William T. Gavin

English

Research Papers in Economics

July 2008 NationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
T
he commodity futures market has changed dramati-
cally over the past five years. The Goldman Sachs
Commodity Index (GSCI) rose from 235 at the end
of December 2002 to 787 on the last day of May 2008—an
average annual commodity price inflation rate of 25 percent.
The price of agricultural commodities rose about 15 percent,
and energy prices soared almost twice as fast—at 29 percent.
Futures market participants normally include commercial
hedgers and speculators. Commercial hedgers are firms that
produce the commodity or use it in producing goods and
services. For example, wheat farmers sell wheat ahead of the
harvest to hedge against a falling price at harvest time. On the
other side of the market, the bread and pasta producers buy
wheat in advance to hedge against the risk of rising prices
in coming months (and years). Speculators bring liquidity
to the market and are generally believed to make the market
more efficient in discovering the equilibrium price. 
One big change in this market is the growth of index funds
that invest in long positions. In 2002, only a small percentage
of the long positions were held by such funds. Over the past
five years, however, the index funds’ long positions have
grown. They now represent a significant share of the invest-
ment in commodity futures. The rise of index funds has been
accompanied by a rapid rise in the use of derivatives based
on commodity price indices. Note, however, that not all of
these investors are speculators. Although it is true that they
are not hedging risk in the commodity markets, many
large investors, including the employee pension
funds for the federal government and the state of
California, are using the commodity futures index
funds to hedge risk in the stock and bond markets.
Why the rapid growth in the use of commodity
futures to hedge risk in the stock and bond markets?
Readers seeking to understand this change are
referred to a recent research paper by Gary Gorton
and Geert Rouwenhorst in which they develop a data
set on commodity futures prices that spans the period
from July 1959 to December 2003.1 They analyze
the return an investor would have earned on a long
position in an equally weighted portfolio of invest-
ments in a broad set of commodity futures. They
show that such an investment displays the risk-
return characteristics of a similar investment in
equities. The most interesting fact they uncover,
however, is that the return to commodity futures was negatively
correlated with returns in both stocks and bonds. The com-
modity future returns are positively correlated with inflation,
unexpected inflation, and changes in expected inflation. In
other words, an investment in commodity futures would have
been an effective hedge against the business cycle and infla-
tion risk that had been thought difficult, if not impossible, to
hedge. Of course, the history of returns likely would be dif-
ferent if large investors actually had been using commodity
markets in this way during the past 47 years.
The recent increase in commodity futures prices has been
accompanied by a large increase in volatility that has raised
the cost of maintaining margin accounts. Anecdotal evidence
from the Eighth Federal Reserve District suggests that the
rising costs of maintaining margin accounts have led to less
commercial hedging in the cotton and grain markets—at least
by the smaller market participants. This development is inter-
esting because the commodity futures market now is being
asked to hedge not just the risks to producers and consumers
of commodities, but also to hedge risks in the much larger
markets for stocks and bonds. This is uncharted territory. It
will be interesting to see whether the commodity sector is
large enough to effectively insure all this risk.
—William T. Gavin
1 See Gary B. Gorton and K. Geert Rouwenhorst, “Facts and Fantasies about
Commodity Futures,” Financial Analysts Journal, 2006, 62(2), pp. 47-68.
research.stlouisfed.org
Index Funds: Hedgers or Speculators?
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Index funds: hedgers or speculators?

http://research.stlouisfed.org/publications/net/20080701/cover.pdf

Index funds: hedgers or speculators?

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