The role of hedgers and speculators in commodity...

Brunetti, The role of hedgers and speculators in commodity markets - Thematic Semester

The role of hedgers and speculators incommodity markets

Celso Brunetti

Thematic Semester on Commodity Derivatives MarketsParis

November 6, 2015

Brunetti, The role of hedgers and speculators in commodity markets - Thematic Semester

The views expressed here are solely the responsibility of the author andshould not be interpreted as reflecting the view of the Board of Governorsof the Federal Reserve System or of any other person associated with theFederal Reserve System.

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterIntroduction

Introduction

Commodity markets are evolving

Historical low correlation with other asset classesCommodities: a new asset classCommodity Index Traders (CITs)

Introduction

Historical low correlation with other asset classes

Commodities: a new asset classCommodity Index Traders (CITs)

Introduction

Historical low correlation with other asset classesCommodities: a new asset class

Commodity Index Traders (CITs)

Introduction

Historical low correlation with other asset classesCommodities: a new asset classCommodity Index Traders (CITs)

Introduction - cont’dThree papers (and some preliminary results)

Brunetti and Reiffen: Commodity Index Trading andHedging Costs (Journal of Financial Markets, 2014)Brunetti, Buyuksahin and Harris: Speculation, Prices andVolatility (JFQA, forthcoming)Brunetti, Buyuksahin and Harris: Regime switching,hedgers and speculators (work in progress)Brunetti and Reiffen: Are hedgers hedging? (Preliminaryresults, no paper yet)

Brunetti and Reiffen: Commodity Index Trading andHedging Costs (Journal of Financial Markets, 2014)

Brunetti, Buyuksahin and Harris: Speculation, Prices andVolatility (JFQA, forthcoming)Brunetti, Buyuksahin and Harris: Regime switching,hedgers and speculators (work in progress)Brunetti and Reiffen: Are hedgers hedging? (Preliminaryresults, no paper yet)

Brunetti and Reiffen: Commodity Index Trading andHedging Costs (Journal of Financial Markets, 2014)Brunetti, Buyuksahin and Harris: Speculation, Prices andVolatility (JFQA, forthcoming)

Brunetti, Buyuksahin and Harris: Regime switching,hedgers and speculators (work in progress)Brunetti and Reiffen: Are hedgers hedging? (Preliminaryresults, no paper yet)

Brunetti and Reiffen: Commodity Index Trading andHedging Costs (Journal of Financial Markets, 2014)Brunetti, Buyuksahin and Harris: Speculation, Prices andVolatility (JFQA, forthcoming)Brunetti, Buyuksahin and Harris: Regime switching,hedgers and speculators (work in progress)

Brunetti and Reiffen: Are hedgers hedging? (Preliminaryresults, no paper yet)

Brunetti and Reiffen: Commodity Index Trading andHedging Costs (Journal of Financial Markets, 2014)Brunetti, Buyuksahin and Harris: Speculation, Prices andVolatility (JFQA, forthcoming)Brunetti, Buyuksahin and Harris: Regime switching,hedgers and speculators (work in progress)Brunetti and Reiffen: Are hedgers hedging? (Preliminaryresults, no paper yet)

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterData

CFTC data: Large Trader Reporting System (andmore)

LTRS identifies daily positions of individual tradersclassified by line of business.

Reporting thresholds: e.g. 350 contracts for crude oil,200 contracts for natural gas and 250 contracts for corn.LTRS data represents approximately 70 to 90 percent oftotal open interest in each market.The LTRS data identifies growth in speculative positions.

LTRS identifies daily positions of individual tradersclassified by line of business.Reporting thresholds: e.g. 350 contracts for crude oil,200 contracts for natural gas and 250 contracts for corn.

LTRS data represents approximately 70 to 90 percent oftotal open interest in each market.The LTRS data identifies growth in speculative positions.

LTRS identifies daily positions of individual tradersclassified by line of business.Reporting thresholds: e.g. 350 contracts for crude oil,200 contracts for natural gas and 250 contracts for corn.LTRS data represents approximately 70 to 90 percent oftotal open interest in each market.

