Sunday, August 14, 2016

The financialization of commodities - traders have to broaden their vision

There has been much discussion on the impact of institutions and indexing on commodity markets. Most of the press has been negative.  Large institutional non-hedgers are believed to have distorted prices and increased the correlation with other asset class. The empirical research on this topic has been mixed. While some have shown an impact from institutional usage, there are many studies that show no impact. The question has not been answered and more data may not provide the answer. 

Two researchers took a different approach to the problem by building a theory around the financialization of commodities. While there is no substitute for empirical work on the issue, their model in the Journal of Finance, "A Model of Financialization of Commodities", serves as a useful framework for discussion. There approach is similar to work done on index behavior in equity markets and uses a stochastic discount rate model to provide the foundation for their work. 

When institutions care about performance relative to a commodity index and use a discount rate relevant for their risks, there will be an increase in prices, volatility, and correlations for all commodities but especially of indexed commodities. Similarly, the equity-commodity correlation will also increase. The presence of institutions creates a link whereby financial shocks are transmitted to commodity markets. Institutions who invest in commodity indices reduce the market segmentation that previously existed between commodities and other markets by discounting risk uniformly. 

So what? This is just theory. It is important because it tells us what many have felt in market behavior. there is a link between financial shocks that spill-over to commodities. Commodity traders who prided themselves on being experts in their markets now need to also focus on shocks that could affect the wealth of institutional players. If risk in financial markets change such as with the VIXX volatility index, there will be a carry-over to commodities and there will be a differential between the impact on index commodities and those that are not in an index. 

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