The New Price Makers: An investigation into the impact of portfolio investment on coffee price

behaviour

Susan Newman

“Challenges and Prospects for Commodity Markets in the Global Economy”

A Workshop in Memory of Alfred Maizels

20th September 2008SOAS, University of London

Aims

• Assess the effectiveness of hedging on futures markets for income stabilisation

• Re-examine the relationship between futures and physical markets for coffee

• Challenge the notion that all futures trading activities are stabilising

• Show that price outcomes depend upon the composition of traders on futures markets differentiated by the motives behind their trading activities

Outline

• Stabilising vs. destabilising speculation

• Who are the traders and why do they trade in coffee futures?

• Implications of different types of trading activities on price behaviour

• Quantitative studies on trading and price behaviour on the coffee exchange of the NYBOT

• Supply and Demand vs. Trader Composition• Financial investment and short-term price movements

Stabilising vs. destabilising speculation

• Classical theory of speculation– Speculators as market makers– Constructive speculation (Marshall, 1932)– Speculation is always stabilising and beneficent.

• Neoclassical theory of speculation– Knightian definition of risk– Rational and informed speculators provide liquidity and enhance

the efficiency of the pricing mechanism

• Destabilising speculation– Movement trading (Irwin, 1937)– Post Keynesian theory of speculation– Performative economics (MacKenzie, 2005)

Who’s trading on the coffee exchange of the NYBOT?

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Daily open interest on the coffee “C” market

(Data source: NYBOT 2007)

Hedgers Vs. Speculators I

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Ratio of non-commercial open interest to total open interest in coffee C contracts on the New York Coffee Exchange

(Data source: NYBOT 2007)

Hedgers Vs. Speculators II

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Volume equivalent of C contracts traded per month divided by the monthly volume of arabica exports from ICO member countries

Data Source: NYBOT 2007; ICO 2007)

Investing in commodities“[C]ommodity markets have become more like financial markets in terms of the

motivations and strategies of participants” (Domanski and Heath 2007)

Why invest in commodities?• Commodities as an important portfolio diversifier

– As an inflation hedge

– Commodity price movements have traditionally been negatively correlated to price movements of other financial instruments (such as equities and bonds)

– While equities are bound by country-specific economic pressures, commodity prices tend to reflect the global economy

– Expect an inflow of funds on commodity markets during periods of global economic downturn associated with falling equities prices.

Who invests in commodities?• Institutional Investors

– Hedge funds– Pension funds

• Private investors• Retail investment

Breakdown of UK and European Exchange Traded Fund investorsfrom Doyle, Hill and Jack 2007

Implications of different types of trading activities on price behaviour

Where an inflow of funds onto commodity exchanges occurs as a consequence of changes in the wider economic environment (i.e. not owing to conditions in individual commodity markets) we might expect:

1. A loosening in the relationship between prices and supply and demand conditions.

2. A change in the short-run behaviour of prices that will depend upon the type of fund inflow

Supply and Demand Vs. Trader Composition We apply structural Bai-Perron (2003) break tests to series that describe:

1. the evolution of the total annual volume of trade in futures contracts on the New York Coffee exchange

2. the fraction of non-commercial futures open interest to total open interest for each year

3. the relationship between coffee prices and world supply & demand

Structural breaks in trading activities on the coffee exchange of the NYBOT

Series Specification Break date(s)

Annual volume of “C” contracts traded AR(1) 2001

Annual volume of “C” contracts traded AR(1) with time trend 1999

Annual ratio of non-commercial open interest to total open interest on the coffee “C” exchange

AR(1) 2001

Annual ratio of non-commercial open interest to total open interest on the coffee “C” exchange

AR(1) with time trend 1990

ttt ATVATV 1

ttt tATVATV 110

ttt ANCTOIRANCTOIR 1

ttt tANCTOIRANCTOIR 110

Structural breaks in the relationship between coffee prices and supply and demand

Coffee price model (Maizels, Bacon and Mavrotas 1997)

PCMCTSTfP

1210 tLPLSTRTLP

Best 3 break dates identified by Bai-Perron method

1994, 2000, 2004

Number if breaks selected by BIC

1

Break Date 1994

Intercepts 1.4332727529 (p-value 0.00163319)1.5442321270 (p-value 0.03369707)

Coefficient on LSTRT 1.6469755916 (p-value 0.00248171)1.3112557084* (p-value 0.10207228)

Coefficient on LPt-1 0.6761458959 (p-value 0.00002563)0.5857708346 (p-value 0.01673472)

Financial investment and short-term price movements

• We examine the simple correlation between financial investment in coffee futures and a computed instability index, or volatility index for the futures price (Labys and Thomas 1975)

• We construct monthly measures for volatility and financial investment for the period 1972-2006– Volatility Index (VI)

– Variable for financial investment (SPEC) defined as the natural logarithm of the ratio of the volume equivalent of coffee-C contracts traded and total exports of green coffee from ICO member countries

n

PP

PVI t

2100

Summary of results from Bai-Perron tests of multiple structural breaks in the relationship between financial investment and price volatility

(1980:01 to 2006:12) BIC

Best 5 break dates identified by Bai-Perron method

1981:03, 1981:09, 1987:06, 1994:04, 2000:10

1.33945

Best 4 break dates identified by Bai-Perron method

1980:05, 1986:11, 1994:04, 2000:10

1.37260

Best 3 break dates identified by Bai-Perron method

1987:06, 1994:04, 2000:10 1.38572

Best 2 break dates identified by Bai-Perron method

1994:04, 2000:10 1.44880

Best break date identified by Bai-Perron method

2000:10 1.53878

Number if breaks selected by BIC 1

Break Date 2000:10

ttt uSPECVI 21

Estimation results for for the 4 sub-periods between 1980:01 to 2006:12

ttt uSPECVI 21

Variable Estimated coefficient p-value

1980:01 to 1994:04, R-squared = 0.718231, R bar-squared = 0.048808, ρ = 0.233176

Constant -3.773838265 0.09257627

SPEC 0.836345100 0.00208172

1994:04 to 2000:10, R-squared = 0.839774, R bar-squared = 0.203926, ρ = 0.462745

Constant -45.75715604 0.00009639

SPEC 5.66135965 0.00001756

2000:10 to 2006:12, R-squared =0.861727 ,R bar-squared = 0.019330, ρ = 0.163134

Constant -3.171043700 0.46426916

SPEC 0.731497994 0.12120941

1994:04 to 2006:12, R-squared=0.790368, R bar-squared =0.007724, ρ = 0.180504

Constant -3.407337938 0.51972349

SPEC 0.855760676 0.14160197

Volatility Index vs. measure of financial investment

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Speculation Index (SPEC)

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Conclusions and further research

• The behaviour of coffee prices has been affected by the extent, as well as the type, of financial investment that has taken place on the coffee exchange of the NYBOT.

• The increase in coffee prices that took place from 2002-2007 can in part be attributed to financial investmetn rather than changes in supply and demand.

• Other studies have found excess comovement in prices of different, un-related commodities that has been attributed to portfolio diversification (Garrett and Taylor, 2001)

• A next step in this research is to investigate the extent to which coffee prices and the prices of unrelated commodities move together.

Thank you for your attention