A Model of Financialization of Commodities

• Author: ANNA PAVLOVA,SULEYMAN BASAK
• DOI: http://doi.org/10.1111/jofi.12408
• Published date: 01 August 2016
• Date: 01 August 2016

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 4 •AUGUST 2016

A Model of Financialization of Commodities

SULEYMAN BASAK and ANNA PAVLOVA∗

ABSTRACT

We analyze how institutional investors entering commodity futures markets, referred

to as the financialization of commodities, affect commodity prices. Institutional in-

vestors care about their performance relative to a commodity index. We find that all

commodity futures prices, volatilities, and correlations go up with financialization,

but more so for index futures than for nonindex futures. The equity-commodity cor-

relations also increase. We demonstrate how financial markets transmit shocks not

only to futures prices but also to commodity spot prices and inventories. Spot prices go

up with financialization, and shocks to any index commodity spill over to all storable

commodity prices.

ASHARP INCREASE IN THE POPULARITY of commodity investing over the past

decade has triggered an unprecedented inflow of institutional funds into com-

modity futures markets, referred to as the financialization of commodities.

At the same time, the behavior of commodity prices has become highly un-

usual. Commodity prices have experienced significant run-ups, and the na-

ture of their fluctuations has changed considerably. An emerging literature on

the financialization of commodities attributes this behavior to the emergence

of commodities as an asset class, which has become widely held by institu-

tional investors seeking diversification benefits (Buyuksahin and Robe (2014),

Singleton (2014)). Starting in 2004, institutional investors have been rapidly

building their positions in commodity futures.1A Commodity Futures Trading

Commission (CFTC) (2008) staff report estimates institutional holdings to have

∗Suleyman Basak and Anna Pavlova are at the London Business School and CEPR. We thank

participants at the Advances in Commodity Markets, AFA, Arne Ryde, Cowles GE, EFA, MFS,

NBER Asset Pricing, NBER Commodities, Paul WoolleyCentre, Rothschild Caesarea, and SFI con-

ferences, as well as seminar participants at Bank Gutmann, Berkeley, BIS, BU, Chicago, Geneva,

IDC, Imperial, Frankfurt, INSEAD, LBS, LSE, Luxembourg, Melbourne, Monash, Nova, Oxford,

St. Gallen, Stanford, Stockholm, and Zurich, as well as Viral Acharya, Steven Baker, Francisco

Gomes, Christian Heyerdahl-Larsen, Lutz Kilian, Andrei Kirilenko, Kjell Nyborg, Michel Robe,

Sylvia Sarantopoulou-Chiourea, Olivier Scaillet, Dimitri Vayanos, and WeiXiong for helpful com-

ments. We have also benefitted from the valuable suggestions of Ken Singleton and two anonymous

referees. Adem Atmaz provided excellent research assistance. Pavlova gratefully acknowledges fi-

nancial support from the European Research Council (grant StG263312).

1Related empirical literature dates the start of the financialization of commodity futures around

2004 (Buyuksahin et al. (2008), Irwin and Sanders (2011), Tang and Xiong (2012), Hamilton and

Wu (2014), Boons, De Roon, and Szymanowska (2014), among others), and some of these works

explicitly test for and confirm a structural break around 2004.

DOI: 10.1111/jofi.12408

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increased from $15 billion in 2003 to over $200 billion in 2008. Many institu-

tional investors hold commodities through a commodity futures index, such as

the Goldman Sachs Commodity Index (GSCI), the Dow Jones UBS Commodity

Index, or the S&P Commodity Index (SPCI). Tang and Xiong (2012) document

that after 2004 the behavior of index commodities has become increasingly

different from that of nonindex commodities, with the former becoming more

correlated with oil, an important index constituent, and more correlated with

the equity market. These intriguing facts could be attributed to the entry of

institutional investors into commodity futures markets. The financialization

theory has far-reaching implications for regulation: the 2004 to 2008 run-up

in commodity prices has prompted many calls for restrictions on the posi-

tions of institutions who may have generated the run-up (see Master’s (2008)

testimony).

