Global Commodities Forum 

31 January - 1 February 2011 

Commodity Markets and Excess 

Volatility: 

An Evaluation of Price Dynamics under 

Financialisation

by 

Prof. Machiko Nissanke, Department of Economics, 

School of Oriental and African Studies, 

University of London 

 

"The views expressed are those of the author and do not necessarily reflect the views of 

UNCTAD" 
Commodity Markets and Excess Volati

An Evaluation of Price Dynamics un

Financialisa

Machiko Nissa

Department of Econom

SOAS, University of Lon

Global Commodity Forum, UNCTAD, 1st February, 2
Outline

z Changing Structures in Commodity Markets

 The Recent Commodity Markets Boom-Bust Cycle Changing Market Fundamentals over the Last Decade Increasing Participations of Financial Investors in Derivati

Financialisation Process

z Financialisation of Commodity Markets and Its Impact on Price 

 Intensified Financialisation with the Rapid Expansion of de Market Structures and Commodity Price Dynamics Microstructures of Asset Markets and Speculative Bubble Empirical Tests of the Financialisation Hypothesis

z Concluding Remarks

 The case for Reducing Excess in price volatility Proposals- Virtual Interventions

GCF-UNCTAD, February 1st 2011 
Changing Structures in Commodity M

Market Funamentals and Financial
Background: Commodity Price Dynamics –High 

Volatility

GCF-UNCTAD, February 1st 2011
Recent Price Swings: A) Price movement of 200

B)Price Movement in Global Recession and Rec

GCF-UNCTAD, February 1st 2011 
GCF-UNCTAD, February 1st 2011 

Changes in demand-supply relationships- Marke

fundamentals

z The shifts in fundamental demand-supply relationships -

price movements for commodities over medium term: C2002-8 – ‘an entering into a super price cycle?’

z An Asian Driver story on the demand side across comm

and agricultural raw materials and products; 

z supply constraints due to subdued investment in the low 

the 1980s and 1990s;

z Neglected agricultural sectors- low investment in agricul

and supporting infrastructures in LICs with high dependefood, leading to acute food crisis.

z Inventories was low at the time of price surge for minera

commodities– an asymmetry in inventory and price mov

z The high correlation between minerals, and agricultural 

close interlinks between oil and agricultural and mineral higher transport costs and other input cost;

z Higher food prices from the abrupt shift in arable land us

towards bio-fuel crops and increased vulnerability to climClimate-change effect); 
GCF-UNCTAD, February 1st 2011 

Increased Participation of Fin. Investors in DeriMarkets and Deals –Financialisation

z the rapid growth of commodity derivatives markets since 

associated with dot-com babble-burst, low interest envir

z Easy monetary condition: real interest rates- an importa

real commodity price working through shifts in the cost oinventories as well as (Kaldor, 1939- through convenienof net benefits yielded from holding stocks) 

z The CFTC granted investment banks an exemption from 

their over-the-counter (OTC) commodity swaps transact

z New actors in commodity markets (investment funds, m

pension and hedge funds and sovereign wealth funds);

z The flights from equity and bonds markets where the ad

crisis in the summer 2007 led to further monetary easingmoving into commodity markets

z High correlation across commodities as a result of comm

trading and momentum trading, less reflective of the fun

z An intensification of financialisation in 2002-8 (in particu

‘commodity super-price cycle story at the back of Asian 

high growth performance of EMs and other DCs coupled 

hypothesis
GCF-UNCTAD, February 1st 2011 

The rapid expansion of derivatives contr

Source: BIS, Quarterly Review, June 2009, table 23B. Source: BIS, Quarterly Review, June 

Figure 1: Futures and options contracts 

outstanding on commodity exchanges, number 

of contracts, million, December 1993 – March 

2009

05

101520253035404550

Dec.1993 sept.95 Jun.1997 mars.99 Dec.2000 sept.02 Jun.2004 mars.06 Dec.2007

Figure 2: Notional amount of outsta

counter commodity derivaties, Dec

December 2008, $trillio

02468

101214

Dec

98

Dec

99

Dec

00

Dec

01

Dec

02

Dec

03

Dec

04

De

05

Gold Other precious metals 
GCF-UNCTAD, February 1st 2011 

Estimated Index trader Positions and CommodiJanuary 2006- May 2009
Financialisation of Commodity Market

Impact on Price Dynamics
GCF-UNCTAD, February 1st 2011 

Questions Over Excess Co-Movements in ComPrices- the Financialisation Hypothesis

3⁄4 Q: The large swing and synchronised commodity boom-

2002-9- can be explained exclusively by structural shifts market fundamentals ? 

