An Equilibrium Analysis of Hedging with Liquidity Constraints, Speculation, and Government Price Subsidy in a Commodity Market

  • Author(s): Zhongquan Zhou
  • Published: Dec 17, 2002
  • Pages: 1705-1736
  • DOI: 10.1111/0022-1082.00069

We develop a simple commodity model to analyze (i) the effects of hedging with liquidity constraints, due to producers' inability to bear unlimited trading losses, (ii) the role of speculation in the process of risk allocation between consumers and producers, and (iii) the equilibrium implications of government price subsidies to the producers. We find that (1) liquidity constraints can cause futures prices to exhibit mean reversion, which then makes speculation profitable; (2) speculation tends to make futures price volatility an increasing function of futures price; and (3) government price subsidy, if actively hedged by the producers, serves to lower the futures risk premium and reduce futures volatility.

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