What explains the rise in commodity derivatives?

Parantap Basu and William Gavin write a paper on the topic.

The authors point to some startling facts on the rise of commodity derivatives:

  • In 2002 commodity futures index funds at $ 20 bn. In 2008 – $ 250 bn
  • In OTC,  gross market value of commodity derivatives rose by a factor of 25 between June 2003 and June 2008—
    reaching $2.13 trillion in June 2008
  • The outstanding notional amounts of commodity derivatives contracts amount tripled between June 1998 and June 2003 and then rose 19-fold in the next 5 years, peaking at $13 trillion in June 2008. During this period, trading in commodity derivatives grew to exceed trading in equity derivatives
  • Even at 2008 prices, the total output of commodities was less than half the notional value of  outstanding commodity derivatives contracts (nearly $13 trillion)
  • The ratio of the notional amount of commodity derivatives contracts in June 1998 to world GDP rose from 1.5 percent
    in 1998 to 21.6 percent in 2008. Over the same period, the ratio of equity derivatives to world GDP rose from 4.2 percent to 16.7

They point to two reasons for this rise in commodity derivatives

  • Search for yield: Trading in commodity derivatives increased along with the rapid expansion of trading in all derivative markets. This trading was directly related to the search for higher yields in a low interest rate environment. The search for higher yields refers to the tendency of both individual and institutional investors to choose riskier assets when the return on safe assets is low.
  • Hedging Purposes: Second, investors used commodity futures to hedge against equity risk. Both academic and industry economists argued that a negative correlation between returns on equity and commodity futures offered an unexploited hedging opportunity in using commodity derivatives as an asset class.

We so see search for yield hypothesis being true as commodity derivates surge along with rise in other derivatives as well. Low interest rates by central banks led investors to find alternate classes.

The authors say buying commodities for hedging inflation risk is still ok. But for equity risk is controversial. Before the crisis, there was a case for correlation between equity and derivatives being negative/xero. But after the crisis the correlation has become positive with both moving together. Hence, the relationship is not stable and permanent and can reverse anytime.

What are the lessons? It is not to curb activity in this market but to increase transparency:

A lesson from the crisis is that regulators and policymakers should monitor financial innovations closely to learn whether they are being used to take excessive risks—that is, risks firms would not take if they were operating outside the government’s safety net. Under new regulations, the CFTC will collect information that should make trading in commodity derivatives more transparent. Banks argue that they need to use commodity derivatives to help customers manage risks. This may be true, but the recent experience in commodity futures did not reduce risks but exacerbated them just at the wrong time. The challenge to the government is to prevent too-big-to-fail firms from using current and yet invented derivatives to increase overall risk in the financial system.

Standard advice.

Addendum:

Richard Anderson of St Louis Fed in this paper looks at whether low interest rates lead to bubbles in commodity market. He says this rise in commodity prices is a natural reaction to easy mon pol. In other words, the purpose of easy monetary policy is to boost asset prices which then leads to improvement in economic activity:

As long as the FOMC’s pursuit of highly expansionary policy continues, households and businesses remain pessimistic, and  demand is sluggish, the potential exists for asset prices to deviate from their long-run levels by large amounts and for long periods. Such increases per se are not bubbles but a commonplace reaction of the monetary transmission mechanism. Yet, monitoring of prices is essential lest future adjustments be misunderstood by the public as part of the dynamics of aggressive monetary policy. Whether bubbles have been generated remains to be seen.

All confusion really. This crisis has just opened a can of worms on all economic issues.

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One Response to “What explains the rise in commodity derivatives?”

  1. Tweets that mention What explains the rise in commodity derivatives? « Mostly Economics -- Topsy.com Says:

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