Volatility of commodity prices policy responses


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  • Volatility of Commodity Prices
  • Stock markets are 2-4% volatile in normal trading days, it would go to the extent of 8% in times of turmoil. Whereas Commodity markets are less volatile. Hedge against weak dollar –US dollar moves inversely to commodity prices The inflationary impact of the commodity markets is largely determined by the trend of US $. Volatility of Commodity Prices
  • Volatility of Commodity Prices
  • Volatility is not same as risk. As a measure of uncertainty, it is a key input to many investment decisions and portfolio creations. To find the volatility, we have used log returns (corn, crude oil and wheat). Asset returns have the following stylized facts: Thick tails - Mandelbrot (1963): leptokurtic (thicker than Normal) Volatility clustering - Mandelbrot (1963): “large changes tend to be followed by large changes of either sign.” Leverage Effects – Black (1976), Christie (1982): Leverage effect which corresponds to a negative correlation between past returns and future volatility Co-movements in volatility – Ramchand and Susmel (1998): Volatility is positively correlated across markets/assets. As suggested by Robert F.Engle, we have employed GARCH (Generalized Auto Regressive Conditional Hetroscadasticity) (1,1) model includes: Predictive (Conditional) Uncertainty (Hetroscadasticity- changing variance overtime) That fluctuates over time (Auto Regressive - current errors are related to past errors) Volatility of Commodity Prices
  • Panel 1: S&P – GSCI (Standard and Poor’s – Goldman Sachs Commodity Index) Commodity Index in US ($) Panel 2: Money Supply (M1 in US $ Billions): M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately. Commercial bank assets – loans and leases in bank credit (US $ billions) Prime rate charged by banks (%) - Prime is one of several base rates used by banks to price short-term business loans. Bid rates for Eurodollar deposits collected around 9:30 a.m. Eastern time. Annualized using a 360-day year or bank interest. Rate posted by a majority of top 25 (by assets in domestic offices) insured U.S.-chartered commercial banks. US – Inter bank 1 month interest rates (LDN:BBA) (US $) : British Bankers Association (BBA) interest settlement rates are also known as LIBOR fixings. Used as the underlying reference price for derivatives, they are regarded as benchmarks because of their consistent accuracy and high correlation between maturities. The BBA LIBOR Fixing is based upon rates supplied by BBA LIBOR Contributor Panel Banks. Correlations/ Associations Full period (2001 to till date) Commodity Index Money Supply (M1)Commercial Bank AssetsPrime rateInter bank rateCommodity Index 1.0000.6440.8460.086-0.074Money Supply (M1)0.6441.0000.783-0.458-0.746Commercial Bank Assets0.8460.7831.000-0.057-0.296Prime rate0.086-0.458-0.0571.0000.757Inter bank rate-0.074-0.746-0.2960.7571.000 Pre Crisis Period (2001 to August, 2008) Commodity Index Money Supply (M1)Commercial Bank AssetsPrime rateInter bank rateCommodity Index 1.0000.7890.9570.4640.801Money Supply (M1)0.7891.0000.8210.4190.617Commercial Bank Assets0.9570.8211.0000.6070.861Prime rate0.4640.4190.6071.0000.624Inter bank rate0.8010.6170.8610.6241.000 Post Crisis Period (September, 2008 to till date) Commodity Index Money Supply (M1)Commercial Bank AssetsPrime rateInter bank rateCommodity Index 1.0000.837-0.656-0.084-0.313Money Supply (M1)0.8371.000-0.736-0.539-0.670Commercial Bank Assets-0.656-0.7361.0000.5540.775Prime rate-0.084-0.5390.5541.0000.934Inter bank rate-0.313-0.6700.7750.9341.000Relationship of liquidity and asset returns: Liquidity could give rise to inflation in asset prices if excess liquidity increases the demand for a fixed supply of assets. An increase in liquidity could coincide with a rise in asset prices, if both stem from improved economic prospects. A decline in interest rates driven by an increase in liquidity may lead to an increase in equity prices by reducing the discount factors that price future cash flows. These ideas also suggest some channels for international transmission. There are perhaps two such channels, a “push” channel or a “pull” channel, each with different empirical implications. If rapid money group in a country gave rise to capital flows from that country to foreign asset markets, we would expect upward pressure on foreign stock and bond prices A decline in interest rates driven by an increase in liquidity may lead to an increase in equity prices by reducing the discount factors that price future cash flows ( the declines in interest rates could also stimulate demand and imply higher future dividends, which could also lead to an increase in stock piles) Mechanisms: Ample monetary liquidity would support market making by lowering the cost of funding. An increase in liquidity may coincide with a rise in asset prices, if both stem from improved economic prospects. Improved economic prospects might bring general increases in liquidity: an increase in money demand, an increased willingness to take risk among banks and traders; and an increased willingness to take on debt among corporations
  • Panel 1: a) Money Supply (US $ Billons) b) Consumer Price Index United States The Consumer Price Index (CPI) is a measure of the average change over time in the prices of consumer items. Money supply vs. inflation Correlation: 0.895 (whole period, i.,e 2001 – till date) 0.942 (2008 – till date) Panel 2: CFTC (Commodity Futures Trading Commission): Index Investment Data (US $ Per Contact) Volatility of Commodity Prices
