Academic journal article Journal of Agricultural and Resource Economics

New Evidence That Index Traders Did Not Drive Bubbles in Grain Futures Markets

Academic journal article Journal of Agricultural and Resource Economics

New Evidence That Index Traders Did Not Drive Bubbles in Grain Futures Markets

Article excerpt

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Food commodity prices increased rapidly after 2006, punctuated by large spikes in 2007-2008 and again in 2010-2011. Effective policy responses to rising and volatile food commodity prices require careful assessment of the underlying causes. Much recent attention has been directed toward the trading activities of a new type of participant in commodity futures markets-commodity index traders (CITs). Hedge fund manager Michael Masters has played a leading role in raising concerns, testifying numerous times before the U.S. Congress and Commodity Futures Trading Commission (CFTC) that unprecedented buying pressure from index investments created a series of massive bubbles in commodity futures prices (Masters, 2008, 2009). These bubbles were then transmitted to spot prices through arbitrage links between futures and spot prices, with the end result that commodity prices far exceeded fundamental values. Irwin and Sanders (2012) use the term "Masters Hypothesis" as a shorthand label for this argument.

Several prominent international development and civic organizations have expressed support for the Masters Hypothesis (e.g., de Schutter, 2010; Herman, Kelly, and Nash, 2011; Robles, Torero, and von Braun, 2009). This statement from Joachim von Braun, director of Germany's Center for Development Research is representative of the level of concern in these organizations: "We have good analysis that speculation played a role in 2007 and 2008. . . Speculation did matter and it did amplify, that debate can be put to rest. These spikes are not a nuisance, they kill. They've killed thousands of people" (as quoted in Ruitenberg, 2010).

Gilbert and Pfuderer (2014) and Sanders and Irwin (2016) summarize various mechanisms through which index-trading activities could affect commodity prices and drive prices away from fundamentals. First, in an illiquid market where the short-run elasticity of supply of counterparty positions is low, it is possible for prices to temporarily deviate from fundamental values when there is a large demand for counterparty positions (e.g., high demand for short positions due to index buying). Second, if index traders have unpredictable market positions, then the large-scale entry of index funds may create "noise trader risk," making arbitrage against their positions difficult. Prices may be pushed away from fundamentals in such circumstances (see de Long et al., 1990). Third, in futures trading, information is revealed through trading activities. Other traders in futures markets may associate index buying with valuable private information and revise their own demands upward, which-in turn-could push prices higher (Sockin and Xiong). Sanders and Irwin (2016) argue that none of these theoretical explanations for price impacts of index activities are very compelling given the widely-known reasons for index trading in commodity markets (i.e., portfolio diversification, inflation hedges, and capturing long-run risk premiums).

In practice, whether financial index investments created large bubbles in the agricultural markets during the price spikes of 2007-2008 and 2010-2011 is ultimately an empirical question. To date, research has mainly focused on testing statistical links between price movements and index investment activities in agricultural futures market, using either time-series regression tests, such as Granger causality tests (e.g., Brunetti, Büyük§ahin, and Harris, 2016; Büyük§ahin and Harris, 2011; Capelle-Blancard and Coulibaly, 2011; Gilbert, 2010a,b; Hamilton and Wu, 2015; Sanders and Irwin, 2011a,b; Stoll and Whaley, 2010), cross-sectional regression tests (e.g., Irwin and Sanders, 2012; Sanders and Irwin, 2010), or conditional correlation tests (e.g., Büyük§ahin and Robe, 2014; Tang and Xiong, 2012). While most studies have failed to establish a causal link between index positions and price changes in agricultural futures markets, some studies report evidence of an impact; a few cases report a very large impact. …

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