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Nongnuch Tantisantiwong School of Business University of Dundee Dundee DD1 4HN UK email:n.tantisantiwong@dundee.ac.uk tel: +44 1382 385838 January 20, 2011

Abstract The framework presents how trading in the foreign commodity futures and domestic forward foreign exchange markets can aﬀect the optimal spot positions of domestic commodity producers and traders. It generalizes the models of Kawai and Zilcha (1986) and Kofman and Viaene (1991) to allow both intermediate and ﬁnal commodities to be traded in the international and futures markets, and the exporter to face production shock, domestic factor costs and a random price. Applying the mean-variance expected utility, we ﬁnd that a rise in exchange rate volatility can reduce both supply and demand for commodities and increase the domestic prices if the exchange rate elasticity of supply is greater than that of demand. Even though the forward foreign exchange market is unbiased, and there is no correlation between commodity prices and exchange rates, the exchange rate can aﬀect domestic trading and prices through oﬀshore hedging and international trade if the traders are interested in their proﬁt in domestic currency. It illustrates how the world prices and foreign futures prices of commodities and their volatility can be transmitted to the domestic market as well as the dynamic relationship between intermediate and ﬁnal goods prices. The equilibrium prices reﬂect trader behaviour i.e. who trade or do not trade in the foreign commodity futures and domestic forward currency markets. The empirical result applying a two-stage-least square approach and Thai rice and rubber prices supports the theoretical result. Keywords: oﬀshore hedging, currency hedging, asset pricing, price transmission JEL Classiﬁcation: F1; F3; G1; Q1

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Electronic copy available at: http://ssrn.com/abstract=1744049

**Price Transmission and Eﬀects of Exchange Rates on Domestic Commodity Prices via Oﬀshore Hedging
**

Abstract The framework presents how trading in the foreign commodity futures and domestic forward foreign exchange markets can aﬀect the optimal spot positions of domestic commodity producers and traders. It generalizes the models of Kawai and Zilcha (1986) and Kofman and Viaene (1991) to allow both intermediate and ﬁnal commodities to be traded in the international and futures markets, and the exporter to face production shock, domestic factor costs and a random price. Applying the mean-variance expected utility, we ﬁnd that a rise in exchange rate volatility can reduce both supply and demand for commodities and increase the domestic prices if the exchange rate elasticity of supply is greater than that of demand. Even though the forward foreign exchange market is unbiased, and there is no correlation between commodity prices and exchange rates, the exchange rate can aﬀect domestic trading and prices through oﬀshore hedging and international trade if the traders are interested in their proﬁt in domestic currency. It illustrates how the world prices and foreign futures prices of commodities and their volatility can be transmitted to the domestic market as well as the dynamic relationship between intermediate and ﬁnal goods prices. The equilibrium prices reﬂect trader behaviour i.e. who trade or do not trade in the foreign commodity futures and domestic forward currency markets. The empirical result applying a two-stage-least square approach and Thai rice and rubber prices supports the theoretical result. Keywords: oﬀshore hedging, currency hedging, asset pricing, price transmission JEL Classiﬁcation: F1; F3; G1; Q1

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Introduction

Many frameworks try to explain the behaviour of traders and commodity prices in an economy that has both commodity spot and futures markets. However, some small countries are the world largest exporters or importers of commodities, and they do not have their own commodity futures market. The domestic traders in these small countries are price takers. The world prices can therefore aﬀect the domestic commodity prices, and the higher volatility of world prices can have an adverse eﬀect on these small economies. For example, many oil importing countries suﬀered from the recent oil price crisis in 2008. The inﬂation of South Korea, Taiwan and the Philippines rose sharply due to the rise in oil and rice prices as they are the world largest importers of both commodities. On the other hand, the higher volatility of oil and rice prices causes economic instability of oil and rice exporting countries. For instance, in the ﬁrst half of 2008 Thai people suﬀered from a continuous increase in the domestic price of rice which is main and necessary food of the country because more rice was exported due to the higher world price, leaving the country with the lower supply. The rise in oil price caused a higher production costs of synthetic rubber and thus increased the demand for substitutes (e.g. natural rubber). Thailand which is the world largest exporter of milled rice and rubber products beneﬁted from this. That is, Thai export growth increases, so Thailand experienced a resilient economic growth in spite of facing higher fuel import bills. Later, the commodity prices dropped 1

Electronic copy available at: http://ssrn.com/abstract=1744049

following a sharp fall in oil price in July 2008. This caused a decrease in Thai export growth, farm incomes and incomes of rice mills and rubber sheet manufacturers, leading to a reduction of private consumption growth. As a result, the economic growth dropped from 0.8% y-o-y in the ﬁrst half of 2008 to —0.7 and -4.9% y-o-y in the third and fourth quarters of 2008, respectively. From this, we can see that traders facing price risk are not only exporters, but also producers, processors and storage companies. Without the domestic futures market, domestic traders can only hedge their price risk in the foreign commodity futures markets or use the foreign futures prices as information in predicting future commodity prices. For example, before the Agricultural Futures Exchange of Thailand (AFET) started trading futures contracts of smoked rubber sheet in May 2004 and futures contracts of milled rice in August 2004, Thai rubber traders hedge their price risk in the Singapore Commodity Exchange (SICOM)1 and Thai rice traders trade in the Chicago Board of Trade (CBOT)2 . This raises a concern whether exchange rates can aﬀect domestic commodity prices also through foreign futures trading. Kawai and Zilcha (1986) found that if the economy has only the forward foreign exchange market, exports could be increased by the introduction of domestic commodity futures markets and decreasing exporters’ risk aversion. Many recent literatures found the optimal oﬀshore hedging strategy for the exporters or the importers. Kawai and Zilcha (1986) and Kofman and Viaene (1991) found the exporters’ optimal strategy in the case of incomplete market such that there is no commodity futures market in the economy. Their models were focused on intermediate commodity which was storable, quoted in the foreign demanding country’s currency and traded in the international and futures markets. Yun and Kim (2010) found that Korean oil importers’ hedging would be more eﬀective if they hedged their price risk in the foreign futures market and simultaneously entered into currency futures contracts. Moreover, Jin and Koo (2002) developed a theoretical model to ﬁnd a hedging strategy when the traders face hedging cost and in their empirical work they also found the optimal hedging ratio for Japanese wheat importers who hedged their price risk in the CBOT and hedged exchange rate risk in the Tokyo International Financial Futures Exchange (TIFFE). Unlike others, Kofman and Viaene (1991) also found the optimal strategies of domestic producers and processors as well.

1 There are more Thai traders trading the futures contract of smoked rubber sheet in the SICOM than in other futures market because the Singapore is the largest port shipping smoked rubber sheet for Thailand and Malaysia, the world largest exporters of smoked rubber sheet. 2 For the case of rice, there are more Thai traders trading in the CBOT than in other futures market because the US is one of the largest importers of Thai milled rice. However, rice traded at the CBOT is rough rice, not milled rice.

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Electronic copy available at: http://ssrn.com/abstract=1744049

We show that even if there is no correlation between commodity prices and 3 . for example. or crude oil and reﬁned oil) can be exported in some countries. An aim of this paper is to develop a framework to explain what are the eﬀects of trading in the foreign commodity futures and domestic currency markets on the domestic commodity market of a small country and how exchange rates can aﬀect domestic commodity prices through this trading. exporters face export uncertainty. both intermediate and ﬁnal commodity (raw sugar and reﬁned sugar. In addition. Feder. some studies currency hedging for international ﬁnancial portfolio. whether exports are contracted in advance. Investigating the relation between Thai milled rice price and the US dollar exchange rate. For some commodities e.g. The framework here expands the models of Kawai and Zilcha (1986) and Kofman and Viaene (1991). corn. Chen.g. allowing either intermediate commodity or ﬁnal commodity to be traded in the international and futures markets. Schmittmann (2010) found that both exchange rate volatility and the correlations of exchange rates with bond and equity returns can increase risk exposure to investors. which traders hedge their price and exchange rate risks. Unlike Danthine (1978). rice. equilibrium prices. Some of their assumptions are also relaxed e. Timmer (2009) found that the Euro-US Dollar exchange rate signiﬁcantly Granger caused prices of commodities e. and exchange rates depend upon which product is exported. Rogoﬀ and Rossi (2010) showed that exchange rates had signiﬁcant power in forecasting commodity prices. domestic factor costs and domestic price of ﬁnal goods. Applying Granger Causality test. We ﬁnd that relationships among optimal strategies. and whether the commodity prices and the exchange rates are correlated. Apart from commodity prices. crude oil and palm oil. much higher delivery cost. Some literatures found the empirical relationship between spot exchange rates and domestic commodity prices. the agents’ optimal commodity spot and futures holdings and optimal forward exchange holding in this particular case are speciﬁed. some small countries allow exports of ﬁnal goods only e.While these models focused on optimal strategies of exporters of intermediate commodities. By applying a two-period mean-variance approach. Kofman and Viaene (1991) found a positive ex-post correlation coeﬃcient while Gilbert (1991) found the exchange rate elasticity equal to -1. Thai rough rice and natural rubber cannot be exported due to nature of products. the degree of risk aversion can aﬀect all optimal spot positions. and Benninga and Oosterhof (2004).g. wheat. Holthausen (1979).g. and regulations. sugar and oil. Just and Schmitz (1980).

