A Feedback Model for the Financialization of Commodity Markets

Abstract

Recent empirical studies find evidence that commodity prices have become more correlated with financial markets since the early 2000s. This increased correlation is called the financialization of commodity markets and is conjectured to be due to the influx of external (portfolio optimizing) traders through commodity index funds, for instance. We build a feedback model to try and capture some of these effects, in which traditional economic demand for a commodity, oil say, is perturbed by the influence of portfolio optimizers. We approach the full problem of utility maximizing with a risky asset whose dynamics are impacted by trading through a sequence of problems that can be reduced to linear PDEs, and we find correlation effects proportional to the long or short positions of the investors, along with a lowering of volatility.