Commodity, Futures and Financial Markets

Louis Phlips The stabilisation of primary commodity prices, and the related issue of the stabilisation of export earnings of developing countries, have traditionally been studied without reference to the futures markets (that exist or could exist) for these commodities. These futures markets have in turn been s~udied in isolation. The same is true for the new developments on financial markets. Over the last few years, in particular sine the 1985 tin crisis and the October 1987 stock exchange crisis, it has become evident that there are inter­ actions between commodity, futures, and financial markets and that these inter­ actions are very important. The more so as trade on futures and financial markets has shown a spectacular increase. This volume brings together a number of recent and unpublished papers on these interactions by leading specialists (and their students). A first set of papers examines how the use of futures markets could help stabilising export earnings of developing countries and how this compares to the rather unsuccessful UNCTAD type interventions via buffer stocks, pegged prices and cartels. A second set of papers faces the fact, largely ignored in the literature, that commodity prices are determined in foreign currencies, with the result that developing countries suffer from the volatility of exchange rates of these currencies (even in cases where commodity prices are relatively stable). Financial markets are thus explicitly linked to futures and commodity markets.

I: Export Earnings.- 1. Market Solutions to the Problem of Stabilizing Commodity Earnings.- 1. Introduction.- 2. Nonparametric Stabilization Rules.- 2.1. Operating on the Futures Markets: Optimal Hedging Strategies.- 2.2. Extensions: Private Stockholding and Speculation.- 2.3. Non-Market Interventions: Optimal Price Stabilization Rules.- 2.4. When is Price Stabilization Preferable to Hedging?.- 3. Conflicts between Market and Private Stabilization Schemes.- 3.1. Hedging.- 3.2. Price Stabilization.- 3.3. Strategic Errors.- 4. Intervention Costs: Stabilizing Net Revenues.- 4.1. Hedging Strategies with Costs.- 4.2. Buffer Stock Strategies with Costs.- 5. Empirical Analysis.- 5.1. Tests of Non-Normality.- 5.2. Hedging versus Price Stabilization: No Intervention Costs.- 5.3. Hedging versus Price Stabilization Allowing for Intervention Costs.- 6. Private versus Aggregate Market Strategies.- 7. Conclusions.- References.- 2. Hedging Commodity Export Earnings with Futures and Options Contracts.- 1. Introduction.- 2. Hedging with Futures Markets.- 2.1. An Optimal Model of Hedging on Futures Markets.- 2.2. Estimation Results.- 2.3. Optimal Hedging and Uncertain Production.- 2.4. Estimating the Risk Gains.- 3. Hedging with Options Contracts.- 3.1. Introduction.- 3.2. Joint Hedge with Futures and Options Contracts.- 3.3. The Joint Hedging Performance.- 4. Conclusion.- References.- Appendices.- 3. Options to Alleviate the Costs of Uncertainty and Stability: A Case Study of Zambia.- 1. Introduction.- 2. The Copper Price and Zambia 1964–1984.- 3. Instability and Uncertainty.- 4. Options to Stabilize or Insure Commodity Export Earnings.- 5. Conclusions.- References.- II: Financial Markets and Commodity Prices.- 4. The Response of Primary Commodity Prices to Exchange Rate Changes.- 1. Introduction.- 2. A Simple Static Model.- 3. Multi-Commodity Generalizations.- 4. Relation to Purchasing Power Parity.- 5. Stockholding and Intertemporal Price Adjustment.- 6. Futures Markets.- 7. The Exchange Rate Index.- 8. Choice of Weighting Schemes.- 9. Consequences of Exclusion of LDC Exchange Rates.- 10. Estimated Exchange Rate Elasticities.- 11. Conclusions.- References.- Appendix: Commodity Price Definitions.- 5. Exchange Rates and Storables Prices.- 1. Introduction.- 1.1. Consumers of Primary Commodities.- 1.2. Producers of Primary Commodities.- 1.3. Traders in Primary Commodities.- 1.4. Speculators and Arbitragers.- 2. Specification of Agents’ Optimizing Behaviour.- 2.1. Commodity Processor.- 2.2. Producer.- 2.3. Marketing Board.- 2.4. Speculator in Currency.- 3. Solving the Model in Equilibrium.- 3.1. Currency Spot Clearing.- 3.2. Commodity Spot Clearing.- 3.3. Currency Forward Clearing.- 3.4. Commodity Futures Clearing.- 4. The Link between Exchange Rates and Commodity Prices.- 4.1. The Correlation Coefficient.- 4.2. Exchange Rate Elasticity.- 4.3. An Expected Depreciation of the Currency.- 4.4. Decreasing Exchange Rate Volatility.- 5. Summary.- References.- 6. An Evaluation of the Performance of Speculative Markets.- 1. Introduction.- 2. The Inadequacy of Conventional Tests of Market Performance.- 3. Welfare Measures.- 4. A Two-Period Model.- 4.1. The Structure of the Market Model.- 4.2. Bayesian Error.- 5. Application of the Theory.- 5.1. Research Design.- 5.2. Empirical Results.- 6. Conclusion.- References.- 7. Dynamic Welfare Analysis and Commodity Futures Markets Overshooting.- 1. Introduction.- 2. Basic Specification.- 2.1. Basic Model Specification.- 2.2. Fixed Output and Overshooting.- 2.3. Endogenous Output and Empirical Results.- 3. A Dynamic Multicommodity Welfare Measure.- 4. Methodology, Data, and Empirical Results.- 5. Conclusion.- References.- III: Monopolistic Commodity Markets.- 8. Futures Trading for Imperfect Cash Markets: A Survey.- 1. Introduction.- 2. Motives for Trading Futures.- 3. Speculation and Hedging by Powerful Agents.- 4. Hedging by the Competitive Fringe.- 5. Strategic Futures: Cournot Oligopolists.- 6. Strategic Futures: Cartel Futures Policies.- 7. Strategic Futures: Storable Goods.- 8. Strategic Futures: Durable Goods.- 9. Exhaustible Resources.- 10. Futures Price Bias and Volatility.- 11. Conclusion.- References.- 9. Duopoly, Inventories and Futures Markets.- 1. Introduction.- 2. The Model with Futures Only.- 2.1. The Cash Market.- 2.2 The Futures Market.- 3. The Model with Inventories Only.- 3.1. Producers’ Decisions at Time 2.- 3.2. Producers’ Decisions at Time 1.- 4. The Model with Both Futures and Inventories.- 4.1. The Cash Market.- 4.2. Time 1 Decisions.- 5. Conclusion.- References.- 10. Monopsony Power and the Period of Commitment in Nonrenewable Resource Markets.- 1. Introduction.- 2. Relations with Other Problems.- 3. The Markov Time-Consistent Equilibirum.- 4. A “Locally” Time-Consistent Equilibrium.- 5. A Comparison with Reproducible Goods.- 6. Conclusion.- References.