Financialization in Commodity Markets

Project Start:02/2014
Researchers:Patrick Grüning
Category: Financial Markets
Funded by:LOEWE

The term ‘financialization’ refers to the fact that the volume of investment in commodity-related financial instruments (mostly futures contracts and commodity index-related products) has increased considerably over the past decade. In the public debate it has often been argued that this ‘non-fundamental’ and ‘purely financial’ type of investment has been harmful for society by causing higher levels and higher volatilities of prices, especially for basic food commodities and has thus been especially detrimental to the poor, who have to spend a large share of their income on these types of goods. On the other hand, more liquid futures markets enable market participants to better share commodity price risk, so that the impact of supply shocks can be borne by more agents. Given this, it is not clear whether the increased activity of financial investors on commodity markets has been beneficial or harmful.

We want to contribute to the discussion of this question, which is a core issue in the context of the overall role of financial markets in society, by analyzing a stylized version of financialization in a general equilibrium model. We consider a production economy with three types of agents and two types of goods, a commodity and a non-commodity. The first agent (‘producer’) is endowed with both goods and can furthermore utilize the commodity in the production of the non-commodity good. The second agent (‘speculator’) is endowed with the non-commodity, from which he also derives his utility. He can trade bonds and commodity futures with the producer, thereby benefitting from premia on commodity risk and simultaneously allowing the producer to share this risk. The third agent (‘consumer’) also has an exogenous endowment of the non-commodity good, but derives utility from the commodity good only, which he has to buy from the producer. The consumer and the producer thus trade with each other in the spot market. The speculator and the producer trade bonds and futures and thereby benefit from the financial markets, whereas the consumer is ‘left out’ of these markets and can only passively ‘accept’ the resulting implications for commodity prices.

Our model is designed to enable us to see under which conditions and to what degree the agents’ activities significantly drive commodity spot and futures prices and under which conditions these price dynamics are predominantly driven by fundamentals. Furthermore, we can analyze the welfare implications for each of the three types of agents.

We are still at the stage of model development. A first version of the model has generated promising results, but there is still a significant amount of fine-tuning to be done.


Related Working Papers

No.Author/sTitleYearProgram AreaKeywords
131Nicole Branger, Patrick Grüning, Christian SchlagCommodities, Financialization, and Heterogeneous Agents2016 Financial Markets Commodities, General Equilibrium, Heterogeneous Preferences, Financial Markets