The robustness of the theoretical result is also discussed. foreign future prices and exchange rates. but their impacts on price depending on which between supply and demand is aﬀected more. and the exchange rates of Thai Baht against US Dollar and Singapore Dollar before futures contracts ﬁrst traded in the AFET. but has 4 . the framework shows how world prices are transmitted to domestic intermediate and ﬁnal commodity markets. The forward foreign exchange market is biased. Here.exchange rates. That is. allowing the forward exchange rate to have impacts on the optimal spot position and commodity prices. it may be due to Thailand moving from the ﬁx exchange rate system to the managed-ﬂoat system in 1997. In Section 3. the two-stage-least-square regression shows how prices of intermediate and ﬁnal commodities are related and how they are aﬀected by world prices. and thus the optimal futures and spot position. Section 4 concludes and suggests some further research.1 Framework Assumptions In this framework. there are still some exchange rate eﬀects on the commodity prices via exporting/importing and trading in the foreign futures if the agents are interested in their proﬁts in domestic currency. the theoretical framework is developed to ﬁnd the optimal strategies and equilibrium prices. For empirical studies. we consider how oﬀshore commodity hedging and domestic currency hedging of traders can aﬀect the domestic spot commodity market of a small country which does not have its own commodity futures market. The higher volatilities of spot prices and futures price will reduce both demand and supply of the commodity. we use the data on Thai rice and rubber prices. In the next section. As an advantage of this framework. the estimation result can reﬂect who trades in the foreign commodity futures and forward foreign exchange markets and who does not. This result is diﬀerent from the ﬁndings of Kofman and Viaene (1991) and Gilbert (1991). the contemporaneous correlations of exchange rates with commodity prices are insigniﬁcant for the case of rice and signiﬁcant for the case of rubber. IAs another aim of the paper. The empirical ﬁnding supports the theoretical result. The rest of paper is outlined as follows. The higher volatility of exchange rate can lower the optimal forward position. 2 2. both intermediate and ﬁnal commodities are storable and internationally tradable.

Primary commodity market Exported commodities Processor Producer Domestic Intermediate + Final Goods Markets Consumer Storage companies Flows of Primary Commodity Flows of Intermediate Commodity Flows of Final Commodity Exporters World Market Figure 1: Flows of intermediate and ﬁnal commodities within an exporting country the forward foreign exchange market. storage and internationally delivery take one period (i. exporters (or importers). The mean-variance expected utlity maximization is applied to ﬁnd the optimal strategies of domestic traders: producers. With the optimal level of input (intermediate commodity) chosen at period t. importers pay for importing commodities at the world prices at period t. They sell the commodities to the domestic market in the next period after receiving 5 . processors produce the ﬁnal commodity and sell it to storage companies or exporters at price Qt+1 at period t+1. storage companies or exporters at price Pt+1 at period t+1. In the case that the country imports commodities. and storage companies. traders hold the positions for a single-period horizon). primary commodity) at period t and sell their output (intermediate commodity) to processor. exporters buy the commodities from the domestic market.g. processors. after packing they deliver the commodities to the foreign importers and get paid in foreign currency in the next period at the world prices (Pmt+1 and Qmt+1 ). and in each period both intermediate and ﬁnal commodities are traded in the domestic market. Storage companies can buy either intermediate or ﬁnal commodities from the domestic markets and sell them to the domestic market in the next period to make a proﬁt.e. Production and trade ﬂows among traders for the commodities that the country exports is shown in ﬁgure (1) while ﬂows for the commodities that the country imports is shown in ﬁgure (2) We assume that the production process. The intermediate producers choosing the optimal level of input (e. For the exporting country.

and hedge their exchange rate risk in the domestic forward exchange market. The framework also has assumptions as follows.Primary commodity market Imported commodities Processor Producer Domestic Intermediate + Final Goods Markets Consumer Storage companies Flows of Primary Commodity Flows of Intermediate Commodity Flows of Final Commodity Importers World Market Figure 2: Flows of intermediate and ﬁnal commodities within an importing country commodities. Xit denotes the position of the agent of type i in the primary good at time t and similarly for Yit (intermediate good). domestic traders can hedge their price risk in the foreign commodity futures market. i = ey for the ﬁrm exporting intermediate good and i = eh f denote the position of the agent of type i in the forward exchange for the ﬁrm exporting ﬁnal good. As the country does not have a commodity futures market. Let Zit contract at time t. All agents can hedge or speculate in the foreign futures market by selling or buying the futures f Ft et in domestic currency. It follows that all contract with a full margin at time t which is worth Yit domestic traders close their futures position by the last trading day of period t+1 by a cash settlement 6 . the maturity of the futures and forward contracts is at time t + 1. In addition. i = sh for the companies storing ﬁnal good. The export/import and futures prices are quoted in the foreign demanding country’s currency. Πi is the proﬁt of trader i where i = f for the intermediate producers. In the sequel. i = p for the processors. Either intermediate or ﬁnal commodity is traded in the futures market. Note that in period t all stochastic variables of time t + 1 are unknown. i = sy for the companies storing intermediate good. A1. Hit f (ﬁnal good) and Yit (futures contract for intermediate or ﬁnal commodity).

7 . Any variables such as the optimal spot and futures positions at time t chosen by agent i at time t depend on his own information set available at time t (Iit ). traders can short or long the forward exchange contract at time t. The domestic spot and forward exchange markets are insigniﬁcantly aﬀected by the uncertainty of commodity spot and futures prices. Broll and Schimmelpfennig (2000) here the expected future exchange rate for trader i. they can also buy market. noise trading in the commodity futures and forward foreign exchange markets are uncorrelated and do not have serial correlations. After the cash transfer. there is no margin requirement in the forward market so the payment in the forward exchange market is only made at maturity t + 1. traders face exchange rate risk. This risk premium can be time varying. Eit (et+1 ). all traders choose their optimal decisions by maximising their expected utility function (V ) depending on their proﬁt in domestic currency. Due to international trade and foreign futures trading. Unlike the trade in the futures market. All traders transfer the cash (in foreign currency) through the foreign futures market’s f Ft is made at time t with the exchange rate clearinghouse both at time t and t + 1 e. the foreign currency remaining in their hands can be sold to the spot exchange f . Eit (·) denotes agent i’s expectation depending on Iit . et and the payment on Yit A2. A4. foreign futures market and domestic forward exchange market relatively to trading volume in the markets. Braulke. is not necessarily equal to the forward exchange rate. If their actual payment (receipt) in foreign currency is larger (smaller) than Zit more foreign currency in the spot market. A5. Production shock. The discount factor. ρ.because delivering to or taking delivery from the foreign futures market requires substantially additional costs. is assumed to be 1/(1 + it+1 ) where it+1 is the interest rate at time t+1 and perfectly foreseen at time t. or the commodity traded in the foreign futures market is diﬀerent from the commodity of which price is hedged.g. A3. storage and export uncertainty. V arit (·) denotes agent i’s expected variance of a variable depending on Iit . ft . To hedge exchange rate risk. ft = Et (et+1 )+ risk premium. Unlike the assumption of Battermann. Domestic traders in a commodity market are rational and are small in the international commodity market. based on the expected future payment or receipt (in foreign currency). the payment on Yit f Ft+1 is made at time t+1 to close futures position with the exchange rate et+1 . At time t. So Eit (et+1 ) = Et (et+1 ).

Zpt foreign currency in the spot exchange market if it turns out that he has underhedged his exchange rate risk 3Y 1/2 } + t+1 where l is other inputs and 0 < b < 1. he may buy more foreign currency from the spot exchange if f f Zf t < Yf t Ft+1 . l of seeds and the other production cost which depends on the amount of input used in the production. We assume that the production shock. The production shock is realised just before delivering the output to the spot market 2 at time t + 1. After taking delivery of Zpt at the forward rate ft .2. he can also sell futures contracts of f ) to hedge his price risk. He may buy the exact amount of the foreign currency which he has to pay to the futures market from the spot exchange f market at t +1 at the rate et+1 and thus Zf t = 0.2 2. He sells his ﬁnal goods at time t+1 in the domestic market of ﬁnal commodity at price Qt+1 . therefore. He can hedge his exchange rate risk by buying the f f . 2. t+1 )) 3 in the spot market at time t +1.2. On the other hand. he may buy the remaining forward exchange contract. he may take delivery of the amount of foreign f f f currency Zf t from the forward exchange market. At time t.1 Proﬁt Functions Intermediate producers A producer buys primary commodity at time t to produce intermediate commodity and sells his output (f (Xf t .2 Processors At time t a processor purchases intermediate goods to produce ﬁnal goods. l. Alternatively. the cost function is equal to the cost f t+1 = min{bXf t+1 . He can hedge his price risk by selling futures contracts maturing at time t + 1. His proﬁt function is. 2 Πf = Yfft Φt − rt Xf t − θXf t + ρ{(f (Xf t ) + f − Yfft Φt+1 + (et+1 − ft )Zf t }. He closes all of his futures position the ﬁnal commodity maturing at time t+1 (Ypt at time t+1 by buying futures contracts at price Ft+1 . θXf t is the production cost excluding the cost of seeds (θ > 0). at price Ft in the foreign futures market at time t. 8 . Because of closing futures position with cash settlement. t+1 has Ef t ( t+1 ) = 0 and V arf t ( t+1 ) = σ 2 . t+1 )Pt+1 (1) where rt is the primary commodity price and Φt (=Ft et ) is the foreign futures price in domestic currency at time t. he faces exchange rate risk which he can hedge by buying forward exchange contracts maturing at time t + 1 at the forward rate ft . He may sell his excess foreign currency Zf t − Yf t Ft+1 in the spot exchange market at t + 1 if his actual payment (in foreign currency) to the futures market at time f t + 1 is smaller than Zf t . Yfft .2. Therefore.

