An Equilibrium Analysis of Hedging with Liquidity Constraints, Speculation, and Government Price Subsidy in a Commodity Market

Authors

  • Zhongquan Zhou

    1. Washington University in Saint Louis, Wharton Center for Quantitative Finance
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    • Zhongquan Zhou is from Washington University in Saint Louis and the Wharton Center for Quantitative Finance. The author is grateful for useful comments from Sassan Alizadeh, Martin Graf, Sanford Grossman, Wendy Li, Craig Pirrong, an anonymous referee, and in particular, René Stulz (the editor). I also want to thank seminar participants at Columbia University (Mathematical Finance Workshop), and at Washington University in Saint Louis for useful comments. The author can be reached at: Zhongquan Zhou; Quantitative Financial Strategies, Inc.; 100 Four Falls Corporate Center; Suite 314; Conshohocken, PA 19428; (610) 828–26700.

Abstract

We develop a simple commodity model to analyze (i) the effects of hedging with liquidity constraints, due to producers' inability to bear unlimited trading losses, (ii) the role of speculation in the process of risk allocation between consumers and producers, and (iii) the equilibrium implications of government price subsidies to the producers. We find that (1) liquidity constraints can cause futures prices to exhibit mean reversion, which then makes speculation profitable; (2) speculation tends to make futures price volatility an increasing function of futures price; and (3) government price subsidy, if actively hedged by the producers, serves to lower the futures risk premium and reduce futures volatility.

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