An equilibrium model for spot and forward prices of commodities

Abstract

We consider a market model that consists of financial investors and producers of a commodity. Producers optionally store some production for future sale and go short on forward contracts to hedge their future commodity price uncertainty. On the other hand, speculators invest in these contracts to diversify their portfolios. The forward and the spot equilibrium commodity prices are endogenously derived as the outcome of the interaction between producers and speculators. Assuming that both are utility maximizers and that the demand shocks and the exogenously priced financial market are correlated, we provide semi-explicit expressions for the equilibrium prices and analyze their dependence on the model parameters. The model can explain why increased speculators' participation in forward commodity markets and higher correlation between the commodity and the stock market could result in higher spot prices and lower forward premia.