wt+1 ) = 0 where j = y and h. A processor’s proﬁt function is the spot exchange market at the rate et+1 at time t+1 and thus Zpt f f f 2 Φt − Pt Ypt − αYpt + ρ{(g (Ypt ) + vt+1 )Qt+1 − Ypt Πp = Ypt +1 Φt+1 + (et+1 − ft )Zpt } (2) where g (Ypt .t intermediate commodity is f y f f 2 Φt − Pt Ysy. 9 . he may choose to buy foreign currency from the f = 0. the company’s proﬁt function is f f f 2 h Φt − Pt Hsh. in f = 0.t Φt+1 + (et+1 − ft ) Zsh. Zsj. the cost function is equal to the cost of intermediate goods and the other production cost which depends on the amount of intermediate goods used in the production. Instead.e.3 Storage companies A storage company purchases intermediate goods or ﬁnal goods at time t and sells them to make a proﬁt y 2 2 h or γ h Hsh. Therefore. ft .t Ft+1 in the spot exchange market if it turns out (Zsj.t + ρ{(Hsh.t }.t or Qt Heh. he can hedge his exchange rate risk due to the payment to the futures market at time t+1 with the forward exchange contract f f f ) at the forward rate.t ) where 0 < γ < 1. we assume that export prices at time t+1 are random. V arsj.t }.t ) plus delivery and 4H 1/2 } + ν pt+1 = min{a(Ypt ). (3) For the company that stores the ﬁnal commodity. ν t+1 ) is a production function of the ﬁnal good (Hpt+1 )4 . wt at time t+1. he may choose to buy this amount of the foreign currency. Ypt Ft+1 > Zpt . He purchases the commodities at time t and export them at time t+1.t Φt+1 + (et+1 − ft ) Zsy.t + wt Πsh = Ysh. he can hedge his price risk by selling the futures contract maturing at time t and close the futures position at time t+1. In addition. (4) 2.t (wt +1 . αYpt is the other production cost which depends on the amount of intermediate commodity.4 Exporters/Importers An exporter commits to export intermediate goods or ﬁnal goods.t + wt Πsy = Ysyt +1 )Pt+1 − Ysy.t (wt+1 ) = σ jw .t − γ y Ysy.t − Ysj.t +1 and wt+1 denotes storj j 2 age uncertainty for intermediate goods and ﬁnal goods with Esj.t (wt +1 ) = 0.t +1 )Pt+1 − Ysh. He may sell Zsj.t + ρ{(Ysy.f f f i. k t+1 where k is other inputs and 0 < a < 1. ν t+1 has a 2 zero mean and a constant variance (σ 2 v ). The proﬁt of the company that stores the spot exchange market at t+1 at the rate et+1 i. 2. The production shock. Like Kawai and Zilcha (1986).t − γ h Hsh. Alternatively.e.2.2. and y h Covsj. At time t.t that he has overhedged his exchange rate risk. His total production cost is the cost of commodity (Pt Yey. His storage cost is (γ y Ysy. k. Ypt Ft+1 .

t − βHeh. and eh). he faces price risk from selling the commodity to the domestic market and also exchange rate risk from oﬀshore hedging.2 2 h transaction costs (βYey. He may sell Zej. processors and storage companies bought at time t. Given that he makes decision at time t. Or else. he may buy foreign currency from the f = 0.t Ft+1 in the spot exchange market contract (Zej.t t+1 )Qmt+1 et+1 − Yeh.3 Optimal Strategies Each trader chooses his optimal commodity spot position. instead of Pt and Qt while the commodity is sold at time t+1 at the domestic price. spot exchange market at t+1 at the rate et+1 so Zej. Pmt and Qmt .t or βHeh.t t+1 )Pmt+1 et+1 − Yey.t The proﬁt function of the intermediate goods exporter is f f f 2 Φt+1 − Pt Yey. The decision is made at time t.t (uj t+1 ) = 0. Yit for i = p. (6) In the framework of an imported commodity. 2. At time t. sy and ey .t (ut+1 . V arej.t }.t if it turns out that he has overhedged his exchange rate risk.t + uh Πeh = Yeh.t Φt+1 + (et+1 − ft ) Zey. In addition. commodity futures position and forward exchange position by maximising the mean-variance expected utility depending on their proﬁts. so the domestic supply of intermediate and ﬁnal commodities at time t+1 depends on the input that producers.t ) where 0 < β j < 1.t Φt+1 + (et+1 − ft ) Zeh.ut+1 ) = 0 where j = y and h. and Hit for i = sh f f ) and the forward position (Zit ).t }.t − Yej.t + ρ{(Heh. (5) The ﬁnal goods exporter’s proﬁt function will be f f f 2 Φt − Qt Heh. the futures position (Yit 10 .t + ρ{(Yey. the importer’s input costs will be the world prices.t + uy Πey = Yey.t − βYey. he can hedge his exchange rate risk due to the payment to the futures market at time t+1 by purchasing the forward foreign exchange f f f ) at time t at the forward rate ft . uy t+1 and ut+1 denotes uncertainty aﬀecting exports j y 2 h of intermediate goods and ﬁnal goods with Eej. he can also hedge his price risk in the foreign futures market by selling the futures contract maturing at time t and close it at maturity.t (ut+1 ) = σ ju and Covej. The objective function Vi = Uit (Πit ) + ρEit Uit+1 (Πit+1 ) (7) is maximised with respect to the spot position (Xf t for i = f .

et+1 )Corrit (Mit+1 . we also ﬁnd the optimal output level at time t+1 regardless of production shocks i. ξ it+1 ) = χit ¯ ¯s ¯ Φt − ρEit (Φt+1 ) ¯ V arit (Mit+1 ) ¯ ¯ Corrit (Mit+1 . Φt+1 ) Mit+1 is the price of product sold by trade type i: Pt+1 for the producer and the company storing or importing the intermediate commodity. Let Sit be the vector of the optimal spot positions i. ∗ From this. Qt for the company storing or exporting ﬁnal goods. We assume that Covit (Mit+1 .e. and Qmt+1 et+1 for the exporter of the ﬁnal commodity. eh. Φt+1 ) − Corrit (Φt+1 .e. et+1 ) ¯ ¯s ¯ ρ(Eit (et+1 ) − ft ) ¯ ¯ V arit (Mit+1 ) ¯ Corrit (Φt+1 . This is because a decrease in the supply of 11 . et+1 ) + ¯ ¯ 2 (Φ ¯ χit V arit (Φt+1 ) ¯ 1 − Corrit t+1 . the optimal spot position is trading for the producer and g (Ypt volume. f (Xf t ) for i = f . Pmt+1 et+1 for the exporter of the intermediate commodity. et+1 ) Corrit (Mit+1 . Pt /a for the processor. The optimal ∗ and for the company storing position at time t for the company storing intermediate goods is denoted as Ysy. at time t which is carried forward to the period t+1.t ∗ ∗ ∗ .t ∗ ∗ for the exporter of ﬁnal goods. not the stock of commodity. For storage companies. Yit for i = sy. ξ it+1 ) < 0.3. Qt+1 for the processor and the company storing or importing the ﬁnal commodity. g (Ypt Solving the ﬁrst order conditions (see Appendix A) yields the optimal position ∗ Sit for all i where ¢ ρEit (Mit+1 ) − Cit − ρAi Eit (Mit+1 )Covit (Mit+1 . ∗ ∗ ∗ ) for i = p. Φt+1 ) − Corrit (Mit+1 .t is the optimal position at time t for the exporter of intermediate goods and Heh.1 The optimal spot position ∗ ∗ The optimal spot position of the producer is Xf t while the optimal spot position for the processor is Ypt . Cit is the input cost: rt /b for the producer.t ﬁnal goods as Hsh. ξ it+1 is production shock for the producer and the processor. et+1 )Corrit (Mit+1 . et+1 ) + (8) ¯ ¯ 2 (Φ ¯ χit V arit (et+1 ) ¯ 1 − Corrit t+1 . f (Xf t) ∗ ) for the processor. ey and Hit for i = sh. et+1 ) ¡ 2 (Φt+1 . et+1 )Corrit (Mit+1 . Pmt+1 et+1 and Qmt+1 et+1 for the importers of intermediate and ﬁnal commodities. et+1 ) > 1 > Corrit Corrit (Φt+1 . storage uncertainty for storage companies. Pt for the company storing or exporting intermediate goods. Yey. and export (import) uncertainty for exporters (importers).2.

While the higher volatility of domestic spot prices. the optimal spot position here depends on trading in other markets and the degree of risk aversion. Q. Unlike Anderson and Danthine (1983). Then. 2β y or 2β h for the exporters (importers). χit > 0 implies that the second order conditions (SOCs) are satisﬁed. 2γ y or 2γ h for the storage company. et+1 ) p = Eit ( ) et+1 V arit (Lt+1 ) V arit (Lt+1 )V arit (et+1 ) Eit (Φt+1 ) = Eit (Ft+1 )Eit (et+1 ) for all i and Eit (Mit+1 ) for the exporters are Eey. Φt+1 ) + Corrit (Mit+1 . the higher Corrit (Mit+1 . the separation theorem is not applicable. et+1 ) p V arit (Lt+1 )V arit (et+1 ) Eit (Lt+1 /et+1 )V arit (. the optimal positions of traders are still aﬀected by the exchange rate and 12 . et+1 ) p V arit (Lt+1 )V arit (et+1 ) s V arit (et+1 ) Lt+1 Eit (Lt+1 /et+1 )V arit (. et+1 ) = 0 for all i where R = P. F. thus. futures or forward market increases. et+1 )Corrit (Mit+1 . et+1 ) = = = Covit (Lt+1 . Qm . This is supported by the ﬁnding of Bahmani-Oskooee and Mitra (2008) that exchange rate volatility has negative impacts on exports and imports of commodities between the US and India. χit = λi + ρAi V arit (Mit+1 ){1 − 2 2 Corrit (Mit+1 . and Benninga and Oosterhof (2004) in which the country has its own futures market. e t+1 t+1 ) 2Corrit (Mit+1 . world prices and foreign futures prices of commodities and exchange rate can cause a reduction of the optimal spot positionm. et+1 )Corrit (Φt+1 .t (et+1 ). Corrit (Rt+1 . Kofman and Viaene (1986) and Schmittmann (2010). for the processor. Pmt+1 et+1 and Qmt+1 et+1 . Like Kawai and Zilcha (1986). Corrit (Lt+1 . Pm . The eﬀects on his proﬁt are in the same direction as those on the optimal spot positions if the expected marginal gain of trading in futures and forward markets is non-negative and that the marginal revenue product (MRP) of input is not less than its marginal resource cost (MRC). For Lt+1 = Φt+1 . et+1 ) + Eit (et+1 )Covit (Lt+1 /et+1 . If there is no correlation between commodity prices and exchange rates. λi = 0 if there is no other costs apart from the cost of commodity. When the expected gain in the spot. Φt+1 ) + } 2 (Φ 1 − Corrit t+1 .t (et+1 ) and Eeh.g. Φt+1 ) reduces the optimal spot position (See Appendix B). weather and rotting) will raises the commodity price. et+1 ) 2α a2 where λi is equal to 2θ b2 for the farmer.t (Qmt+1 )Eeh. et+1 ) 2 (Φ 1 − Corrit . Antoniou (1986).the commodities due to a negative shock (e.t (Pmt+1 )Eey. the traders tend to hold a larger spot position. the failure of uncovered interest rate parity (UIP) allows currency hedging to have an impact on the spot position.

