Financialization And The Volatility Of Commodity Prices

A recent article in the Journal of Risk and Financial Management  takes a fresh look at a familiar issue:whether the development of exchange-traded funds (ETFs) and related instruments tracking the commodities industry (or, in short, the financialization of commodities) has had an impact on the volatility of the prices of the underlying assets.

The new article is by Wing Hong Chan and two other scholars. Wing is with Wilfred Laurier University, in Waterloo, Ontario.

The debate over the unintended (and possibly deleterious) consequences of financialization has been around at least since Michael Masters gave testimony on the subject before the Committee on Homeland Security and Government Affairs of the US Senate in May 2008. Masters said that the market demand consisting of the entry of institutional investors into commodities through such instruments is “one of [the] factors affecting commodity prices today” and that speculation on indexes by institutions may in fact be the primary factor in price inflation. Masters believed that the institutions were as of the time of this testimony contributing mightily to price increases in both food and energy commodities.

Financialization and the Volatility of Commodity Prices

Discussion has moved on over the last decade, and one can get a broad agreement from experts that Masters’ reading of the evidence was too selective and question begging.

The issue, as redefined by subsequent scholarship (such as a seminal 2012 article by Tang and Xiong) is no longer about commodity prices as such, or about an allegedly broad increase in the price levels. It is, rather, about the volatility (in both directions) of commodity prices. It is the sharpness of the zig-zags these prices make on price charts, and the disruption both moves up and moves down can have on people’s lives, that justifies some concern about financialization.

A Negative Correlation

Wing and colleagues maintain that the impact of financialization on the volatility of certain commodities is the opposite of what the pessimists in these discussions think it is. The correlation is negative. Further, that negative correlation is likely causation—the new institutional investors, who have “very different investment incentives from the traditional market participants,” have damped down volatility.

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