An analysis of illiquidity in commodity markets

• Author: Sungjun Cho,Chanaka N. Ganepola,Ian Garrett
• Published date: 01 August 2019
• Date: 01 August 2019
• DOI: http://doi.org/10.1002/fut.22007

Received: 27 February 2019

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Accepted: 1 March 2019

DOI: 10.1002/fut.22007

RESEARCH ARTICLE

An analysis of illiquidity in commodity markets

Sungjun Cho

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Chanaka N. Ganepola

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Ian Garrett

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1

Division of Accounting and Finance,

Alliance Manchester Business School,

University of Manchester,

Manchester, UK

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Central Bank of Sri Lanka, Colombo,

Sri Lanka

Correspondence

Ian Garrett, Alliance Manchester Business

School, University of Manchester,

Manchester M15 6PB, UK.

Email: ian.garrett@manchester.ac.uk

Funding information

Central Bank of Sri Lanka

Abstract

We examine the liquidity and insurance premia demanded by hedgers and

speculators in commodity markets. We find that hedgers and speculators demand a

higher premium for illiquid commodities for providing insurance and liquidity,

respectively. Decomposing illiquidity into turnover and size components, we find

evidence of a size premium associated with the insurance premium such that

speculators demand a larger insurance premium for smaller commodities. We also

find that the liquidity premium demanded by hedgers for illiquid commodities

varies across bullish and bearish markets with hedgers demanding a larger

premium from speculators trading in illiquid commodities in bearish markets.

KEYWORDS

hedgers, insurance, liquidity, premia, speculators

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INTRODUCTION

Research in commodity markets tends to emphasize the importance of hedgers and speculators, who allow these

markets to function smoothly. In any market, there are participants who consider themselves as market makers, as they

provide liquidity to the market, and market takers who consume liquidity. Chang (1985), Hirshleifer (1990), and Basu

and Miffre (2013) among others argue that commodity hedgers, consisting of producers and consumers of commodities,

demand liquidity to eliminate price risk associated with holding commodities. Speculators provide the liquidity.

Hedgers thus transfer their price risk to speculators, and speculators earn a premium as reward for taking on this price

risk. Speculators are therefore considered as liquidity providers.

Kang, Rouwenhorst, and Tang (2017), however, argue that there are two independent premia in commodity

markets, one that rewards the investor for providing liquidity and one that rewards the investor for providing insurance.

They suggest that speculators provide insurance to hedgers while hedgers provide liquidity to speculators. In particular,

they argue that the change in net long positions explains liquidity provision from hedgers to speculators while

(smoothed) hedging pressure, as measured by the net short futures position, explains insurance provision from

speculators to hedgers.

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Kang et al. (2017) argue that hedgers demand a higher premium when speculators request short‐term liquidity in

relatively illiquid commodities. However, they do not examine whether speculators demand a premium from hedgers

when they wish to hedge positions in commodities that are illiquid. We examine this question in this paper. From the

theory of normal backwardation, we know that speculators absorb the price risk of hedgers at a cost. The asset pricing

literature finds that illiquid assets require a higher expected return than liquid ones. In this paper, we investigate

whether the same applies in commodity markets, that is, we examine whether hedgers that seek protection in illiquid

commodities pay a larger premium compared to liquid commodities to reward the additional risk taken by speculators.

We find that speculators demand a premium to absorb the price risk only for illiquid commodities.

J Futures Markets. 2019;39:962–984.wileyonlinelibrary.com/journal/fut962

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© 2019 Wiley Periodicals, Inc.

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It follows from the theory of normal backwardation that demand for price insurance by hedgers is reflected intheir net short futures position. Conversely, speculators are net long when futures prices

are expected to increase, thereby earning the premium as compensation for the risk absorbed from hedgers.