As the optimal spot position (10) <(9) <(8). the processor can buy the intermediate commodity to produce the ﬁnal good and sell the output to the market at time t. et+1 ) = 0 and Corrit (Φt+1 . Φt+1 ) ¯ it it+1 ) ¯ + ¯ ¯ 2 (M λi + ρAi V arit (Mit+1 ) [1 − Corrit V arit (Φt+1 ) ¯ it+1 . (9) is also the optimal position for the case that 1) the economy does not have a forward foreign exchange market or 2) the trader hedges only his price risk. the optimal spot position (8) will become ¤ £ ρEit (Mit+1 ) − Cit − ρAi Eit (Mit+1 )Covit (Mit+1 . Φt+1 )] ¯s ¯ ¯ V ar (M ¯ [Φt − ρEit (Φt+1 )] Corrit (Mit+1 . Φt+1 )] ¯ (9) This optimal spot positions is not aﬀected directly by the exchange rates but indirectly through foreign futures trading and exports (see Appendix C). ξ t+1 ) Sit = (ρAi V arit (Mit+1 ) + λi ) (10) for all i. The sum of the ﬁrst two terms of (8) is larger than (9).t (Pmt+1 ) and Eeh. exporters face exchange rate risk even though they do not 13 . he does not need to hedge exchange rate risk. The second term of the optimal input level of (8) and (9) is the eﬀect of futures trading. If the ﬁnal good production process is short. ρgyp Qt+1 − Pt+1 2α (11) Unlike other trader types. Eey. By how much the production level or trading volume in the spot market for each trader increases depends on whether the commodity prices and foreign exchange rates are correlated and whether the forward exchange market is unbiased. et+1 ) = 0 for all i. If the forward market is also unbiased. If the producer does not hold futures position or if he is not allowed to trade in the foreign futures market. His optimal spot position is Ypt = where gyp = ∂g (Ypt ) ∂Ypt . In this case. With the eﬀect of speculative trading in the forward foreign exchange market on the optimal spot position. the optimal position will be Sit ¤ £ ρEit (Mit+1 ) − Cit − ρAi Eit (Mit+1 )Covit (Mit+1 . ξ it+1 ) = 2 (M λi + ρAi V arit (Mit+1 ) [1 − Corrit it+1 . allowing the trader to hedge his risks in the foreign futures market and the domestic forward exchange market will raise production level and supply of commodity in the domestic market. (8) À (9). In this case he does not face any price risk and has no need to trade in the foreign futures and forward foreign exchange markets.t (Qmt+1 ) in (10) will be replaced by or be a function of Ft . Eit (Qt+1 ). If the trader does not trade in the foreign futures market but use the futures price to predict the future spot price. Eit (Pt+1 ).its volatility. or Corrit (Mit+1 .

therefore. et+1 )) (Φt − ρEit (Φt+1 )) 2 (Φ ρAi V arit (Φt+1 ) ((1 − Corrit t+1 . As 2 (Φt+1 . e )) t+1 t+1 (14) H for all i. et+1 )} H ∗ ¯ Yit = Sit ¯ ¯ 2 (Φ ¯ V arit (Φt+1 ) ¯ (1 − Corrit t+1 . The ﬁrst two terms are eﬀects of speculation in the foreign commodity futures market and the forward foreign exchange market. Considering a case in which the exporter precommits to export intermediate (ﬁnal) commodity at time t at the preset export price Pmt+1 (Qmt+1 ). The exporter has no need to hedge price risk. et+1 ))) (Ef t (et+1 ) − ft )Corrf t (Φt+1 . Corrit (Mit+1 .3. the second term disappear and the last term is reduced. Thus. As can be seen from equation (8). et+1 ) . Φt+1 ) 14 . The optimal futures position has 2 components: speculation and hedging. Φt+1 ) − Corrit (Mit+1 . If he does not trade in the futures market. the preset export price can be determined by the current export price and thus Pmt+1 (Qmt+1 ) are known at time t as assumed by Kofman and Viaene (1991) and Benninga and Oosterhof (2004). et+1 )Corrit (Φt+1 . et+1 ) = 0 and Corrit (Mit+1 . Whether the trader will short or long the contract depends on the expected gains in the foreign futures and forward foreign exchange markets.t = 2. then they face more exchange rate risk. the optimal spot position depends on whether he also trades in the foreign futures market and the forward exchange market. The optimal positions of the exporters will be Yey.2 The optimal futures position [ρQmt+1 ft − Qt ] 2β (13) [ρPmt+1 ft − Pt ] 2β (12) The optimal futures position of the trader type i is f∗ Yit = for all i. and his spot position.t = and Heh.involve in the foreign commodity futures market. et+1 ) > Corrit Corrit (Φt+1 . Yit is a partial hedge of the expected output level. Φt+1 ) = 0. Corrit (Φt+1 . If they choose to hedge their price risk in the oﬀshore futures market. et+1 )Corrit (Mit+1 . his optimal spot position becomes smaller than (8) but greater than (10). et+1 ) H ¯ + ¯ + Yit ¯p ¯ 2 (Φ Ai ¯ V arit (Φt+1 )V arit (et+1 )¯ (1 − Corrit . H is the hedging component: Yit ¯s ¯ ¯ V ar (M ) ¯ {Corr (M it t+1 ¯ it it+1 . but he hedges the exchange rate risk of his export incomes.

Covit (Pmt+1 et+1 . Φt+1 ).e. and Covit (Φt+1 .if there is no correlation between commodity prices and exchange rates and the trader hedges his exchange rate risk. The second term of (16) is a partial hedge of the expected payment of receipts of foreign currency due to closing futures position at time t+1 and its last term is a partial hedge of the expected future receipts from the spot market.3. et+1 ) = Eit (Ft+1 )V arit (et+1 ). Covey. oﬀshore hedging is more eﬀective when they hedge both We ﬁnd that Yit price and exchange rate risks.t (Pmt+1 et+1 . et+1 )) > 0. This is supported by empirical ﬁndings of Yun and Kim (2010).e. For example. If commodity prices and exchange rate are uncorrelated. The optimal position is reduced to be f∗ = Yit Φt − ρEf t (Φt+1 ) ∗ Covit (Mit+1 . Thus. Zit there are no Covit (Φt+1 . the denominator increases as 2 V arf t (Φt+1 − Eit (Ft+1 )et+1 ) > V arf t (Φt+1 )(1 − Corrf t (Φt+1 . Zit terms). the optimal futures position will be smaller than (14). Suppose that only intermediate commodity is traded in the foreign futures market. et+1 ). f∗ is zero for all i.3 The optimal forward position The optimal forward position of the trader type i is f∗ = Zit Eit (et+1 ) − ft f ∗ Covit (Φt+1 . Covit (Qmt+1 et+1 . the second term f∗ Eit (Ft+1 ). et+1 ) and 15 . the covariance between the domestic price of ﬁnal (intermediate) good and the foreign futures price of intermediate (ﬁnal) good may be lower than the covariance between the domestic prices and the foreign futures price of the same good. et+1 ) in (14). et+1 ) + Yit − Sit Ai V arit (et+1 ) V arit (et+1 ) V arit (et+1 ) (16) f∗ is composed of two components: speculation (the ﬁrst term) and hedging (the last two Obviously. and the last term will be zero for all traders except exporters. 2. This will become a full hedge. The size of futures position may be aﬀected by the type of commodity traded in the foreign futures market through the futures price and Covit (Mit+1 . Yit is because the output prices for exporters are Pmt+1 et+1 and Qmt+1 et+1 i. The optimal spot and forward positions are also aﬀected through the change in futures position. Then the second term disappear and If traders do not hedge their exchange rate risk. et+1 ) ∗ Covit (Mit+1 . Φt+1 ) + Sit ρAi V arf t (Φt+1 ) V arit (Φt+1 ) (15) H in (15) is greater than in (14) i. et+1 ).

Without hedging price risk in the foreign futures markets or exchange rate risk in the forward foreign exchange markets. The supply of commodites does not depend on the current domestic spot prices. the demand for commodities depends on the current spot price.t (et+1 ).t+1 + Hct+1 = np aYpt + ν t+1 + nsh Hsh. the spot commodity markets will have both lower demand and lower supply.4 Equilibrium solution From the optimal spot positions in the previous section. and exchange rates at time t. as well as price expectations of producers and storage companies perceived at time t. With both equilibrium conditions.t (Qmt+1 et+1 .t + wt+1 (18) the current domestic price.Coveh. ni denotes the number of the trader type i. the market-clearing conditions for the markets of intermediate and ﬁnal commodities in the exporting country at time t+1 are £ ∗ ∗ ∗ ∗ np Ypt +1 + ney Yey. the foreign futures price. export prices and spot and forward exchange rates are exogenous. the optimal spot position is aﬀected by the degree of risk aversion and thus the separation theorem is not applicable.t +1 + nsh Hsh. the futures price. assuming to be linear with £ ∗ ¤ £ ∗ ¤ ∗ ∗ ∗ h neh Heh. all optimal positions are aﬀected by the type of commodity traded in the foreign futures market only through the futures prices and covariance between output prices and foreign futures prices. et+1 ) in this case are equal to Eey (Pmt+1 )V arey. For all traders.t+1 + nsy Ysy. Yey and Heh are on the supply side. Note that by changing the subscript t to be t+1. respectively. The left-hand side represents the demand in the spot market while the right-hand side represents the supply5 .t +1 ] (17) ∗ where Hct +1 (Qt+1 ) is the demand for ﬁnal goods of consumers at time t+1. the domestic equilibrium spot prices of intermediate and ﬁnal commodities at time t+1 are speciﬁed. It also depends on the current futures price 5 For the importing country.t+1 = nf f (Xf t ) + and t+1 ¤ y ∗ + wt + nsy [Ysy. we can get the optimal positions at time t+1 for all traders. 2. It depends on the domestic spot prices of inputs. 16 . In short. As domestic traders are small in the international market and the foreign futures and forward foreign exchange markets.t (et+1 ) and Eey (Qmt+1 )V arey. In contrast.

