volatility of commodity prices policy responses

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Volatility in commodity prices: Challenges and

Policy Responses

Dr. Vijay Kumar Varadi

Volatility of Commodity Prices

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Recently, commodities have become “asset class” Liquidity transmission into commodity assets Volatile stock market – “commodity markets are investors

heaven” Low interest rates in the host nations Hedge against weak dollar

Commodity market now is an important constituent of the financial markets.

It is important to develop a vibrant, active and liquid commodity market.

This would help investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities in the market.


Why so much interest in the commodity markets?

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There are active futures markets for many of the most important commodities – wheat, rice, crude oil etc.,

Active trading allows markets to efficiently incorporate information about supply and demand fundamentals. Standard economic theory suggests that incorporation of information should result in more efficient and less volatile price.

However, if uninformed trading takes place, futures market can act as a distorting lens that prices reflect misinformation. In that case, speculation may increase volatility.

Commodity futures prices were a kind of bubble over 2006-08 i.e., high volatility and high prices during the crisis


Futures Markets

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Volatile prices create uncertainty and can cause unplanned losses and bankruptcies

Volatility is a measure of directionless variability – typically the annualized standard deviation of log returns

Price level and volatility are usually correlated. Typically prices are more volatile when they are higher

because high prices are associated with low inventories which increases potential price responsiveness to shocks.

Link between prices and volatility has been observed (using GARCH(1,1) method) in corn, crude oil and wheat between (1907-2010). Please see in (Annex.1)


High or volatile prices?

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I. Traditional Factors for Price Volatility (Annex.2) Demand Factors Supply Factors

II. Monetary (Global Liquidity)

III. Financial Factors (Portfolio Investment and speculation)


Price Volatility Dynamics

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Monetary liquidity, which is often associated with short-term interest rates or the aggregate quantity of money, is commonly thought of as related to conditions in the short-term credit markets (Garry J. Schinasi 1999).

Monetary liquidity consists of short-to-medium term bank liabilities, which can fund trading and underwriting in securities and commodity markets.

The behavior of monetary aggregates may reflect not only contemporaneous output, price and interest rate developments, but also a “spectrum of yields” on a number of financial and real assets. Is money supply an indicator of inflationary pressure only? Or, the role of international transmission of monetary shocks and

investment on commodity markets?


II. Monetary (Global Liquidity)

Monetary liquidity in US markets: i) S&P commodity index

ii) Money supply, Commercial Bank Assets : Loans and leases

iii) Prime Rate charged by banks and inter bank interest rates

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Question 1: Money Supply an indicator of inflationary pressure? Ans. Yes. Both are Positively related

Question 2: The role of international transmission of monetary shocks and investment on commodity markets? Ans. When liquidity is high the investment in CFTC (long ) positions are also high and vice versa


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The traditional distinction in futures markets is between hedgers (“commercials”) and speculators (“non-commercials”).

Speculators are seen as trend-spotters. The concern is that trend spotting (“the trend is your friend”) can, in aggregate, create the trends that are subsequently identified.

Increasing speculative activity in futures markets – Large percentage of market place has no intent of taking futures

to delivery, causing price volatility. Commodity markets have started setting price of commodities as

an asset. Therefore created a price distortion and speculative bubble.


III. Have high prices been caused by speculation?

Stabilizing and destabilizing speculation

Source: P Shome (2011), “Capital Controls: Instruments and Effectiveness”, ICRIER Working Paper, 2001.

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Indian Commodity Markets…. Significant evidence for speculative bubble (index investors do play a major role in fueling the commodity prices volatility) during the financial crisis

Data Sources: Forward Markets Commission India, Period: April 2006 – March 2010

Speculation Bubble (Liquidity and Traded Volumes) in Commodity Markets


GOI intervened

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The transformation of commodities (commodity derivatives) into financial assets is often blamed for the instability of commodity prices.

A new breed of market participants are demanding commodities only on paper: Institutional investors - pension funds, endowments and other corporate investors

Commodity Index Investment Commodity index investment is an activity typically characterized

by a passive strategy designed to gain exposure to commodity price movements as part of portfolio diversification strategy.

Investors have identified commodities as an “asset class”. They see portfolio diversification advantages in adding a proportion of commodity futures to equity and bond portfolios i.e., obtaining a higher return for the same level of risk – Gorton and Rouwenhorst (2006).

The investors engaging in index activity in commodity markets include index funds, swap dealers, pension funds, hedge funds and mutual funds. And also includes exchange traded funds (ETFs), exchange traded notes (ETNs) and similar exchange-traded products that have a fiduciary or other obligation to track the value of similar commodity or basket of commodities in an essentially passive manner.


