Thursday, April 5, 2012

"The rise of the machine: Does high-frequency trading alter commodity prices?"

We looked at this late last month in UPDATED--"High-frequency trading distorts commodities prices" and "More on High Frequency Trading in Commodities". Those posts linked to a U.N. Conference on Trade and Development paper available as a RePEC and hosted at the University of Munich'a Personal Research Archive.
We'll embed the paper below the jump.
From VoxEU:

Trade in commodity derivatives – such as oil futures – has grown tremendously over the last few decades. Some believe that the "financialisation" of commodity markets has made them more efficient. Others worry that financialisation has resulted in greater price distortions and volatility. This column presents high-frequency trading data suggesting that the sceptics may have a point.
What is causing the sharp price movements of many primary commodities? The debate goes on. (See Fattouh et al 2012 on Vox for a recent contribution.) Yet despite the range of views, three developments over the last decade are constantly referred to:
  • First, large developing economies have grown rapidly and steadily, boosting global demand for primary commodities.
  • Second, significant supply shocks like adverse weather and export bans have amplified price movements on some already tight markets.
  • Third, the growing presence of financial investors in commodity markets has become significant. While these developments are widely acknowledged, there is debate whether the ‘financialisation’ of commodity trading has affected commodity prices and their volatility and, ultimately, whether it benefits the commodity markets.

The growing ‘financialisation’ of commodities markets

Investing in commodities through futures markets has gained importance among ever since the burst of the dot-com bubble. Stung by losses, financial investors were on the lookout for a new asset class to diversify their portfolio and reduce their risks. The seminal paper by Gorton and Rouwenhort (2006) – showing that commodity futures have historically offered the same return as equities but are negatively correlated with equity and bond returns owing to different behaviour over the business cycle – supported this diversification strategy.

Investment in commodities became a common part of a large investor portfolio allocation, which coincides with a significant increase of assets under management of commodity indexes. From less than $10 billion around the end of the last century, commodity assets under management reached a record high of $450 billion in April 2011 (Institute of International Finance 2011). Consequently, the volumes of exchange-traded derivatives on commodity markets are now 20 to 30 times greater than physical production (Silvennoinen and Thorp 2010). Similarly, financial investors, which accounted for less than 25% of all market participants in the 1990s, now represent more than 85%, in some extreme occurrences, of all commodity futures market participants (Masters 2008).

Does financialisation benefit the commodity markets?

The benefits of these developments have been debated. On the one hand, the proponents would argue that the presence of new players in the commodities markets would ease the price discovery problem and bring the price closer to its underlying fundamentals. In addition, it would provide further liquidity and transfer risks to those who are better prepared to take them on....MORE
HT: FT Alphaville
Via Scribd: MPRA Paper 37486