Given the importance of liquidity to our analysis, we examine the sensitivity of our results to the measure of

liquidity. A concern with the seminal Amihud (2002) measure of illiquidity is that it can be distorted by size (Cochrane,

2005). This is a particular concern for our analysis given the significant growth in the total size of commodity markets

over the period 2003–2008. Florackis, Gregoriou, and Kostakis (2011) and Brennan, Huh, and Subrahmanyam (2013)

propose a solution to this problem. Florackis et al. (2011) use stock turnover rather than dollar volume when calculating

illiquidity

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while Brennan et al. (2013) decompose the Amihud measure into two components: absolute returns earned

per unit of turnover, which is a turnover version of the Amihud measure, and market capitalization. We make use of

this decomposition to examine if there is both a liquidity effect related to turnover and a size effect present in

commodity markets and whether any such effects carry additional premia. With regard to the liquidity effect, we

examine whether the liquidity (insurance) premium paid by speculators (hedgers) differs depending on the degree of

illiquidity of commodities. We find that hedgers (speculators) require an additional premium for providing short‐term

liquidity (insurance) in illiquid commodities. With regard to the size effect, a considerable number of papers discuss the

size effect in stock returns (see among many others Banz, 1981; Blume & Stambaugh, 1983; Fama & French, 1993)

whereby small cap stocks earn a higher return than large cap stocks, implying that small cap stocks are more risky

compared to large cap stocks. We investigate whether this applies in commodity markets. In particular, we examine

whether a larger premium is required to induce investors (speculators or hedgers) to take positions in small

commodities compared to large ones. Kang et al. (2017) argue that the liquidity premium is the reward for fulfilling the

short‐term liquidity needs of speculators while the insurance premium is reward for providing insurance to hedgers

over the long term. We examine whether any size effect in commodity markets is reflected in the liquidity premium

and/or the insurance premium. Our results suggest that there is no size effect in the liquidity premium across

commodities of different sizes. However, we find that speculators provide insurance to hedgers at a lower cost in large

commodities compared to smaller commodities.

A final question we consider is whether there is an asymmetric relationship between liquidity and returns across

bull and bear markets, that is, we examine whether the liquidity premium is higher in down markets rather than up

markets. For the stock market, Hameed, Kang, and Vishwanathan (2010) find that liquidity is affected more when stock

returns are negative than when they are positive. Brennan et al. (2013) compare the illiquidity of the stock market on

days where returns are negative to those days where returns are positive. They find that illiquidity on down market days

is significantly priced in stock returns while illiquidity on up market days is not. One possible explanation for this is

offered by Brunnermeier and Pedersen (2009), who argue that market financiers tighten funding requirements during

bear markets such that investors may have to sell their holdings at a lower price, depending on the urgency of the

margin requirement. Therefore, traders seeking liquidity in down markets pay a larger premium compared to up

markets. We ask whether speculators pay a larger premium for liquidity in down markets compared to up markets. If

financiers tighten funding requirements as per Brunnermeier and Pedersen (2009), then it not unreasonable to suppose

that it might also affect hedgers. If hedgers face funding constraints, they should pay a larger insurance premium in

down markets. We find that only speculators incur a higher cost when buying illiquid commodities in down markets.

The insurance cost of illiquid commodities for hedgers, on the other hand, is not affected by whether markets are

bullish (up) or bearish (down). These findings are consistent with Daskalaki and Skiadopoulos (2016) who find that

increases in margins affect positions held by speculators rather than positions held by hedgers.

The remainder of the paper is organized as follows. Section 2 discusses the data and the variables we use. Section 3

discusses the empirical findings while Section 4 concludes.

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DATA

We use the data provided in the Commitment of Traders report published weekly on Fridays by the US Commodity

Futures Trading Commission (CFTC). The report provides details on the positions taken by commercial investors

(hedgers) and noncommercial investors (speculators) at market close every Tuesday for each commodity.

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We extract

the weekly long and short positions and total open interest of hedgers and speculators for 24 commodities over the

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Brennan et al. (2013) identify this measure as the turnover version of the Amihud measure.

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Producers, merchants, processors, and those who use futures for hedging purposes are known as commercial traders by the CFTC. Noncommercial investors include speculative traders (see http://

www.cftc.gov/idc/groups/public/@commitmentsoftraders/documents/file/disaggregatedcotexplanatorynot.pdf for more details). The literature also identifies commercial traders as hedgers and

noncommercial traders as speculators.

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