Financialization in commodity markets

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Financialization and its impact on commodity markets:i) Spot Commodity indices (SP) Vs. Open Interest (Long positions) (CME-GSCI) – Evidence the

feedback of information in spot markets and investors behaviour

ii) Spot Commodity indices (SP) Vs. ETNs and ETFs

iii) Commodity Price Index Vs Stock and Oil Price Index


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To make markets more efficient and transparent To address concerns over what some have characterized as

“excessive speculation” and “excessive volatility” in commodity markets. Excessive speculation can cause unreasonable or unwarranted price fluctuations.

There are six standard justifications for regulation Investor protection Detecting and preventing manipulation or abusive practices Checking Insider trading Reduction in systematic risk Externalities – excess volatility being the most important In the case of food articles, food security

Regulation to curb excess volatility Can we regulate to reduce volatility without jeopardizing market

liquidity?


Why Regulate?

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Regulators should address issues including Imposing Financial Transaction Tax (FTT) Making monetary policies stronger, safer and more transparent Surveillance on foreign portfolio investments (FIIs, FDIs and Exchange

Trade products)

In view of Recent Global crisis, regulators should address issues like Complexity of markets Instruments of global liquidity New disclosure norms and accounting practices

Promote stronger liquidity buffers at banks.

Develop tools for assessing the resilience of banks’ liquidity cushions and for constraining any weakening in liquidity maturity profiles, diversity of funding sources, and stress testing practices.


Regulators in global liquidity

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Given the global nature of commodity futures trading, international collaboration among regulators agencies is needed.

Impose speculative position limits for the purpose of preventing “excessive speculation” . Monitor daily potential violations in the market.

Surveillance of individual/institutional trader’s activities and potential market power and enforces speculative position limits by using a large trader reporting system (LTRS)

CFTC (2010) [Dodd-Frank Act] believes that the data generated from such reporting requirements are “reasonably necessary for implementing and enforcing aggregate position limits for certain physical commodity derivatives”

Exercise the special call provision for preventing insider trading and prevent manipulation or abusive practices

Ban on High Frequency Trading in Commodity markets Settle contracts every month – either by delivery or cash, reduce leverage by

increasing margins and reduce existing position limits.

Regulators in financialization & commodity markets


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Encourage further investigation on Role of OTC commodity derivatives Unorganized futures markets Insider trading and the role of ETFs and ETNs in commodity index

investments Order book commonalities on markets and liquidity

Regulators can take initiation to bring on table Causes for lack of convergence between the spot and futures markets The role of excessive short term bank lending in the phase of

aggravating the commodity price cycle

Cont….


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Prices are in levels, volatility calculated from GARCH(1,1) model

1. Source: USDA and British Petroleum Statistics, annual data series for 1907- 2010, Average Monthly Prices. Corn ($ per bushel), Wheat ($ per MT), Crude Oil ($ per barrel)

2. Results: Both high prices and volatility of respective commodities are correlated


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I. Traditional demand and supply factors for commodity price volatility

Source: Cooke, and Robles(2009) and other sources.

Factors Mechanism Demand-side Factors Rising world demand for grains Increasing purchasing power in emerging economies and rising

population Increased production of ethanol and biofuels Increased demand for biofuel, owing to the subsidies in the

United States and Europe

Increasing activity and speculation in futures markets

Large percentage of market place has no intent of taking futures to delivery, causing price volatility. Also, commodity markets have started setting prices of commodities as an asset instead according to market mechanism. Therefore created price distortion and speculative bubble.

Precautionary demand for food stock in many economies/purchases by importers

Sustained procurements in global markets made by Bangladesh and the Philippines

Easy monetary policy in USA or low real interest rates

Boosts demand through low interest rates

High FOREX reserves Causes inflation because of expensive imports Changing food consumption pattern Consumer preferences have been shifting away from cereals and

moving towards high-value agricultural produce due to higher incomes and changing lifestyles. Causes shifting of crop land towards high value commodities and hence pushing up prices of staples.

Supply- side Factors Low research and development investments in agriculture

Causes limited production growth

Trade barriers, export restrictions and import surges

Causing supply shortfalls of grains worldwide

Droughts and bad harvests Occurring mainly in Australia and China, major grain-producers, and hence lowering production

Decline in cereal yields Because of low production

Rising energy costs (oil and fertilizers) Through increasing transportation cost

Slow growth in agricultural production Because of low R & D investment

Reduction in food stocks Creates supply crunch and pushes up prices

Increased production of agro fuels Its cultivation absorbs agriculture land and reduces food production through substitution effect

Rising farm production costs Farmers generally pass on this increase in cost of production to retail prices of agricultural commodities

Other Factors Dollar devaluation Most commodities’ indicators are dollar nominated

Climate change Increasing temperatures, droughts and cyclones have negative impact on agri production and yields


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Thank You


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