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An Equilibrium Analysis of Hedging with Liquidity Constraints, Speculation, and Government Price Subsidy in a Commodity Market
Author(s) -
Zhou Zhongquan
Publication year - 1998
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/0022-1082.00069
Subject(s) - speculation , futures contract , economics , market liquidity , volatility (finance) , commodity market , financial economics , contango , forward market , monetary economics , futures market , commodity , microeconomics , macroeconomics , market economy , finance
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.