The LTRS data identifies growth in speculative positions.

LTRS identifies daily positions of individual tradersclassified by line of business.Reporting thresholds: e.g. 350 contracts for crude oil,200 contracts for natural gas and 250 contracts for corn.LTRS data represents approximately 70 to 90 percent oftotal open interest in each market.The LTRS data identifies growth in speculative positions.

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterBrunetti and Reiffen: Commodity Index Trading and Hedging Costs (JFM, 2014)

Introduction

Brunetti and Reiffen: Commodity Index Tradingand Hedging Costs (JFM, 2014)

How CITs affect the cost of hedging

I Fundamental role of commodity marketsI Medium-term perspective

Theoretical model of how different agents behave in thesemarketsTest the model using LTRS data: Ags onlyI Sample: July 2003 – November 2012

Introduction

How CITs affect the cost of hedgingI Fundamental role of commodity marketsI Medium-term perspective

Introduction

Theoretical model of how different agents behave in thesemarkets

Test the model using LTRS data: Ags onlyI Sample: July 2003 – November 2012

Introduction

Hedging Costs

Short hedge: a corn grower is able reduce her exposure toprice risk by taking a short position in the futures market.

Long Hedge: a flour mill, that plans to buy the crop afterit matures, can reduce its exposure to price risk by buyingthe crop in advance using futures.Cost of hedging: it is the equilibrium discount price (fromexpected spot prices) hedgers accept in order to avoidprice risk.

Hedging Costs

Short hedge: a corn grower is able reduce her exposure toprice risk by taking a short position in the futures market.Long Hedge: a flour mill, that plans to buy the crop afterit matures, can reduce its exposure to price risk by buyingthe crop in advance using futures.

Cost of hedging: it is the equilibrium discount price (fromexpected spot prices) hedgers accept in order to avoidprice risk.

Hedging Costs

Short hedge: a corn grower is able reduce her exposure toprice risk by taking a short position in the futures market.Long Hedge: a flour mill, that plans to buy the crop afterit matures, can reduce its exposure to price risk by buyingthe crop in advance using futures.Cost of hedging: it is the equilibrium discount price (fromexpected spot prices) hedgers accept in order to avoidprice risk.

Hedging Costs

Two-step procedure

Yt,i ,j = [Et(PT )− Pt ]/Pt

= b0,i ,j + b1,i ,jYt−1,i ,j + b2,i ,jΛt,i ,j +

b3,i ,jVolt,i ,j + b4,i ,jrt + b5,i ,jADSt + b6,i ,jDSt + εt,i ,j

b0,i ,j = a0,j + a1,j Ii ,j + a2,jC aggi ,j +

3∑k=1

a2+k,jFF ki ,j + υi ,j

σ0,i ,j = z0,j + z1,j Ii ,j + z2,jC aggi ,j +

3∑k=1

z2+k,jFF ki ,j + ξi ,j

Hedging Costs

Table 2: Hedging Costs

Corn Soy WheatHedging Cost Volatility of

hedging costHedging Cost Volatility of

hedging costIi,j -4.86e-07*** -2.51e-08** -3.78e-06* -5.41e-08** -3.01e-07* -2.55e-08*

(0.73e-07) (1.19e-08) (2.64e-06) (2.61e-08) (2.14e-07) (1.94e-08)

Caggi,j 1.05e-07*** 4.81e-08*** 6.53e-07 2.51e-08*** 9.80e-07 1.03e-09

(1.11e-08) (2.27e-08) (8.86e-7) (8.80e-09) (1.44e-06) (1.35e-08)

R2 0.0994 0.2357 0.0785 0.1551 0.0429 0.1113

Note: Bootstrapped standard errors are in parentheses. Asterisks indicate significance at 20% (*), 5% (**),and 1% (***).