3⁄4 Q: Is high price volatility linked to the financialisation?3⁄4 the excess co-movement hypothesis advanced by Pindy

(1990) - an influence of speculation

3⁄4 Q: co-movement beyond the effects of common macroe

on stock levels?

3⁄4 Q:Can an “open interest”, i.e. virtual commodity stocks h

diversified asset portfolios, exert a significant effect on c

3⁄4 Q: Are commodity prices and inventory adjustments are 

swings in market sentiments in asset markets in genera

3⁄4 Can excess in co-movement be explained by the “liquidi

traders operating across asset markets are subject to comovements in market liquidity conditions ?- market liquid
Commodity Price dynamics Under Finan

3⁄4 Q: Has the precipitous fall in prices after Sep. 2008 expl

market sentiment- a flight to Quality triggered by the crisleading to massive deleveraging in many assets market

3⁄4 Q: How are commodity price dynamics related to develo

financial markets, e.g. bond, equity and currency market

z challenges against the position that the financialisation o

derivatives markets/deals affect commodity price dynam

z Krugman (2008) “investors interested only in futures not tak

change spot prices”

z However, given low price-elasticities, price stability cann

only through inventory adjustments and changes in futuaffect spot prices through changes in market sentiments

z Futures prices can influence spot prices through profit a

not only to changes in precautionary demand for holding also to shifts in market sentiments

z physical commodity stakeholders make decisions with re

prices
GCF-UNCTAD, February 1st 2011 

Factors behind the unprecedented price swings: Financialisation Explanation 

z The precipitous fall and collapse in commodity prices in 

 in part a reflection of the actual and expected shift of 

fundamentals due to the anticipated sharply weakene

 resulting from the shift in market sentiments influenci

commodities - the massive liquidation of long positionfutures and OTC deals through deleveraging on the pinvestors.

z disentangling empirically the two conditions( the fundam

financialisation) is not easy, but the spectacular rise and prices for 2006-8 cannot be explained in terms of markealone; - reflecting in wedges between futures and cash p

z The effects of financialisation continue to filter through p

2009-10- financial investors are back in commodity exch
GCF-UNCTAD, February 1st 2011 

Market Structures and Commodity Price Dynam

z The significant overshooting and undershooting in comm

commodity prises are determined as other assets pricesexpectation formation on the part of heterogeneous part

z Q: whether their expectations are always formed in relat

market fundamentals;

z Strongest arguments against the financialisation hypoth

Market Hypothesis (EMH)

z Q : whether the “EMH” holds or not: “any and all informa

rational decisions is contained in prices determined in co

z If Markets are efficient, it play an important role of “Price 

Risk Management”.

z Empirical test of the EMH in commodity markets on accoz commodity market structures: heterogeneous traders : in

noise trading and uninformed trading;

z information failures’ and ‘weight-of-money’ effects by ex

in commodity market structures (e.g. Mayer, 2009, Gilbe
Market Structures and Commodity Price Dyna

(Cont’d)

z Three types of traders (trading rules):

 Informed trading: stakeholders in physical commoditi

for hedging purpose,based on market fundamentals due to uncertainties over future findamenatals, poor inoises in market information: when markets are in bufollow market sentiments and the herd;

 Noise trading e.g. commodity index traders and strate

relation to development of other asset markets; tradeindex, commodity prices get correlated;

 Uninformed traders (e.g. money fund managers)- use 

trading and high-tech chartists, not refer to market futo price development, but not distinguishing between due to shifts in market fundamentals or moves of nois

z the information failure effects – information does not refl

market fundamentals – imperfect information

z The ‘weight-of-money’ effects – prices are influenced by 

by large traders in the absence of matching counter-partimperfect competition

GCF-UNCTAD, February 1st 2011 
Market Structures and Commodity Price Dynam

z Momentum or programme trading create arbitrage/profit z The composition of traders (trading rules) change as ma

shift - in search for high risk premium and market liquidit

z Profit/arbitrage opportunities arising from the interface o

trading rules, leading to a creation of speculative bubble

z Activities in futures prices through leveraging and deleve

investors

z Q: Is speculation stabilising (if guided by fundamentals, 

enhancing arbitrage dominates) or destabilising (if acting agents do not refer to fundamentals in decision-making, formation becomes extrapolative (not regressive with anfundamentals), leading to destabilising speculation

z Asset prices deviating from fundamentals, if agents ente

predominantly on fads and in search for risk premium 

z Shifts from fundamental equilibrium to bubble equilibrium 

finance literature on existence of multi-equilibria)