Λit .−p + ney Yey. Λjt+1 .t + wt+1 ) (19) t+1 ∗ where Yit +1.−q + Hct+1. Λkt = {Ekt (Qt+1 ). Pt . (20) can be rewritten as h Qt+1 = f (Pt .−q = c. perceived by the trader type k at time t and the trader type m at time t+1. Moreover.−q denotes the optimal position of trader type i excluding the eﬀect of Qt+1 . sh and m = e. Φt+1 . ξ t+1 ) < 0. Ωkt . Λit and Λjt+1 are sets of the expected future domestic and world prices of the intermediate commodity (Eit (Pt+1 ) and Eit (Pmt+1 )).and exchange rates. Ωjt+1 ) − (nf 17 y + nsy wt +1 ) t+1 (23) . perceived by the trader type i at time t and the trader type j at time t+1. Eet+1 (Qmt+2 et+2 ). sh. Ωit and Ωjt+1 are sets of expected variances and correlations. storage companies or the buﬀer stock’s manager can raise the current spot price by buying more of the commodity to increase their stock at time t+1. ft+1 . We can also rewrite (19) as Pt+1 = f (rt . Ωkt and Ωmt+1 are sets of expected variances and covariances of domestic and world prices of ﬁnal goods. If there is no correlation between prices and exchange rates.−p denotes the optimal position of the trader type i excluding the eﬀect of Pt+1 .t+1. ∗ then Hct +1. From (18). Emt+1 (Φt+2 ). Qt . Λmt+1 . Φt+1 . Λit . sy and j = p. with the assumption A4 that Eit (et+1 ) = Ejt (et+1 ) = Et (et+1 ) Pt+1 = f (rt . sy . the expected exchange rate.−p − Ysy. Λkt . This supports the assumption given before that Covit (Pt+1 . of future prices and exchange rates.−q + ns (Hst+1. the world market and the foreign futures commodity market. Pt . Φt . Ωmt+1 ) − (np vt+1 + nsh wt +1 ) (22) where k = p. Ωit . Emt (et+2 )}. If Hct+1 = c−dQt+1 . and the expected futures price and exchange rate (Eit (Φt+1 ) and Eit (et+1 )). the futures price and exchange rate. Ωjt+1 ) − (nf y + nsy wt +1 ) t+1 (21) where i = f. Λjt+1 . ft+1 . Φt .−q − Hst + wt+1 ) (20) ∗ ∗ where Hit +1. Φt+1 . ft . ey. perceived by the trader type i at time t and the trader type j at time t+1.t+1. and the expected future prices of commodities sold at time t+2 in the domestic market. So from (17).−p + nsy (Ysy. Φt . Ωit . ft . Eit (et+1 )} and Λmt = {Est+1 (Qt+2 ). £ ∗ Pt+1 = −nf f (Xf t) + ¤ £ ∗ y ¤ ∗ ∗ ∗ + np Ypt +1. the equilibrium price of ﬁnal goods in the domestic market is £ ∗ ¤ ¤ £ ∗ ∗ ∗ ∗ h + ν t+1 + ne Het Qt+1 = −np aYpt +1. Ekt (Φt+1 ).

Ωmt+1 ) − (np vt+1 + nsh wt +1 ) (24) where Λkt = {Ekt (Qt+1 ). as the ﬁrst product. which are the input. However. As Thailand only ∗ exports ﬁnal goods of rice and rubber (milled rice and smoked rubber sheet (RSS)). Ekt (Ft+1 )ft } and Λmt = {Est+1 (Qt+2 ).B. This lowers the domestic supply of commodities and thus increases the domestic price. Thus the equilibrium price are also aﬀected by exchange rate volatility.O. In the case that the country is the importer of commodities. Qt . prices. to increase. If the elasticity of supply is greater than.where Λit = {Eit (Pt+1 ). Φt+1 . Eet+1 (Qmt+2 )ft+1 . less than. This is supported by the conclusion of Chu and Morrison (1984) that one of the dominant sources of commodity price variability was the volatility of exchange rates. then prices will increase. Eet+1 (Pmt+2 )ft+1 . whether the eﬀect is positive or negative depends on which traders hedge their price and exchange rate risks and the exchange rate elasticity of supply and demand. the determinants of equilibrium spot prices at maturity are investigated. maturing in September 2004. This paper applies Thai rice and rubber markets as case studies. decrease or remain unchanged.t +1 = 0 and the domestic prices are not aﬀected by the world price of the intermediate good. Ωkt . Yey. trading in the foreign commodity futures and domestic forward exchange markets aﬀects the domestic spot price through the speculative component of the traders’ optimal spot holding. therefore. As can be seen in (8) and (9). if the current world price increases. For the case of Thai rubber. An increase in the expected value of world prices and a decrease in their volatilities will raise export volume. Eit (Ft+1 )ft } and Λjt+1 = {Est+1 (Pt+2 ). In this section. Emt+1 (Ft+2 )ft+1 }. The increase in export volume causes the domestic demand for commodities. Λkt . The export prices of milled rice and RSS3 in this empirical study are Thai F. the domestic prices of commodities increase. So the world price and domestic prices are positively correlated. the AFET has the futures contract of smoked rubber sheet. import volume will decrease. h Qt+1 = f (Pt . Φt . Ept+1 (Qt+2 ). or equal to the elasticity of demand. The aim is to ﬁnd whether the spot prices are aﬀected by the foreign futures price and exchange rates through foreign futures trading. Due to limitation of data available from the Thai oﬃce of the rubber 18 . Λmt+1 . Ejt+1 (Ft+2 )ft+1 }. the optimal spot position decreases when V arit (Φt+1 ) or V arit (et+1 ) increases. 3 Empirical studies Based on the theoretical result in the previous section.

the analysis covers the period from January 2001 .S. Agents know that the domestic commodity spot price is a linear function of production and storage uncertainty.142 0. so production cost is mainly ﬁxed cost and cost of seed is relatively small and ignorable (rt ≈ 0).155 0.S.061 0. March.177 0. September. Pmt+1 . the futures contract maturing in November 2004 is the ﬁrst contract of milled rice traded in the AFET. Ft+1 and et+1 are exogenous.110 replanting aid fund and exclusion of the eﬀect of exchange rate regime switching on July 2. Regarding the case of Thai rice.142 0.146 test of variables Ft et et ft 0. The null hypothesis of KPSS test is that the series is stationary. The foreign futures price is U. all variables are stationary at 0. conditional variances and covariances of prices and production shock are constant through time6 .117 ln(ft ) 0. Spot and 1-month forward exchange rates are in Thai Baht/Singapore Dollar. Rubber tree takes many years to grow. The CBOT trades rough rice futures contract with 6 maturity months: January. for each agent. So there are totally 42 monthly observations for the case of rubber. July.3 (RSS3). The spot and 2-month forward exchange rates are in Thai baht/U. As shown in table 1. The domestic prices of intermediate and ﬁnal goods applied in this study are of natural rubber sheet and smoked rubber sheet no. we can assume that. the conditional distribution for each agent comes from distributions of production shocks and storage uncertainty as well as the market-clearing condition determining Pt+1 and Qt+1 above. 5% = 0.1997.131 0. Table 2 shows that rubber prices are negatively correlated with the THB/SGD exchange rate while rice prices are not signiﬁcantly correlated with the THB/USD exchange rate.108 ln(et ) 0.June 2004. If the mean values of market prices are nonnegative. rough rice futures price.061 0.139 0. That is.144 0. the covariance and variances of these variables are given and assumed to be constant. Apart 6 This assumption can be justi ﬁ ed by a rational expectations paradigm. To simplify the solution and to allow the model to be easily estimated.151 Rice 0. So this assumption is valid. The contract has 12 maturity months i.Table 1: The KPSS unit root Commodity Pt Qt Qmt Qmt et Ft Rubber 0. The primary commodity of rough rice is rough rice. dollar.216. 19 . There are totally 46 observations for this case.186 Critical Values: 1% = 0.01 signiﬁcance level. and November.. so rt = Pt . The domestic prices are Thai rough rice and milled rice prices.184 0. 12 calendar months. Thus. Before estimating the system of equations.181 0.191 0. the rational agents’ expected values of future prices will also be nonnegative. the KPSS unit root test is applied to test the stationarity of the variables. These variables have constant variance-covariance matrices through time so do the distributions Ωit .e. the optimal positions of traders and equilibrium prices in the Thai rubber market and the Thai rice market are diﬀerent. The data covers the period from July 1997 to June 2004. As Qmt+1 .175 0.115 0. The futures price of RSS3 is the price of futures contract traded at SICOM.061 0. May.