  • The purpose of introducing futures in commodities is – price discovery and efficient price transmission of price Few players would involved in the market, for profit making, they are short-selling (or) go for long positions according to market movement – which again influences the convergence of prices Commodities are playing a vital role in attracting the investors as they became “asset class”. Investors such as, Index funds, ETF’s, ETN’s and Other Exchange traded products have been attracted to make huge profits in a short-term. Fluctuations in the financial markets are likely to amplify the movement of commodity prices as financialization of commodities has increased the co-movement between commodity markets and other traditional markets through the effects of portfolio rebalancing by financial investors. Volatility of Commodity Prices
  • Cause: Index investors (speculators) – During the Jan-March 2007, Index investors increased investments with the positive news that the global commodity prices would increase. But, India banned trading and exports of various commodities such as wheat, rice, cocoa and others, which had a significant impact on the trading volumes and liquidity inflows in commodity markets in India. Post crisis, Indian markets are moving with world commodity markets in the same direction.
  • Recent commodity price developments have been attributed to changes in fundamental supply and demand relationships i.e. increased demand from the BRICs. The strong and sustained increase in primary commodity prices between 2002 and mid-2008 was accompanied by the growing presence of financial investors on commodity futures exchanges. This financialization of commodity markets has caused concern that much of the recent commodity price developments. The financialization of commodity markets has weakened their efficient use of information and physical adjustment mechanisms… this heightens the risk of speculative bubbles occurring. To the extent that financial investors increase price volatility, hedging becomes more expensive, and perhaps unaffordable for developing-country users. The behavior of financial investors on commodity markets is motivated by considerations that are largely unrelated to commodity market fundamentals. Financial investors invest in commodity markets with a view to broadening their portfolios in order to diversify risk. Financialization of commodity trading appears to have increased price changes that are unrelated to market fundamentals. The impact of index traders on momentum trading seems to have been concentrated in agricultural markets. Definitions: Swap Dealers: An individual who acts as the counterparty in a swap agreement for the fee (called a spread). Exchange Traded Funds (ETFs): offer investors the ability to diversify over an entire sector or market segment in a single investment. Exchange Traded Notes (ETNs): ETNs are similar to  exchange traded funds  (ETFs), but they differ in structure.    ETNs are  structured products  that are issued as senior debt notes by Barclays, while ETFs represent a stake in an underlying commodity. In comparison, the return from commodity-based ETFs will come from the interest on Treasury bills, short-term capital gains realized on the rolling of futures contracts, and long-term capital gains. Outside of the tax treatment, the difference between ETNs and ETFs comes down to credit risk vs.  tracking risk . Because ETNs possess credit risk, if Barclays goes bankrupt, the investor may not receive the return he or she was promised. An ETF, on the other hand, has virtually no credit risk, but there is tracking risk involved with holding an ETF. In other words, there is a possibility that the ETF's returns will differ from its underlying index.  Other Exchange Traded Products: is a derivatively-priced  security  which trades intra-day on a national  stock exchange . ETPs are typically benchmarked to indices ,  stocks ,  commodities , or may be actively managed. There are several different types of ETPs, including: Closed-end funds (CEFs), Exchange-traded derivative contracts ETPs also qualify for advanced types of orders such as  limit orders  and  stop orders . This is in contrast to traditional  mutual funds  which are only available for buying and selling at the close of business each day. Volatility of Commodity Prices
  • Panel 1: S&P - GSCI Commodity Index (US $) CME –GSCI Total Open Interest (US $ per contracts) : Chicago Mercantile Exchange-Goldman Sachs Commodity Index Total OI – it shows the commitment of trader’s activity Correlation between the two is -0.197. When Commodity index is low, investors see it to grow further and take long positions, and vice versa. The close correlation between commodities and other asset classes during the second half of 2008 suggests that financial investors have had a strong influence on commodity prices. The greater impact of oil price movements on food prices (commodity index) may have been due to the financialization of commodity futures trading. Panel 2: S&P - GSCI Commodity Index (US $) Exchange Traded Funds (ETFs – US $ Billions) - United States, Flow of Funds Sectors, Closed-end and Exchange-Traded Funds, Exchange-traded