The risk premium in commodity markets
Creators: name: Scott, Ernest Maurice
Publisher: name: University of British Columbia
Year: 2010

description: The economic function of commodity futures markets is generally acknowledged to be that of affording the commodity handler the opportunity to reduce his risk per unit of the commodity by shifting that risk to an economic unit which is better able, or more willing, to accept it, with attendant long run benefit to the ultimate consumer. In the literature related to the theory of hedging and speculative activity conflicting views have evolved and remain unresolved concerning the process of price determination and the related question of the nature of the risk premium, which represents the return for acceptance of the price risk. Some authors have argued in a manner consistent with the concept that a risk premium is built into the structure of futures prices. This view conforms with the basic tenet of the theory of finance and of economics to the effect that investors are fundamentally risk averse and that their behaviour reflects an attitude of risk aversion throughout. However, a challenge to the assumption of risk averse behaviour has been a recurring theme throughout the literature of commodity markets. Several authors have contended that the services of risk reduction afforded to hedgers are available at no cost. If the latter view is confirmed to be valid it implies, at the very least, that commodity markets are a unique type of financial market. Utilizing theoretical, descriptive, and particularly empirical analysis, the primary objective of this study is to examine an aspect of the theory of commodity markets: the nature and magnitude of the risk premiums, if any, which are received by speculators from hedgers; and the significance of hedging activity relative to the payment of .any such risk premiums. Based on the theory of risk aversion and the implications of wealth effects, a theory of hedging and speculation is suggested. The risk premium is then assumed to be determined by the set of simultaneous relationships which comprise the supp1y-demand model for futures contracts. In the empirical analysis, linear regression techniques are employed to test the demand function of the model and to examine certain other characteristics of commodity markets. Using market data for the nominal period 1961-70, the three commodities studied are among the most heavily traded on United States commodity exchanges, namely; wheat, corn, and soybeans. As expected, the mean semi-monthly holding period realized risk premium is not found to be significantly different from zero. Also, in the context of the capital asset pricing model, the systematic risk measure for each of the three commodities is found to be not significantly different from zero These conclusions are consistent with those of previous authors. Concerning the significance of hedging activity, it is concluded that the realized risk premium is positively related to the change in net short hedging consistent with the theory suggested. However, contrary to expectations and to the theory of financial markets, the speculative demand function for futures contracts is found to be very highly if not infinitely elastic. Finally, a test of the characteristics of commodity markets concludes that such markets conform with the efficient markets hypothesis.