995 0. risk-averse traders have to receive a risk premium to compensate for the uncertainty regarding the expected future spot rate.Table 2: The chi-square test of correlation coeﬃcients Pt 1. So it is possible to assume that the expected future exchange rate is a function of the current foward exchange rate.008 0.59) 9.621 −0.173) −0.00 0.890 0.988 Qt 1.985 35.00 (59.89% AR Test: F-stat (Prob. 20 .038) Note: ** and * denote the signiﬁcance of coeﬃcients at THB/USD Coeﬃcient (S.E.151 −0.88 (0.52 (0.00 0.911 0. Which between intermediate and ﬁnal commodity prices is aﬀected by the forward exchange rates depends on who hedge their price risk in the foreign commodity futures market and their exchange rate risk in the forward foreign exchange market.797) Rubber Qmt et Ft et et Pt Qt Pt Qt Qmt et Ft et et (204.e.017) 1.219) (−4.988 1.965 (7.00 (34.639) (40.048) Rice Qmt et Ft et et 0.) 2.966) Pt 1.630 −0.) Constant 0.016) (12.994 0. trading in the forward exchange market can aﬀect the optimal position in the rubber market and the optimal position is (8) if traders choose to hedge their exchange rate risk.11)** 30.00 et 0.984 Ft et 1.54 (0.87 (0.38 (0.596) (63.00 (8.) 1.000) 1% and 5% signiﬁcance levels.77 (0. χ2 -stat (prob) 6.064) 0.786 0. Also. The heteroscedasticity-robusted standard error ordinary least square regression of ln(et ) = φ0 +φ1 ln(ft−1 )+ ω t in Table 3 shows that the forward exchange markets are biased and the current exchange rate depends on the previous forward rate.00 (−5.027 1.904) (−5.854) (−4. the commodity equilibrium prices also depend on the biasedness of the forward foreign exchange market.06)** Adj-R2 84. to be persuaded to hold forward contracts.611 −0.323) (6. For the rice market.028) (0.588) (−0.42)** 0.00 0.13) H0 : φ0 = 0. As shown in the theoretical result above and the proposition of Kawai and Zilcha (1986) and Kofman and Viaene (1991). the forward foreign exchange market is biased i.00 Note: The values in parentheses are t-statistics Table 3: Market eﬃciency hypothesis testing of forward foreign exchange markets Currency Market THB/SGD Variable Coeﬃcient (S.50 (0.742 0.879) (14.604 −0.958) (41. The forward exchange rate is expected to have a signiﬁcant eﬀect on Thai rubber prices.19)* ln(ft−1 ) 0. φ1 = 1.00 (−0. In other words.18 (0.137) Qmt et 1.E. Et−1 (ln(et )) 6= ln(ft−1 ). the optimal position is (9).010 1.999 0.721 Qt 1. respectively from the correlation between commodity prices and exchange rate.24% 0.009) (0.

and Et−1 (Ft ) = λ0 + λi Ft−i . Et−1 (Qt ) = β 0 + i=1 i=1 i=1 p1 X αi Pt−i and i=1 numbers of lags. so Et−1 (Qmt et ) = Pt = a0 + a1 Qt + a2 Pt−1 + a3 Ft−1 et−1 + a4 Ft et + a5 ft−1 + a6 ft + ηpt . Therefore. Et−1 (Qmt ) = δ 0 + δ i Qmt−i . Though more lags may be included if the regressions have autocorrelation problem. both are also used to expect the future prices at time t. (28) a0 and b0 are the sums of the constant term in expectation functions. the mean values of η pt and η qt are equal to zero. we assume Ψ(ft−1 ) = θft−1 and pi are equal to 1 and thus equations (23) and (24) can be rewritten as Ψ(ft−1 ). Et−1 (Pt ) = α0 + p2 p3 p4 X X X β i Qt−i . we estimate equations (21) and (22) for the Thai rubber market and equations (23) and (24) for the Thai rice market by assuming that all the terms in a coeﬃcient (such as the degree of risk aversion. respectively.Consequently. pi . degree of freedom. commodity prices and exchange rates are correlated. Qt = b0 + b1 Qmt et + b2 Pt−1 + b3 Ft−1 et−1 + b4 Ft et + b5 ft−1 + b6 ft + b7 Qt−1 + ηqt . Et−1 (Qmt et ) = Et−1 (Qmt )Et−1 (et ) = i =1 Ã ! p4 X λi Ft−i Ψ(ft−1 ). To simplify the model and avoid losing the Et−1 (Ft et ) = Et−1 (Ft )Et−1 (et ) = λ0 + i=1 Ã p3 X δ0 + δ i Qmt−i ! Pt = a0 + a1 Qt + a2 Pt−1 + a3 Ft−1 et−1 + a4 Ft et + a5 ft−1 + a6 ft + a7 Ft−1 ft−1 + a8 Ft ft + η pt . For the case of Thai rice prices. Based on the theoretical result. Pt−1 is the input cost for farmers and storage companies selling the intermediate commodity at time t and Qt−1 is the input cost of storage companies selling the ﬁnal good at time t. are equal to 1. (27) Qt = b0 + b1 Qmt ft + b2 Pt−1 + b3 Ft−1 et−1 + b4 Ft et + b5 ft−1 + b6 ft + b7 Qt−1 + b8 Ft−1 ft−1 + b9 Ft ft + ηqt . negative or insigniﬁcant. a2 and b7 can be either positive. the number of traders and variances and covariances of prices) are constant. Pt−1 is the input cost of processors. Thus. ηpt = nf t+1 (25) (26) y h + nsy wt +1 and η qt = np vt+1 + nsh wt+1 are the residuals. While a3 and b3 are expected to be negative as shown in (19) and (20) if 21 . Due to the limitation of data. so b2 is expected to be positive. so they can be either positive or negative. we assume that the δ0 + i=1 i=1 For the case of Thai rubber. a1 and b1 are expected be positive as Qt and Qmt et are used to forecast the future prices of outputs that have input prices Pt and Qt . Equations (21) and (22) can be rewritten as p5 p6 X X δ i Qmt−i et−i and Et−1 (Ft et ) = γ 0 + γ i Ft−i et−i .

*. If the companies storing intermediate goods (ﬁnal goods) trade in the futures market.17 (7. respectively producers or storage companies hedge their price risks.11) 0.48) Ft−1 et−1 -0.87 (0.34 (8.09 (0.45 (0.52 (0.50 -43.23)** 0.32) Note: **.09)** Adj-R2 99.50) 0.84 (0. the domestic spot price of intermediate goods are highly correlated with the domestic and world prices of ﬁnal goods.07)* -4.02 (0. 10% signiﬁcance levels.75 (0.39 (0.11% 99. then a5 .12 (0.50% -22. a3 and a4 (b3 and b4 ) both will be signiﬁcant.10 (0.12)** Pt−1 -0.48 (0.19)** Adj-R2 99.72 (0.35 (0.15)† Model System RS3 -0.26 -39.00) 3. The most appropriate 22 .61 0. Thus.13)** Qmt−1 et−1 -0.54 (6.71 (0.15)* -0. For the Thai rubber market.53) Qt−1 0.88) -22.) 8.19)† -0.32)† Qmt et 0.62) 0.13)** 0.43 (0.15)** 0. a7 and a8 (b8 and b9 ) should have the opposite sign to a3 and a4 (b3 and b4 ).00) 4. a6 .) 0.01 (0.12)** 0.84 (0.47) 0.13 Autocorrelation: F − stat (prob.36 (0.23)** ft -0.26 (0.91) 0.93)** 0.48 (0.04) 2.05)** 0.11)** -0. Applying the two-stage-least-square estimation approach.28 (0.23 (0.64)* -12.Table 4: Regression result of the Thai rubber market Equation Pt Constant Qt Pt−1 Ft−1 et−1 Ft et ft−1 ft Ft−1 Ft−2 et−2 Pt−11 Pt−12 Model RS1 3.07)** -0.14 (0. b5 and b6 of (25) and (26) will be signiﬁcant.61 (0.16)** Ft et 0.66) -0.65 (0.27 (0.81 (0.11) Mis-speciﬁcation: LR − stat (prob.03 (0.62) Model RS2 -0.) 16.24)† Ft−2 et−2 -0.61 (0.05 (0.46) 0.96 (0. If the traders also hedge their exchange rate risk.48% Log likelihood -46.02 (0. † denote the signiﬁcance of coeﬃcients at 1%.80 Autocorrelation: F − stat (prob.00 (0. as shown in the correlation matrix.68 (0.44 (0. a4 and b4 are expected to be positive if processors or exporters hedge their price risk.15 (0.72 (0.73 (0.68)** -0.31% 99.18 -39.08)† 0.17)** ft−1 1.34 (0.38% Log likelihood -50.32 (0.52% 99.54)† 0.33 (0.69 (1.42) 1. respectively.23) -0.49 (0.18) 0.03 (0.10)** 0. Removing Pt−1 to correct multicollinearity problem and adding more lags of variables to correct autocorrelation problem yield models RS2 and RS3.08)** 99.01) Qt Constant -18.46 (5.18 (0. the estimators of b2 and b7 in model RS1 are insigniﬁcant.24)† 0. 5%. the estimation result in Table 4 and 5 shows that commodity prices are aﬀected by spot and forward exchange rates through exports and oﬀshore hedging.09)** 0.

55) 0.10 (1041.32) Ft−1 ft−1 0.62)* Qt−1 0.37) 31.81) Qt Constant -1142.24 (0. The estimator of a6 is insigniﬁcant while the estimator of b5 is signiﬁcant. autocorrelation and mis-speciﬁcation problems.30)** 2107.45 (0.48 (1183.47 (0.65 -289.85% 86.19 (0.54 (450.62) ft 9.66) Adj-R2 85.81 (0.Table 5: Regression result of the Thai rice market Equation Pt Model R1 Model R2 Model R3 1126.08 (0.04)** 0.13 (27.60 (7.49)* 3.71)† 1.10)† Ft−1 et−1 -0. the previous forward exchange rate can aﬀect the ﬁnal commodity price only through the optimal spot position of storage companies in the previous period.95)** 0.11 (0.72) 0.43 (0. this implies that processors do not hedge their price and exchange rate risks.19)† -18.75) Mis-speciﬁcation: LR − stat (prob.69) -33.98 (0.58)† -1.96)* 24. 5%.30% Log likelihood -289.62)** ft−1 14.81 (0. † denote the signiﬁcance of coeﬃcients at 1%.91 (0. et+1 )Corrit (Mit+1 .92 (23.93 (0.762 (944.83 (9.24 (0.11)** 0. both processors and exporters use the current output price to predict their future output prices.63) 0.13 (260.52 -310. respectively model here is RS3 that does not have multicollinearity. *.79 (0.15 (0.55 Autocorrelation: F − stat (prob. The eﬀects of the current forward exchange rate on the ﬁnal goods price through trading by storage companies may be oﬀset by the eﬀects through trading by exporters.59)† -0. Unlike the smoked rubber sheet market.07 (0.91 (0. 10% signiﬁcance levels.04)** Adj-R2 97.72)† -1.21 (0.59)† 1.05)** 0.96 (18. The positive coeﬃcient of b5 supports our assumption that 2 1 > Corrit (Φt+1 . The estimators of a1 and b1 are positive as expected.10) 0.) 0.13 (0.35 -285.87 (0.99 (0.59)† 0.86 (0.92) Ft et 3.49)** -3.29 (0.11 (0. Thus.34 (0.09 (0.41 (0. That is.61 (0.53)** -3.14 (0.90) Ft ft -3.37 (0.94% 98.93 (0.04)** 0. causing the insigniﬁcance of the estimator of b6 .18)* -14.85 (0.65% Log likelihood -284.05 (18.82)† 32.59) Qmt ft 0.07)** 0. et+1 ) > Variable Constant Qt Pt−1 Ft−1 et−1 Ft et ft−1 ft Ft−1 ft−1 Ft ft Corrit (Φt+1 .31 (0.18)* 0. traders in the natural rubber sheet market do 23 .12) 2.30 (0.21 (0.17% 86.) 0.74)* -1737.22) 2323.48 (477.51 (18.62) -1770.07) 0.12) Note: **.31 (0.87 -291.54)** 3.05)** Pt−1 -0.88 (0. The result also shows that exports and storage companies in the ﬁnal goods market hedge their price and exchange rate risks.09)** -1.50) 2.07)** 0.15 (16.05% 97.32 (0.90) 0. as expected the estimator of b3 is signiﬁcantly negative and b4 is signiﬁcantly positive.78 Autocorrelation: F − stat (prob.) 0. et+1 ) Corrit (Mit+1 .74) 1. Φt+1 ) and χi > 0.