GCF-UNCTAD, February 1st 2011 
Empirical Tests of the Financialisation Hypothe

z Testing excess in co-movement in commodity prices and thos

different assets: Lescaroux (2009) vs Tang and Xiang (2010) Thorp (2010) 

z Testing the presence of speculative bubbles and the effect of i

z Irwin and Sanders (2010) “no empirical evidence of specula

prices of agricultural commodities as results of the financialmarkets”

z Gilbert (2010)- modest presence of extraporative bubbles w

impcts of index-based investments

z Mayer (2009)-Money managers vs index traders

z Testing interactions of market fundamentals and financialisatio

et.al (2008)

 financialisation generates a non-linear adjustment patte

prices to its fundamental value.

 Slow adjustments to fundamentals after an exposure to  the impact of financialisation can be on short run price d

than in the long term equilibrium level of prices

GCF-UNCTAD, February 1st 2011 
Concluding Remarks : Policy Imp
GCF-UNCTAD, February 1st 2011 

Consequences of Market Failures

z the entry and presence of speculative noise trading or th

herd behaviour (Pindyke (2004) ; 

z Excessive volatility not reflecting commodity fundamenta

markets- markets do not work for hedging and risk manacommodity stake-holders: 

z Price signal- does not indicate and predict properly a fut

movement for investment and other technological advansubstitution and conversation)

z An enormous wedge between private returns (short-term 

social returns (long term consequences) as a result of m

z In the end, it is not a situation of winners and losers, but 

game for the global economy and community.

z The cost for Commodity Dependent LICs- huge- Commo

Trap 

z The failure of the earlier ICAs should not be an excuse f
GCF-UNCTAD, February 1st 2011 

What can be done ? towards making Markets W

z Regulatory measures over markets (e.g. by CFTC):

 i) aggregate position limits on futures contracts to co

“weight-of money” effects;

 ii) increase the transparency of futures markets and  iii) capital deposit requirements on portion of each fut iv) Eliminate the loopholes in regulations;  iv) counter-cyclical margin requirements. 

z Regulatory reform of commodity derivatives markets as 

over other asset markets- requiring international coordinharmonisation

z Relying exclusively on buffer stock management for stab

ineffective and costly in the face of rapidly shifting marke

z What is required is a smart and efficient regulation, work

market development; i.e. liquidity enhancing for risk hed

z Aiming at acting on excessive volatilities (defending pric

difficult when market fundamentals change rapidly)

z Innovative commodity stabilisation schemes through virt

cum better inventory management
GCF-UNCTAD, February 1st 2011 

Innovative (Virtual) Stabilisation Schemes and inmanagement

z IFPRI Proposal (Two- Pronged Schemes): 

 1) A small physical food reserves should be establish

smooth response to food emergencies ( 5 % of the cumanaged by the WFP in different locations, backed u

funds 

 2) An innovative virtual reserve, backed by financial 

intervention mechanisms in futures market should be 

price spikes and to keep prices close to fundamenta
GCF-UNCTAD, February 1st 2011 

Target Zone schemes

z Working effectively on agents’ expectation formation wit

intervention ( creating “honeymoon” effects and “announ

z Which instruments can deliver this credibility? 
GCF-UNCTAD, February 1st 2011 

The Case for Price- stabilisation – Target Zone 

z Moving Target zones applied to commodity derivatives t

the use of multi-tier transaction tax as a part of global fi

z understanding movements of “equilibrium” prices in marz implicit target or guidance zones for prices of main asse

commodities ( a wide and adjustable target zones in the fundamentals).

z Multi-tier transaction tax schemes (Nissanke 2005)- wo

expectation, taming excessive volatilities, leading to spe

 The first tier tax can be zero under normal market co

within a band, as it serves “as a monitoring and contrallow normal efficient function of markets with plentifu

 The second tier of the exchange surcharge would fun

automatic circuit-breaker at times of increased proba

speculative bubbles;

 The threat of a surcharge levy alone, if credible, may 

prices within a target zone, without the use of physica

buffer stocks. 

 The possibility of orderly realignments of commodity 

market fundamentals
Can such innovative mechanism be made feasi

z The credibility and effectiveness of innovative mechanis

 how well the future price development is forecasted i

fundamentals 

 how closely the moving target zone could be designe

implemented to reflect such an evolution of fundame

z Public goods provision in addressing excess volatility de

information- and knowledge-intensive activities from speinternational agencies and institutions (e.g. CFC or UNCcollaborations with international commodity agencies an

z The success of the schemes depends on the political ex

willingness of the global community 

GCF-UNCTAD, February 1st 2011