A Model of Financialization of Commodities

A sharp increase in the popularity of commodity investing in the past decade has triggered an unprecedented inflow of institutional funds into commodity futures markets. Such financialization of commodities coincided with significant booms and busts in commodity markets, raising concerns of policymakers. In this paper, we explore the effects of financialization in a model that features institutional investors alongside traditional futures markets participants. The institutional investors care about their performance relative to a commodity index. We find that in the presence of institutions the prices of all commodity futures go up. The price rise is higher for futures belonging to the index than for nonindex ones. If a commodity futures is included in the index, supply and demand shocks specific to that commodity spill over to all other commodity futures markets. In contrast, supply and demand shocks to a nonindex commodity affect just that commodity market alone. In the presence of institutions the volatilities of both index and nonindex futures go up, but those of index futures increase by more. Furthermore, financialization leads to an increase in the correlations amongst commodity futures as well as in equity-commodity correlations. Increases in the correlations between index commodities exceed those for nonindex ones. We model explicitly demand shocks which allows us to disentangle the effects of financialization from the effects of rising demand for commodities, and find that in the presence of demand shocks the impact of institutions on futures prices becomes considerably stronger.