Some Empirical Regularities

Hedgers (Distributors, Wheat)

Some Empirical Regularities

CITs, (Soy)

The Model

The ModelTwo maturities

Three agentsI CITs: their positions are exogenous and contain no

information.I Hedgers and Speculators have symmetric knowledge of

market fundamentals but have different endowments.Hedgers have positions in both futures and cash marketswhile speculators only have positions in futures markets.

The Model

The Model - cont’d

U(W ) = A− exp(−αW2)

W2 = W0 + X 21 (P2

1 − P20 ) + X 2

2 (P22

−P21 ) + X 1

1 (P11 − P1

0 ) + P22 Ck

The agent consumes her entire period 2 wealth, which is equalto her initial wealth, plus the value of her position in theunderlying, plus the gain/loss she makes on the futures.

The Model

The Model - cont’dAs index traders roll their positions the spread rises. Thisis to be expected, since there is a selling pressure on thematurity i contract and a buying pressure on the maturityi+1 contract. It is not trading per se that affects thespread, but rather the relative sizes of positions in the twomaturities.The spread depends also on hedgers’ cash positions. Thiseffect depends on the production cycle.The price of hedging should be correlated acrosscommodities, at least for those commodities within thetypical fund’s holdings.

Estimating the model

The spread exhibits serial correlation andheteroskedasticityGARCH(1,1)I with variance targetingI GEDI seasonality on both conditional mean and variance

Estimating the model

Main findings

CITs reduce the cost of hedging.CITs have an impact on futures prices: the spreadincreases when rolling.The spread depends on hedgers’ cash positions.

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterBrunetti, Buyuksahin and Harris: Speculators, Prices and Market Volatility (JFQA, forthcoming)

Introduction

Speculators, Prices and Market Volatility(JFQA, forthcoming)

Is speculative activity destabilizing markets?

Does speculative activity move prices?Does speculative activity increase volatility?

We use daily position-level participant data from theCFTC for three markets (2005 - 2009)I Crude oilI Natural gasI Corn

Instrumental variable approach

Introduction

Speculators, Prices and Market Volatility(JFQA, forthcoming)

Is speculative activity destabilizing markets?

Does speculative activity move prices?Does speculative activity increase volatility?

We use daily position-level participant data from theCFTC for three markets (2005 - 2009)I Crude oilI Natural gasI Corn

Instrumental variable approach

Crude oil

Three datasetsI High frequency data → realized volatilityI Daily settlement prices → returnsI Daily positions from LTRS → trading activity

Nearby contractHigh frequency data: very liquid market, medianinter-trade duration below a second

Trader positions

Correlations

Trader position changes and volatility

The instrument

The change in the number of reporting accounts

Traders with large positions are required to report to theCFTC each day.The cost of reporting positions to the CFTC is high.Traders near the reporting threshold continue reportingdaily.Over longer horizons, however, traders falling belowreporting thresholds stop reporting.Position reporting thresholds are set as a number ofcontracts so that market prices do not play a direct rolein whether an account is required to report.

The instrumentThe change in the number of reporting accounts

Traders with large positions are required to report to theCFTC each day.The cost of reporting positions to the CFTC is high.Traders near the reporting threshold continue reportingdaily.Over longer horizons, however, traders falling belowreporting thresholds stop reporting.Position reporting thresholds are set as a number ofcontracts so that market prices do not play a direct rolein whether an account is required to report.

The model

Heterogeneous Autoregressive model of Realized Volatility(HAR-RV) developed by Corsi (2008)

[RV di ,t ]1/2 = αi + γd [RV d

i ,t−1]1/2 + γw [RV wi ,t−1]1/2 +

γm[RV mi ,t−1]1/2 + βj

i |∆TP ji ,t |+ εi ,t

We estimate the model with the two-stage weak instrumentalvariable approach of Stock and Yogo (2005).

Estimation results

Trader position changes and returns

Same instrument

Ri ,t = ϑi +5∑

k=1ζi ,kRi ,t−k + κj

i ∆TP ji ,t + νi ,t

We estimate the model with the two-stage weak instrumentalvariable approach of Stock and Yogo (2005).

