1. Volatility in commodity prices:
Challenges and Policy Responses
Dr. Vijay Kumar Varadi
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2. Why so much interest in the commodity markets?
 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.
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3. Futures Markets
 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
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4. High or volatile prices?
 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)
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5. Price Volatility Dynamics
I. Traditional Factors for Price Volatility (
Annex.2)
 Demand Factors
 Supply Factors
II. Monetary (Global Liquidity)
III. Financial Factors (Portfolio Investment and
speculation)
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6. II. Monetary (Global Liquidity)
 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?
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7. Monetary liquidity in US markets:
i) S&P commodity index
iii) Money supply, Commercial Bank Assets : Loans and leases
iv) Prime Rate charged by banks and inter bank interest rates

8. 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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9. III. Have high prices been caused by speculation?
 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.
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10. Stabilizing and destabilizing speculation
Source: P Shome (2011), “Capital Controls: Instruments and Effectiveness”, ICRIER
Working Paper, 2001.

11. Speculation Bubble (Liquidity and Traded Volumes) in Commodity Markets
GOI intervened
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
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12. Financialization in commodity markets
 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.
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13. Financialization and its impact on commodity markets:
ii) Spot Commodity indices (SP) Vs. Open Interest (Long positions) (CME-GSCI) – Evidence the
feedback of information in spot markets and investors behaviour
iii) Spot Commodity indices (SP) Vs. ETNs and ETFs
iv) Commodity Price Index Vs Stock and Oil Price Index
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14. Why Regulate?
 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?
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15. Regulators in global liquidity
 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.
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16. Regulators in financialization & commodity markets
 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.
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17. Cont….
 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
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18. Prices are in levels, volatility calculated from GARCH(1,1) model
• 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)
• Results: Both high prices and volatility of respective commodities are correlated
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19. I. Traditional demand and supply factors for commodity price volatility
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 Large percentage of market place has no intent of taking futures
markets 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 Sustained procurements in global markets made by Bangladesh
economies/purchases by importers and the Philippines
Easy monetary policy in USA or low real interest Boosts demand through low interest rates
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 Causes limited production growth
agriculture
Trade barriers, export restrictions and import Causing supply shortfalls of grains worldwide
surges
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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Source: Cooke, and Robles(2009) and other sources.

20. Thank You
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