funds, net acquisition of financial assets, Current Prices, AR, SA, USD Exchange Traded Notes (ETNs – US $ Billions) - United States, Flow of Funds Instruments, Treasury Securities, Net purchases, exchange-traded funds, Current Prices, AR, SA, USD Correlation between S&P – GSCI and other two are positive. ETFs 0.642 and ETNs 0.754 Panel 3: S&P – GSCI Commodity Index (US $) Dow Jones Industrial Share Price Index - The Dow Jones Industrial Average, the 108-year-old index of leading US companies. The average is computed from the stock prices of 30 of the largest and most widely held public companies in the United States. CRB Spot Fats and Oil Index – FOB Spot Brent (US $) - World, Crude oil price, USD; source OECD Economic Outlook, Copyright OECD Correlations Full period (2001 to till date) S&P –GSCI Commodity IndexDow-Jones Share Price IndexCRB Spot – Fats and Oil IndexS&P –GSCI Commodity Index1.0000.6150.857Dow-Jones Share Price Index0.6151.0000.511CRB Spot – Fats and Oil Index0.8570.5111.000 Pre Crisis Period (2001 to August, 2008) S&P –GSCI Commodity IndexDow-Jones Share Price IndexCRB Spot – Fats and Oil IndexS&P –GSCI Commodity Index1.0000.7360.835Dow-Jones Share Price Index0.7361.0000.638CRB Spot – Fats and Oil Index0.8350.6381.000 Post Crisis Period (September, 2008 to till date) S&P –GSCI Commodity IndexDow-Jones Share Price IndexCRB Spot – Fats and Oil IndexS&P –GSCI Commodity Index1.0000.9180.929Dow-Jones Share Price Index0.9181.0000.878CRB Spot – Fats and Oil Index0.9290.8781.000 Volatility of Commodity Prices
  • Volatility of Commodity Prices
  • Complexity of markets: It is important for the regulators to know whether the high profits are being made by taking unreasonably high risks Computer systems and pricing models are correct and not being manipulated in the same way (automated trading, algorithm trading) Regulators should distinguish between front, middle and back office (front – traders, middle – risk managers and back office – record keeping and accounts keeping place) Liquidity becomes very important to investors, and illiquid instruments often sell at a big discount to their theoretical values. Financial engineers often calculate zero curve from actively traded government bonds and use it to price bonds that trade less frequently Financial engineer often implies the volatility of an asset from actively traded options and uses it to price less actively traded options Financial engineers often implies information about the behavior of interest rates from actively traded interest rate caps and swap options and uses it price products that are high structured Volatility of Commodity Prices
  • Volatility of Commodity Prices
  • Volatility of Commodity Prices
  • Volatility of Commodity Prices
  • Volatility of commodity prices policy responses

    1. 1. Volatility in commodity prices: Challenges and Policy Responses Dr. Vijay Kumar Varadi06/26/12 Volatility of Commodity Prices 1
    2. 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. 06/26/12 Volatility of Commodity Prices 2
    3. 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 06/26/12 Volatility of Commodity Prices 3
    4. 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) 06/26/12 Volatility of Commodity Prices 4
    5. 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) 06/26/12 Volatility of Commodity Prices 5
    6. 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? 06/26/12 Volatility of Commodity Prices 6
    7. 7. Monetary liquidity in US markets:i) S&P commodity indexiii) Money supply, Commercial Bank Assets : Loans and leasesiv) Prime Rate charged by banks and inter bank interest rates
    8. 8. Question 1: Money Supply an indicator of inflationary pressure? Ans. Yes. Both are PositivelyrelatedQuestion 2: The role of international transmission of monetary shocks and investment oncommodity markets? Ans. When liquidity is high the investment in CFTC (long ) positions are alsohigh and vice versa 06/26/12 Volatility of Commodity Prices 8
    9. 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. 06/26/12 Volatility of Commodity Prices 9
    10. 10. Stabilizing and destabilizing speculationSource: P Shome (2011), “Capital Controls: Instruments and Effectiveness”, ICRIERWorking Paper, 2001.
    11. 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 06/26/12 Volatility of Commodity Prices 11
    12. 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. 06/26/12 Volatility of Commodity Prices 12
    13. 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 behaviouriii) Spot Commodity indices (SP) Vs. ETNs and ETFsiv) Commodity Price Index Vs Stock and Oil Price Index 06/26/12 Volatility of Commodity Prices 13
    14. 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? 06/26/12 Volatility of Commodity Prices 14
    15. 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. 06/26/12 Volatility of Commodity Prices 15
    16. 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. 06/26/12 Volatility of Commodity Prices 16
    17. 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 06/26/12 Volatility of Commodity Prices 17
    18. 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 06/26/12 Volatility of Commodity Prices 18
    19. 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 06/26/12 Volatility of Commodity Prices 19 Source: Cooke, and Robles(2009) and other sources.
    20. 20. Thank You06/26/12 Volatility of Commodity Prices 20