7 This re ﬂ ects the seasonal e ﬀ ect on natural rubber sheet price. In addition. In addition. and it has the higher log likelihood value. The production level is lower during rainy season. a7 . the signiﬁcant estimators of a5 . autocorrelation and mis-speciﬁcation problems. b6 and b9 implies that exchange rates have eﬀects on domestic commodity prices through oﬀshore hedging.Natural Rubber Sheet Prices Actual 60 50 40 30 20 10 0 Jul-03 May-02 May-03 May-04 Mar-03 Mar-02 Nov-02 Sep-02 Nov-03 Sep-03 Mar-04 Jan-02 Jan-03 Jan-04 Jul-02 Smoked Rubber Sheet Prices Actual 60 50 40 30 20 10 0 Mar-02 Dec-01 Dec-02 Mar-03 Jun-02 Jun-03 Jun-01 Mar-01 Dec-03 Sep-03 Sep-01 Sep-02 Mar-04 Jun-04 Fitted Fitted Figure a: Thai rubber prices Rough Rice Prices Actual 8000 7000 6000 9000 Milled Rice Prices 15000 12000 Actual Fitted Fitted 5000 4000 3000 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Sep-99 Sep-00 Sep-03 Sep-97 Sep-98 Sep-01 Sep-02 Mar-04 6000 3000 Mar-98 Mar-00 Mar-02 Mar-03 Mar-99 Mar-01 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Mar-04 Figure b: Thai rice prices Figure 3: Fitted and actual values of intermediate and ﬁnal commodity prices not hedge their risks. removing the insigniﬁcant coeﬃcients we obtain models R2 and R3: one with the ﬁrst lag of intermediate goods price and another with the ﬁrst lag of ﬁnal goods price in (28). The weather causes disease to rubber tree and reduces the production of rubber latex. a3 and b9 are negative while a7 and b4 are positive. the estimators of a1 and b1 are positive. R2 is chosen because all coeﬃcients are signiﬁcant. These indicate that processors and exporters of ﬁnal commodity use the current prices of ﬁnal commodity to predict the future price in the domestic and international market. The negative coeﬃcients of futures price Ft−1 and Pt−11 and the positive coeﬃcient of Pt−12 indicate that producers use the SICOM futures price to predict their future output price while storage companies use the commodity price at the same period in the year before7 . As expected. 24 . The result shows that the producers of intermediate commodity and the exporters of ﬁnal commodity hedge their price risk in the CBOT. For the Thai rice market. the model does not have heteroscedasticity.

this paper is developed to ﬁnd the optimal oﬀshore trading strategy and how it aﬀects the optimal spot commodity and forward foreign exchange positions. The framework 25 . Exporters hedge their price and exchange rate risks in both markets.108 1. The CBOT trades futures contracts of rough rice (intermediate goods) while the SICOM trades futures contracts of RSS no.07 × 10−12 260. This eﬀect depends on whether the commodity prices and exchange rates are correlated and who hedge their price risk in the foreign futures markets and hedge their exchange rate risk in the forward foreign exchange market.442 Rice Pt 1.603 0.211 0. This can relate to the commodities that the foreign futures market trades.063 0.523 0.634 0.266 1. Rice producers hedge their price risk while rubber producers do not.Table 6: Descriptive statistics of estimated residuals Statistics Mean Standard Deviation Skewness Kurtosis Jarque-Bera Prob.785 0. The statistics shows that the estimated residuals are normally distributed with mean values equal to 0 as assumed in the theoretical framework. It derives equilibrium prices at maturity in the domestic commodity markets to show how oﬀshore trading allows the foreign exchange rates aﬀect the domestic commodity prices in a country without its own commodity futures markets.17 0. Rubber Pt Qt −15 −2. The reason why processors do not hedge their risk may be that the production process take a short period and thus they almost face no price risk.038 0.471 3. this may be because rough rice is stored by the government agency through price guarantee program while there is no such a program for rubber.061 2.707 The models have remarkably high explanatory power.66 × 10−13 220.960 0. 3 (ﬁnal goods). this is consistent with the insigniﬁcant coeﬃcient of Pt−1 in the (26) and (28).138 3. Only the companies storing RSS hedge their price risk. η ˆpt and η in Table 6. The graphs of ﬁtted and actual values in ﬁgure 3 ˆqt are the estimated residual of which statistics are summarised show that the models ﬁt very well.674 0. this empirical result shows that biasedness of the domestic forward exchange market allows the spot and forward exchange rates to aﬀect the commodity prices.313 2.303 3. In short.41 × 10 −1.595 Qt −2. 4 Conclusion In conclusion.61 × 10−15 0.

It relaxes the assumptions of Kawai and Zilcha (1986) and Kofman and Viaene (1991) to allow both intermediate and ﬁnal goods to be traded in the international and futures markets. The optimal futures position is a partial hedge of spot position. Like other frameworks. Like Kawai and Zilcha (1986). Oﬀshore hedging of all traders will be more eﬀective when they hedge both price and currency risks. traders are assumed to close all of their futures position due to high delivery and transaction costs. this framework shows that the changes in the futures price and exchange rates and their volatility can aﬀect the spot positions and domestic prices of internationally tradable commodities in many cases. While increases in variances of prices and exchange rates decrease traders’ optimal spot and futures positions. a rise in the covariance between the domestic spot price and the foreign futures price in domestic currency can increase their optimal positions. importers and the traders hedging their price risk in the foreign futures market are interested in the proﬁts in domestic currency. we ﬁnd that without the correlation between commodity prices and exchange rates. speculation in the futures market and the eﬀect of speculation in the forward market. Applying a two-period mean-variance approach. the trader’s optimal position in the forward exchange market is full hedging of his expected payment and receipt in foreign currency and the speculation in the domestic currency market. Firstly. this framework allows exporters to face export shocks. exporters.expands the models of Kawai and Zilcha (1986) to explain trading of other trader types. the increase in exchange rate volatility. the eﬀects exist even though the commodity prices and exchange rates are uncorrelated. As suggested by Kawai and Zilcha (1986). factor costs and random export prices. The decreases in the diﬀerence between the expected spot exchange rate and the forward exchange rate. this depends on which traders hedge their exchange rate risk and whether the eﬀects of these changes on the supply is greater than the 26 . the traders hedge their price risk in the foreign commodity futures market and exchange rate risk in the forward foreign exchange markets which are not unbiased and the commodity prices are correlated with the exchange rate. Second. Thirdly. the traders use the foreign futures price as information in predicting future commodity prices. and the increase in correlations of exchange rates and domestic commodity prices can either increase or decrease the commodity spot price. The spot position will be greater when the traders hedge their risks. We also ﬁnd that the separation theorem does not apply to the optimal spot position here.

370-389. 1-17. P. C. vol.Phil Thesis. [4] Baillie. [2] Antoniou.eﬀects on the demand in the markets. and Oosterhof. Futures markets: Theory and tests. 43-51. The model also indicates that some traders hedge their price risk in the foreign futures market. 71-80. 27 . It could also apply the prices of more commodities in diﬀerent countries to calculate the optimal hedging ratios based on the optimal strategy found in this paper. some do not hedge their risk. Exchange rate risk and commodity trade between the U. 28. vol. and Mitra. (1986). (1987). vol. With the biasedness of the forward foreign exchange market. vol. (2008). R. Further research could compare the optimal strategy.T. R. References [1] Anderson.S. [3] Bahmani-Oskooee. J. International Journal of Forecasting. We ﬁnd that Thai rice and rubber sheet prices are aﬀected by exchange rates though exports and oﬀshore hedging.D. (2004). Hedger diversity in futures market. D. 3. Cointegration and models of exchange rate determination. we ﬁnd the eﬀect of the forward foreign exchange rate on domestic rubber and rice prices even though rice prices (in domestic currency) and the exchange rate are not correlated. (1983). and some use the futures price as information to predict the future spot price. R. Oﬀshore hedging by diﬀerent trader types leads to diﬀerent impacts of foreign futures prices and foreign exchange rates on domestic commodity prices. W. 19. and India. A. Open Economic Review. M. Hedging with forwards and puts in complete and incomplete markets. The University of York . S. Journal of Banking anf Finance. and Selover. and Danthine. The Economic Journal. Empirical work could be done using recent commodity prices to investigate how the prices and trader behaviour change when the domestic commodity future market becomes available. [5] Benninga. The empirical result also supports the theoretical result. 93. D. The ﬁnding would guide the policy makers whether the country should have a domestic commodity futures market. price volatility and trader’s welfare before and after the existence of domestic commodity futures market.

