First and Second Order Impacts of Speculation on Commodity Price Volatility

This paper contributes to the debate on the link between speculation and price volatility in two ways. First, a simple CAPM model is used to derive the demand for commodity futures contracts by institutional investors, and this derived demand is then integrated into a simple rational expectations model of a commodity market with a demand for hedging by merchants. Second, a GARCH model is used to measure volatility in the U.S. rice market before and after the introduction of a futures contract for rice in 1994. The theoretical and empirical analysis both demonstrate that speculation results in a first order decrease in commodity price volatility, but part of this decrease will be offset by second order pricing distortions that are caused by institutional speculators.