COMMODITY PRICE DYNAMICS

Authors:Pallav Kumar, NMIMS ; Ashish Agrawal, NMIMS

In spite of the consistent attempts being made for stabilizing the commodities market, it still remains to be the most volatile one. Several steps are being taken in order to overcome the volatility. In the agricultural commodities for example, commodity buffer stock scheme has been used, the idea behind this is to store a part of the production in the years when there is good harvest, thus increasing the price from what it would have been and sell the stored goods in the years when there is less production, thus reducing the price from what it would have been.

While the neo classical commodity market models (which promotes efficient markets hypothesis) believe the rational speculators to be a key element in the price stability in the commodities market, the speculators are proving themselves to be a major cause of price instability. As per the chartists and fundamental approach, the interaction between heterogeneous agents, chartists and fundamentalists, may cause a skewed movement of asset prices. As per simulations, whenever the govt. imposes a minimum price to support the producers, the volatility decreases, however the average price of the commodities declines too. Likewise, when the government imposes a maximum price to support the consumers, the volatility decreases, but the average price which consumers pay, increases. This puzzling outcome is because of the dynamic lock in effect.

When the price of the commodities has crossed a critical upper limit the bull market turns into a bearish one. When the govt. intervenes to inhibit this shift it puts a cap on the price of the commodity. As a result, the average price becomes higher than what it would have been without the cap. Moreover, since the price is fluctuating at a high level, it reaches the price cap repeatedly so that the buffer stock is likely to finish rather quickly. Alternating between a lower and an upper price boundary can be seen as one of the ways to counter this problem. The price volatility thus gets decreased but the market still remains distorted. This process of changing the level of price limiters and on-off switching however leads to severe bubbles, crashes or volatility clusters. Hence commodity markets are extremely volatile and regularly display severe bubbles and crashes.  Such price dynamics may, of course, be triggered by demand and supply shocks.

As per the cobweb model, complicated price movements can be attributed to nonlinearities. However, apart from this there exists an additional source of market instability. As most of the commodities are traded at stock exchanges, speculators can also prove to be the deciding factor in commodity markets. Surprisingly, this aspect has received only little attention so far. In a market basically three types of agents interact i.e. the consumers, the producers and the speculators. Speculators are considered to be the heterogeneous one since they are used to both technical and fundamental trading strategies, and, at the inception of each trading period, they choose one of the two strategies as their own trading strategy for that given trading period. Their behavior can be regarded to be rational since they decide between these two strategies depending upon the market.

We are assuming that the price adjustment on the commodity markets may be given by a log-linear price function.

Hence, the log of price S at time t + 1 is 

                                              S_t+1 = S_t + a (D^t + W^tC D^t + W^tF D^t )

Here ‘a’ corresponds to the positive scaling coefficient in order to calibrate the price adjustment speed; D^t corresponds to the excess demand of the real economy, the technical and the

fundamentalist analysts respectively at time t.

The weight of the chartists at time t is given as W^tC, whereas the weight of the fundamentalists is given as W^tF

  

 To illustrate the demand and supply decisions for the real economy we are introducing a reduced form assuming that the supply schedules of both the consumers and the producers are log-linear. The excess of demand for the real economy can be expressed as

                                                     D^t = m (F − S_t),

Here ‘m’ refers to the slopes of the supply and demand curves and F corresponds to the long-run equilibrium price (also called the fundamental price).  When the value of the price is equal to the value of the long-run equilibrium price F, the excess demand of the real economy turns out to be zero. We can then assume that the economic structure is quite stable and there are no or very few permanent demand and supply shocks. As a result, the value of F remains constant over time. In the absence of speculators,

                                                   W^tC = W^tF = 0,

In this case law of motion of the commodity’s log price has a unique fixed point at S_t =F, Such a state is obviously efficient. Speculators are familiar with both technical and fundamental analysis.

Now, to model the excess demand generated by chartists or the technical analyst we formulate:

                                                    D^t = b (S_t - F)

Where ‘b’ is a positive reaction coefficient and F is the long-run equilibrium price (also called the fundamental price). The technical analysts believe typically in bear and bull markets. As long as the price is above the fundamental value, chartists regard the market to be bullish. Since a further price increase is expected, chartists believe in buying the commodity.  However, if the price drops below the fundamental value then the chartists tend to lose faith in the stock.  In a bear market, chartists sell the commodity.  Since changes in excess demand are positively correlated with changes in price, it is in a broader sense consistent with positive feedback trading.

Fundamental analysts believe that prices tend to revert back to their fundamental value. If the price is above its equilibrium value, lower prices are expected and fundamental analysts tend to sell the commodity. In the same way if the price is below its equilibrium value, higher prices are expected and fundamental analysts tend to buy the commodity. The excess of demand generated by fundamental analysts can be given as

                                                            D^t = c(F − S_t).                                              

Here c is the reaction coefficient.

The Speculators tend to exploit interchangeably the bull and the bear market situations. However, when the price deviates more from its fundamental value, speculators perceive more risk for the bull or bear market to collapse. As a result, an increasing number of speculators tend to go for fundamental trading. The market share of speculators who tend to apply technical analysis may thus be given as

                                                          t   =1/ 1+d (F−S_t) ².

The higher the switching parameter d is greater than 0, faster the speculators tend to switch to fundamental analysis.

The weight of fundamentalists is       

                                                           W^tF = 1 − W^tC

Although producers and consumers are the two primary participating agents in the commodity markets, there are also other participants, such as speculators, who may have a definite effect on the degree of price variability and on the success of any commodity price stabilization scheme.

Thus we can say that the chartists are a source of market

instability.  Also weak reaction of the speculators (either the fundamentalists or the chartists) can push the market to be either a bull or a bear market and strong reaction of the speculators causes market prices to fluctuate irregularly between bull and bear markets.