H. Oﬀshore commodity and currency hedging strategy with hedging costs. 79-98.. vol. and stabilising speculation. [8] Corbae. 355-370. S. and Ouliaris. J. The response of primary commodity prices to exchange rate changes. Journal of Economic Theory. vol. 15. W. Netherlands: Kluwer Academic Publishers. ask and transaction prices in a specialist market with heterogeneously informed traders. Can exchange rates forecast commodity prices? The Quarterly Journal of Economics. L. C. and Krinsky. 125 (3). K.L.[6] Branson.Philip (ed. 989-995. Just. The minimum covered interest diﬀerential needed for international arbitrage activity. Bid. Agribusiness and Applied Economics Report. vol. 1028-1035. R. vol. Rogoﬀ. [11] Deaton. 69. and Koo. D. Futures markets and the theory of the producer under price uncertainty. Review of Economics and Statistics. R.(1992).). [17] Jin. [12] Deaves.J.. [9] Danthine. 59. On the behaviour of commodity prices. Information. D. (1978). and Laroque. I. and Milgrom. 1-23. 71-100. Do futures prices for commodities embody risk premiums? Journal of Futures Markets. Journal of Financial Economics. Journal of Political Economy. 317-328. (2002). Y. P. 508-511. (2002). 637-648. 1145-1194. A. vol. (1980). In L. D. 97. The changing structure of the world rice market. (1969). R. H.W. [13] Feder. American Economic Review. (2010). [16] Holthausen. Hedging and the competitive ﬁrm under price uncertainty. (1985). 17. [15] Glosten. Futures and Financial Markets: Advanced Studies in Theoretical and Applied Econometrics. [14] Gilbert. Review of Economic Studies. 55. [7] Chen. 28 . vol. 483.E. Quarterly Journal of Economics. P. vol. vol.M. (1991). 77. and Rossi. futures prices. 27. [10] Dawe. 1950-2000. vol. G. B.R. vol. Food Policy. W. Cointegration and tests of purchasing power parity. Commodity. (1988). G. (1995). 14. 87-124. (1978). vol. and Schmitz A.

H.P. [20] Sachsida. Ellery. (2009).. Did speculation aﬀect world rice prices? FAO ESA Working Paper no.). 7.(1991). Hedging strategy for crude oil trading and the factors inﬂuencing hedging eﬀectiveness. Futures and Financial Markets: Advanced Studies in Theoretical and Applied Econometrics. I (1986). Journal of International Economic. Applied Economics Letters. Applied Economics Letters. 25.Zit λi 2 Ai S + ρ[Eit (Π∗ V arit (Π∗ it+1 ) − it+1 )]}. −Yit f f and Zit at time by maximising his expected utility He choose Sit . P. Currency heding for international portfolios. J. [19] Kofman.Philip (ed. C. R. 83-98. Journal of Banking and Finance. (2001). (2000). f M ax {Yit Φt − Cit Sit − f Yit . and Zilcha. Eﬃciency of the Dojima rice futures market in Tokugawa-period Japan. and Teixeira. vol. 3. R. Netherlands: Kluwer Academic Publishers. J. 535-554. In L. 2 it 2 (30) 29 . vol.[18] Kawai. 09-07. 38. Jr. and Viaene. Exchange rates and storable prices. A. M. vol. 2404-2408. Uncovered interest rate parity and the Peso problem. 20. Yit Πi (29) Vi = f Yit . S. and Kim. vol. [23] Wakita. Commodity. [25] Yun. (2010). J. M. vol.J. [22] Timmer. W. [24] Wang. 125-152. 179-182. [21] Schmittmann. 545-548. WP/10/151. (2001). Testing PPP for Asian economics during the recent ﬂoating period. (2010). International trade with forward-futures markets under exchange rate and price uncertainty. Appendix A The proﬁt of the traders can be rewritten in a general form as f 2 = Yit Φt − Cit Sit − θSit + ρ{Mit+1 (f (Sit ) + ξ it+1 ) f f Φt+1 + (et+1 − ft )Zit }.M. P. Energy Policy. IMF Working Paper no.

His FOC with respect to Sit is ∂Vi ∂Xst = −Ct − λi Sit + ρ[Eit (Mit+1 ) − Ai fS {f (Sit )V arit (Mit+1 ) + Covit (Mit+1 ξ it+1 . Φt+1 ) − Zit Covit (Mit+1 . Appendix B The eﬀect of changes in price and exchange rate volatilities are as follows. Covit (Mit+1 ξ it+1 . Φt+1 ) + Zit Covit (Mit+1 . Mit+1 ) f f Covit (Mit+1 .where the expected future proﬁt is f Eit (Π∗ it+1 ) = Eit (Mt+1 )f (Sit ) + Eit (Mit+1 ξ it+1 ) − Yit Eit (Φt+1 ) f + [Eit (et+1 ) − ft ] Zit and the variance of his expected future proﬁt is f2 2 V arit (Π∗ it+1 ) = V arit (Mit+1 )f (Sit ) + V arit (Mit+1 ξ it+1 ) + V arit (Φt+1 )Yit f2 +Zit V arit (et+1 ) + 2f (Sit )Covit (Mt+1 . et+1 )} (32) = 0. et+1 ) −2Yit f f Zit Covit (Φt+1 . Φt+1 ) and Covit (Mit+1 ξ it+1 . et+1 )} −Zit = 0 and ∂Vi f ∂Zit f f = Eit (et+1 ) − ft − Ai {Zit V arit (et+1 ) − Yit Covit (Φt+1 . f f The FOCs with respect to Yit and Zit are ∂Vi ∂Yfft f = Φt − ρEit (Φt+1 ) − ρAi {Yit V arit (Φt+1 ) − Eit (f (Sit ))Covit (Mit+1 . et+1 ) −2Yit ³ ´ f f Covit (Mit+1 . et+1 ). et+1 ) are equal to 0. et+1 )}] = 0 −Yit (31) where fS = ∂f (Sit ) ∂Sit . Mt+1 ξ it+1 ) f f Covit (Mit+1 ξ it+1 . ∗ ∂Sit χ − 2λit ∗ ¯pit ¯ <0 = −Sit ¯ ¯ ∂V arit (Mit+1 ) 3 (M 2χit ¯ V arit it+1 )¯ (33) 30 . Φt+1 ) + 2Zit Covit (Mit+1 ξ it+1 . et+1 ) −2f (Sit ) Yit where Covit (ξ it+1 . et+1 ) + Sit Covit (Mit+1 . Φt+1 ) f Covit (Φt+1 .

Φt+1 ) − Corrit (Mit+1 . et+1 ) ¯ ¯q ¯ it (Mit+1 ) ¯ ρ(Eit (et+1 ) − ft ) ¯ VVar 3 ar (et+1 ) ¯ it > 0 ∗ ∂Sit ∂V arit (et+1 ) = − 2 (Φ 2χit (1 − Corrit t+1 . et+1 )) (Corrit (Mit+1 . B ). et+1 )Corrit (Mit+1 . et+1 )Corrit (Mit+1 . et+1 ) < 0 2 3 χ2 it V arit (et+1 ) (1 − Corrit (Φt+1 . V ar(AB ) = E [XY + XE (B ) + Y E (A) − Cov (A. Φt+1 ) − Corrit (Φt+1 . et+1 )) 2 (Φ χit (1 − Corrit t+1 . B ) + X 2 E (B )2 + Y 2 E (A)2 +2XY E (A)E (B ) − 2XE (B )Cov (A. et+1 )) > 0 Appendix C V ar(AB ) = E [AB − E (AB )] 2 (34) where A and B are random variables. et+1 )) 2 (Φ χit (1 − Corrit t+1 . 31 (35) . E (X 2 Y E (B )) = 0. A = X + E (A) and B = Y + E (B ). Φt+1 ) − Corrit (Mit+1 .∗ ∂Sit ∂V arit (Φt+1 ) = ¯s ¯ ¯ Φt − ρEit (Φt+1 ) ¯ ¯ V arit (Mit+1 ) ¯ ¯ ¯ 3 (Φ ¯ V arit 2χit t+1 ) ¯ Corrit (Mit+1 . Then. et+1 ))2 } 2 (Φ 1 − Corrit t+1 . Φt+1 ) = ∗ +2Sit ρAi V arit (Mit+1 ) ¯q ¯ ¯ V arit (Mit+1 ) ¯ ¯ V arit (Φt+1 ) ¯ (Φt − ρEit (Φt+1 ) + ρ(Eit (et+1 ) − ft )Corrit (Φt+1 . et+1 ) = − (Corrit (Φt+1 . B ) + Cov 2 (A. Φt+1 ) − Corrit (Mit+1 . et+1 ) 2 (Φ 1 − Corrit t+1 . B ) − 2Y E (A)Cov (A. et+1 )Corrit (Mit+1 . et+1 ) ) ¯ ¯q ¯ it (Mit+1 ) ¯ ρ(Eit (et+1 ) − ft ) ¯ VVar arit (et+1 ) ¯ {χit + 2ρAi V arit (Mit+1 ) ∗ ∂Sit ∂Corrit (Mit+1 . Deﬁne X = A − E (A) and Y = B − E (B ). Therefore. E (XY 2 E (A)) = 0. B )]2 = E [X 2 Y 2 + 2X 2 Y E (B ) + 2XY 2 E (A) − 2XY Cov (A. et+1 )) (Corrit (Φt+1 . et+1 )Corrit (Φt+1 . et+1 )) < 0 ∗ ∂Sit ∂Corrit (Mit+1 . B )] As E (X 2 Y 2 ) = V ar(A)V ar(B ) + 2Cov 2 (A.

V ar(Lt+1 ) = V ar( Lt+1 Lt+1 Lt+1 2 )V ar(et+1 ) + E (et+1 )2 V ar( ) + E( ) V ar(et+1 ) et+1 et+1 et+1 (38) 32 . et+1 )E ( )E (et+1 ) +E ( et+1 et+1 et+1 (37) t+1 if Cov ( L et+1 .V ar(AB ) = V ar(A)V ar(B ) + Cov 2 (A. B ) + E (B )2 V ar(A) +E (A)2 V ar(B ) + 2Cov (A. et+1 ) + E (et+1 )2 V ar( ) et+1 et+1 et+1 Lt+1 Lt+1 Lt+1 2 ) V ar(et+1 ) + 2Cov ( . et+1 ) = 0. B )E (A)E (B ) (36) V ar(Lt+1 ) = V ar( Lt+1 Lt+1 Lt+1 )V ar(et+1 ) + Cov 2 ( .

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