Impact of Financial Speculation on Commodity Markets

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Table of Contents

Introduction
Chinese Commodity Market
Indian Commodity Market
Methodology
Discussion
Conclusion
Reference List

Introduction

Research on the influence of financial speculation and price formation in commodity markets has been extensive. The global commodity markets have been highly unstable for the last decade, as illustrated in instances of deregulation, financial crises, and regulatory curbs. On the one hand, the supporters of financial speculation suggested that it can add to a market’s liquidity, decrease risk premiums, and lower hedging costs, along with long-term volatility. On the other hand, researchers have concluded that speculation results in rising volatility on a short-term basis and is responsible for the “frequenting of price bubbles and increased degree of integration with financial markets such as stocks and bonds (Hua Fan et al., 2020). Even though many studies discuss the impact of financial speculation, speculators still play a positive role in commodity markets despite the overall negative perspective toward them. However, there is still a gap in research concerning Chinese and Indian commodity markets and the role of speculation. While generic findings are available, no study explores both markets, compares and contrasts their characteristics, and identifies the role of speculation.

Chinese Commodity Market

Chinese commodity markets have been used as essential indicators for other global economy sectors, especially dry bulk commodities, including coal, steel, ore, and grains. Investors from the country have piled into the markets on speculation requiring infrastructure commodities after the pandemic to increase, with supply remaining limited. For instance, Chinese safety and environmental inspections have influenced domestic coal output (Hua Fan et al., 2020). Therefore, the country’s leadership faces the challenge of balancing rival economic interests, future financial liberalization, as well as broader social concerns. Specifically, it aims to have more leverage over raw materials’ pricing on which the Chinese economy depends. Also, increasing the role of the national currency in global trade needs a greater degree of openness.

As commodity prices surge in the Chinese market, authorities tend to seek solutions to put an end to speculation. Commodity exchanges lead to higher margin requirements as well as increased fees of transactions to reduce speculation. Crackdowns aimed at speculative activities in the market follow a unique pattern (Hua Fan et al., 2020). Bonds, property, and stocks usually undergo cycles of speculative activity as investors shift from one trade momentum to another. For instance, in recent years, cryptocurrencies have been added to the list of speculative instruments that retail investors favored. As the prices of bitcoin and other digital assets have been dropping, commodity and property speculation has become the main focus in the Chinese market (Yang et al., 2018).

Indian Commodity Market

The Indian commodity market can be differentiated into three areas of control in the commodity market functioning. The first layer, which is at the top, consists of the Indian government, and the second layer, which is the middle, is represented by the Forward market commission, now merged with the Securities and Exchange Board of India. The final and the lowest layer is the commodity exchange. Because the country has traditionally been an agricultural economy, there is a high degree of growth associated with it. However, there are specific challenges, such as the lack of commodity prices stability, which has greatly concerned both producers and consumers. Around a third of the population depends on agricultural commodities, with commodity futures markets included in the programs of agricultural liberalization. There is a high need for liberalization, with futures markets representing instruments for achieving that liberalization.

Methodology

The core research question to be answered is the following: “What is the role of speculation on commodity markets of China and India?” No other study is available to cover the topic, which leaves room for data collection and analysis. To address the research question, historical data on Chinese and Indian commodity futures should be obtained, likely covering the period between 2000 to 2020. Considering the fact that India is a predominantly agricultural economy and China is industry-driven, the sample will cover commodities in these two sectors. Specifically, metals, grains, oilseeds, industrials, and energies will be included in the sample. It will be necessary to show the total monthly trading volumes and open interest across future curves and markets. The market is considered to be highly speculative if trading volumes exceed open interests. In addition, it will be necessary to identify speculative pressures. Because no data is available for India and China, a formula for measuring the speculative pressure for each commodity will be used, as follows the example of Hua Fan et al. (2020) in their methodology section. Besides, it will be necessary to identify whether the increased levels of speculation in both Chinese and Indian commodity markets give rise to higher volatility in the commodity sector and the broad market.

Discussion

In both Chinese and Indian markets, speculation may be considered the ‘necessary evil’ because long-short speculators can positively contribute to price discovery by reducing volatility and cross-correlation with stocks. Such a suggestion is drawn from available findings, the majority of which are dedicated to China. The cross-speculative pressure can get maintained on a relatively low level, with the increased speculation not causing seemingly unrelated commodities to become correlated. Such findings align with the broad market effects, confirming that destabilization results are only relevant to specific markets (Haase et al., 2016). Long-term speculators within Chinese and Indian markets who tend to trade on trends or past returns do not have an influence on the commodities’ volatilities that they trade, nor can they influence such commodities as traditional assets and economic growth. Nevertheless, an overall weaker effect can be seen with PPI stocks, which points to the possibility of the commodity price deviation from inflation (Kang et al., 2020). However, it is notable that such findings can generally be in line with the results for broad markets (Haase et al., 2016). In addition, it can be considered reassuring that the followers of systematic trends cannot seem to elevate the volatility of the traded commodities. Altogether, such results also suggest that the information regarding the impact of financial speculation in the commodity market is quite skewed.

Conclusion

To conclude, the overarching presence of speculators in both Chinese and Indian markets of commodity futures does not increase the occurrence of higher market volatility or disrupt the aggregate market’s connection to the fundamentals of macroeconomics. Research has shown that commodity futures are the driving factors of trading prices. Therefore, constant speculation in futures is unacceptable and is in every possible way limited by the theoretical model of the Efficient Market Hypothesis. To calculate the dynamics of the market interaction of commodities and stocks, a three-stage multi-variant dynamic model is used. The VAR-BEKK-GARCH model has already demonstrated the results in the example of the analysis of the Chinese futures market (Ahmed and Huo, 2021). The short-long systematic speculators positively impact markets’ price discovery as compared to market fundamentals by cutting down the volatility of broad markets and cross-market correlation with stocks. Drawing from these findings, even though speculation has its drawbacks, it is a crucial part of commodity markets.

Reference List

Ahmed, A. D., and Huo, R. (2021) ‘Volatility transmissions across international oil market, commodity futures and stock markets: Empirical evidence from China’, Energy Economics, 93.

Haase, M., Seiler Zimmermann, Y. and Zimmerman, H. (2016) ‘The impact of speculation on commodity futures markets – A review of the findings of 100 empirical studies’, Journal of Commodity Markets, 3, pp. 1-15.

Hua Fan, J., Mo, D. and Zhang, T. (2021) ‘The “necessary evil” in Chinese commodity markets’, Journal of Commodity Markets, 2021.

Kang, W., Rouwenhorst, G. and Tang, K. (2020) ‘A tale of two premiums: the role of hedgers and speculators in commodity futures markets’, The Journal of Finance, 75(1), pp. 377-417.

Yang, Y., Goncu, A., and Pantelous, A. A. (2018) ‘Momentum and reversal strategies in Chinese commodity futures markets’, International Review of Financial Analysis, 60, pp. 177-196.

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