated than asset fundamentals, raising price volatility. The covariance structure of asset fundamentals drives that of prices, while the covariance structure of liquidity trade drives that of order flows. We characterize how speculator profits vary with the distributions of information and liquidity trade across assets and speculators, and relate the cross‐asset factor structure of order flows to that of returns.     

Informed arbitrage with speculative noise trading

We consider speculative noise trading when some naïve speculators trade on noise as if it were information [Black, F., 1986. Noise. Journal of Finance 41, 529–543]. We examine the optimal trading strategy of an informed investor who faces such naïve speculators in the market. We find that the informed investor trades aggressively on her information and takes large, opposite positions against the naïve speculators. The trading volume is thereby drastically magnified. While such speculative noise trading enhances liquidity, it makes prices less efficient. The overall dynamic patterns that emerge from our model are most consistent with the evidence for interday variations in volume, volatility, and transaction costs.     

Pricing Efficiency and Arbitrage in the Bitcoin Spot and Futures Markets

This study examines the pricing efficiency for the leading cryptocurrency, Bitcoin using spot prices and all CBOE and CME futures contracts traded from January 2018 to March 2019. We find that the futures basis provide some predictive power for future changes in the spot price and in the risk premium. However, the basis of Bitcoin is a biased predictor of the future spot price changes. Cointegration tests also demonstrate that futures prices are biased predictors of spot prices. Deviations from no-arbitrage between spot and futures markets are persistent and widen significantly with Bitcoin thefts (hacks, frauds) as well as alternative cryptocurrency issuances.     

The relative pricing of European dividend futures and their predictive abilities for index returns

We use dividend futures prices to derive a dividend future discount model. Arbitrage arguments postulate that the sum of discounted dividend futures prices should equal the index price, i.e. the sum of discounted dividends. We analyze whether this relation holds and find that the two valuation approaches lead to a different valuation of expected dividends. These observations indicate that dividend futures and index prices seem to provide the investor with different information on future dividends. We further show that the difference in valuation can be used to forecast index returns and show how an investment strategy can exploit this predictability.     

Trading activities and price discovery in foreign currency futures markets

This study investigates the relation between trading activities and the price discovery efficacy of the futures markets for EUR–USD and JPY–USD. According to data pertaining to weekly positions, collected from the Commitments of Traders reports distributed by the Commodity Futures Trading Commission, the information share of currency futures markets declines with hedgers’ positions but increases with speculators’ positions. In addition, both hedgers’ expected and unexpected positions have negative impacts on the contribution of the futures market; the futures market’s information share relates positively to speculators’ expected positions but is uncorrelated with speculators’ unexpected positions.     

Feedback trading in stock index futures: Evidence from South Africa

This study tests whether investors and speculators in stock index futures contracts on the South African stock market use feedback trading strategies. Feedback trading can be destabilizing and impede on the risk mitigation and price discovery functions of futures contracts. Using the Sentana and Wadhwani (1992) model, and accounting for the global financial crisis, we find no evidence of feedback trading in the Top40 futures index or the Top40 mini futures index contracts. Our findings have important implications for investors who wish to use index futures to mitigate risk or exploit arbitrage opportunities and regulators concerned about the destabilizing effects of futures trading.     

What does futures market interest tell us about the macroeconomy and asset prices?

Economists have traditionally viewed futures prices as fully informative about future economic activity and asset prices. We argue that open interest could be more informative than futures prices in the presence of hedging demand and limited risk absorption capacity in futures markets. We find that movements in open interest are highly pro-cyclical, correlated with both macroeconomic activity and movements in asset prices. Movements in commodity market interest predict commodity returns, bond returns, and movements in the short rate even after controlling for other known predictors. To a lesser degree, movements in open interest predict returns in currency, bond, and stock markets.     

The relationship between futures trading activity and exchange rate volatility,revisited

This paper examines the relationship between trading activity in currency futures and exchange rate volatility. In order to measure trading activity, the paper uses both volume and open interest to distinguish between speculators/day traders and hedgers. The study uses three different measures of volatility: (1) the extreme value estimator that measures intra-day volatility; (2) historical volatility; and (3) conditional volatility from the GARCH (1, 1) process. Main finding is that speculators and day traders destabilize the market for futures. Whether hedgers stabilize or destabilize the market is inconclusive. The results suggest that speculators’ demand for futures goes down in response to increased volatility. Meanwhile, the demand from hedgers shows mixed results, depending on the method used to measure volatility.