While the empirical literature on the financialization of commodities has

contributed to the policy debate, theoretical literature on the subject remains

scarce. Our goal in this paper is to model the financialization of commodities

and to disentangle the effects of institutional flows from the traditional de-

mand and supply effects on commodity futures prices. We particularly focus

on identifying the economic mechanisms through which institutions may influ-

ence commodity futures prices, volatilities, and their comovement, as well as

on how their presence may affect commodity spot prices and inventories.

We develop a multi-good, multi-asset dynamic model with institutional in-

vestors and standard futures markets participants. Institutional investors care

about their performance relative to a commodity index. They do so because their

investment mandate specifies a benchmark index for performance evaluation

or because their mandate includes hedging against commodity price inflation.

We capture such benchmarking through the institutional objective function.

Consistent with extant literature on benchmarking (originating from Brennan

(1993)), we posit that the marginal utility of institutional investors increases

with the index. In particular, institutional investors do not like to perform

poorly when their benchmark index does well and so have an additional incen-

tive to do well when their benchmark does well.2All investors in our model

invest in the commodity futures markets and the stock market. Prices in these

markets fluctuate in response to three possible sources of shocks: (i) commodity

supply shocks, (ii) commodity demand shocks, and (iii) (endogenous) changes in

wealth shares of the two investor classes. We include in the index only a subset

of the traded futures contracts. It is then possible to compare a pair of other-

wise identical commodities, one of which belongs to the index and the other

does not. We capture the effects of financialization by comparing our economy

with institutional investors to an otherwise identical benchmark economy with

no institutions. The model is solved in closed form, and all our results below

are derived analytically.

2One may reasonably argue that there is also a category of institutional investors who want to

perform well when the index does poorly (e.g., hedge funds).

A Model of Financialization of Commodities 1513

We first find that the prices of all commodity futures go up with financializa-

tion. However, the price increase is higher for futures belonging to the index

than for nonindex futures. This pattern obtains because institutions strive to

not fall behind when the index does well, and thus they value assets that pay

off more in high-index states. As a result, relative to the benchmark economy

without institutions, futures whose returns are positively correlated with those

of the index are valued higher. In our model all futures are positively corre-

lated because they are valued using the same discount factor, and so all futures

prices go up with financialization. The comovement with the index, however,

is higher for futures included in the index. Therefore, prices of index futures

rise more than those of nonindex futures. The larger the institutions, the more

they affect pricing—or, more formally, the discount factor—making the above

effects stronger.

We next find that the volatilities of both index and nonindex futures returns

go up with financialization. This is because, absent institutions, there are only

two sources of risk: supply risk and demand risk. With institutions present,

some agents in the economy (institutional investors) face an additional risk

of falling behind the index. This risk is reflected in futures prices and raises

the volatilities of futures returns. While the volatilities of all futures rise,

those of index futures rise more. Index futures are especially attractive to

institutional investors because of their high comovement with the index. Hence,

their volatilities rise enough to make them unattractive to normal investors

(standard market participants), so that they are willing to sell index futures

holdings to institutions.

We also find that the correlations among commodity futures as well as the

equity-commodity correlations increase with financialization. The often-quoted

intuition for this increase is that commodity futures markets were largely seg-

mented before the inflow of institutional investors in the mid-2000s, and that

institutions entering these markets have linked them together, as well as with

the stock market, through the cross-holdings in their portfolios. We show that

this argument does not need to rely on market segmentation, as the increase in

correlations may occur even under complete markets. Benchmarking institu-

tional investors to a commodity index leads to the emergence of this index as a

new (common) factor in commodity futures and stock returns. In equilibrium,

all assets load positively on this factor, which increases their covariances and

correlations. We show that index commodity futures are more sensitive to this

new factor, and so their covariances and correlations with each other increase

to a greater extent than those for otherwise identical nonindex commodities.

Furthermore, we explicitly model demand shocks, which allows us to disentan-

gle the effects of institutional investors from the effects of demand and supply

(fundamentals) and conclude that the effects of financialization are sizeable.

To address the question of how commodity spot prices and inventories are af-

fected by financialization in our model, we follow the classical theory of storage

(Deaton and Laroque (1992,1996)) and introduce intermediate consumption

and storage decisions. Our main departure from the extant storage literature

is that cash flows from storing a commodity are discounted with a (stochastic)