Trader position changes and returns

Estimation results

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterResults

Results, so far

CITs reduce the cost of hedging.CITs have an impact on the spread between the futures ofdifferent maturities.Hedge funds and swap dealers seem to reduce volatilityand, perhaps, provide liquidity.Hedgers seem to increase volatility.Swap dealer activity is not linked to returns.

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterBrunetti, Buyuksahin and Harris: Regime switching, hedgers and speculators (work in progress)

Introduction

Regime switching, hedgers and speculators(work in progress)

Our data cover the period in which commodity priceswent up and down → regime switching approach.Same CFTC positions data as previous paper.Crude oil only.Consider the effect of economic activity.

Trader positions and economic activity

To isolate trading behavior not linked to fundamentals, wefilter traders positions

ADS (economic condition)TED spreadExpected inflation and CPIInventory and Inventory surpriseSeasonality (Fourier transform) plus other controls

Strong link between economic activity and fundamentals.

Regime switching model with time varying probabilities

Regime switching model

yt = µs +k∑

j=1θjXj,t + εt

εt = σtut and ut ∼ iidN(0, 1)

σ2t (St , St−1, ..., S0) = ω(St) +

p∑jαj(St−j)ε

2t−j +

q∑jβj(St−j)σ

2t (St−1, ..., S0)

Pr(St = 0|St−1 = 0,Zt−1) = p00,t = Φ(Z ′

t−1ζ)

Pr(St = 1|St−1 = 1,Zt−1) = p11,t = Φ(Z ′

t−1τ)

Regime switching model - Main findings

The model identifies 2 regimes: Bull and bear markets.Volatility in bear market is about 10 times larger than inbull markets.Hedgers have a significant and positive coefficient in thetime-varying probabilities.Swap dealers (CITs) never significant.Hedge funds not significant in bull market but significantand negative in bear market.

Results, so far

Our evidence suggests that

Hedgers do have an impact on commodity markets, andrightly so.Hedge funds seem to stabilze prices and volatility.Swap dealers do not seem to be connected to regimeshifts.

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterBrunetti and Reiffen: Are hedgers hedging?

Main idea

Are hedgers hedging?

Hedgers play an important role in commodity markets.

Main idea

Hedgers play an important role in commodity markets.Are hedgers hedging?

Data and results

Data on hedgers cash positions.

Combined with LTRS.Compute hedge ratios.Hedge ratios vary considerable and are both positive andnegative.

Data and results

Data on hedgers cash positions.Combined with LTRS.

Compute hedge ratios.Hedge ratios vary considerable and are both positive andnegative.

Data and results

Data on hedgers cash positions.Combined with LTRS.Compute hedge ratios.

Hedge ratios vary considerable and are both positive andnegative.

Data and results

Data on hedgers cash positions.Combined with LTRS.Compute hedge ratios.Hedge ratios vary considerable and are both positive andnegative.

Brunetti, The role of hedgers and speculators in commodity markets - Thematic SemesterConcluding remarks

Concluding remarks

Commodities: very interesting markets.

Yet new players.Why crude oil price is so low?Linkages between large investment banks and commoditymarkets.Liquidity commodity markets.

Concluding remarks

Commodities: very interesting markets.Yet new players.

Why crude oil price is so low?Linkages between large investment banks and commoditymarkets.Liquidity commodity markets.

Concluding remarks

Commodities: very interesting markets.Yet new players.Why crude oil price is so low?

Linkages between large investment banks and commoditymarkets.Liquidity commodity markets.

Concluding remarks

Commodities: very interesting markets.Yet new players.Why crude oil price is so low?Linkages between large investment banks and commoditymarkets.

Liquidity commodity markets.

Concluding remarks

Commodities: very interesting markets.Yet new players.Why crude oil price is so low?Linkages between large investment banks and commoditymarkets.Liquidity commodity markets.

THANK YOU

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