Modelling the impact of financialization on agricultural commodity markets

TL;DR

This paper develops a stylized model to analyze how financialization influences agricultural commodity markets, showing that short-term financial investors increase market volatility despite improving short-term risk allocation.

Contribution

It introduces a model distinguishing long-term producers and short-term financial investors, revealing their contrasting impacts on market stability and volatility.

Findings

Financial investors gain positive expected profits from informational advantages.

Financialization increases volatility of farm default risk and production output.

Short-term investors improve risk allocation but raise overall market volatility.

Abstract

We propose a stylized model of production and exchange in which long-term investors set their production decision over a horizon {\tau} , the "time to produce", and are liquidity constrained, while financial investors trade over a much shorter horizon {\delta} (<< {\tau} ) and are therefore more duly informed on the exogenous shocks affecting the production output. The equilibrium solution proves that: (i) long-term producers modify their production decisions to anticipate the impact of short-term investors allocations on prices; (ii) short-term investments return a positive expected profit commensurate to the informational advantage. While the presence of financial investors improves the efficiency of risk allocation in the short-term and reduces price volatility, the model shows that the aggregate effect of commodity market financialization results in rising the volatility of both farms' default risk and production output.