The financialization of commodity markets.

• Author: Xiong, Wei
• Position: Research Summaries

Over the last decade, commodity futures have become a popular asset class for portfolio investors, just like stocks and bonds. This process is sometimes referred to as the financialization of commodity markets. According to an estimate provided by the Commodity Futures Trading Commission (CFTC) in 2008, investment inflows to various commodity futures indices from early 2000 to June 30, 2008 totaled $200 billion. (1) The increasing presence of financial investors in commodity markets has led to a growing concern of the public and in policy circles as to whether financialization might have affected commodity prices and whether more government regulation in these markets is warranted.

In particular, the synchronized boom and bust cycle in 2007-8 in a large number of commodities across the energy, metal, and agricultural sectors has led to a heated debate regarding whether speculation in commodity futures markets caused a bubble in commodity prices. Testing to determine whether there actually was a price bubble is challenging and deflects attention from analyzing more nuanced impacts of financialization on commodity markets. Mindful of these considerations, in a series of studies my co-authors and I focus on analyzing how the increasing presence of financial traders has transformed commodity markets through the economic mechanisms that underpin these markets: risk sharing and information discovery. This research summary provides an overview of these studies. Ing-Haw Cheng and I have also written a broader review of the literature on the financialization of commodity markets and on the debate about whether there was a price bubble. (2)

Evidence of Financialization

Prior to the early 2000s, despite liquid futures contracts being traded on many commodities, their prices offered a risk premium for idiosyncratic commodity price risk, and had little co-movement with stocks or with each other. (3) These aspects are in sharp contrast to the price dynamics of typical financial assets, which carry a premium only for systematic risk and are highly correlated with market indices and with each other. This contrast indicates that commodity markets were partially segmented from outside financial markets and from each other.

Ke Tang and I present evidence that financialization has increased the integration of commodity futures markets with each other. (4) We find that futures prices of non-energy commodities became increasingly correlated with oil prices after 2004, when significant index investment started to flow into commodities markets. Figure 1, on page 21, shows that while this trend intensified after the world financial crisis triggered by the bankruptcy of Lehman Brothers in September 2008, its presence was already evident and significant before the crisis. In particular, this trend was significantly more pronounced for commodities in the popular S&P-GSCI and DJ-UBS commodity investment indices than for those off the indices after controlling for a set of alternative arguments. The trend increase in the difference in futures price co-movements with oil between indexed and off-index com modities is related to the large inflows of investment capital to commodity index securities during this period.

A compelling alternative argument for the increased co-movements between commodity prices is the rapidly increasing commodity demands from fast-growing emerging economies such as China. (5) Indeed, there is evidence of an increasing return correlation between commodities and the Morgan Stanley emerging...