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CAUSES OF THE CRISIS 41


Because the U.S. Commodity Futures Trading Commission gradually loosened the rules over who may trade in agricultural futures markets such that by 2008, index funds’ participation in futures markets has grown by leaps and bounds: they accounted for about 40 percent of the futures contract trading in wheat, with smaller shares in maize (27.4 percent) and soybeans (20.8 per- cent). The potential significance of this trend is that nontraditional partici- pants can now speculate on food price trends, because the value of a futures contract varies in relationship to the commodity prices in the current spot market, much as bond prices vary in response to changing interest rates. This variation affords speculators an opportunity to bet on futures contracts as a separate asset class quite apart from the spot prices of agricultural commodi- ties in today’s market. So a short futures position (involving contracts that function up to 6 months) protects against price decreases, whereas a long futures position (involving contracts of longer than 6 months) enables the holder to benefit from price increases in the longer term. Most commercial agricultural traders play in the short futures market, because it is critical to the fundamentals of agriculture and decisions on agricultural production and delivery. Most noncommercial players (that is, financial intermediaries) play in the long-term market of contract price expectations. Hence, measures of speculative activity typically focus on long positions, or the share of long positions taken by index funds.


Proponents of the speculation hypothesis must establish theoretical and empirical linkages between speculation and futures prices, and between futures prices and spot prices. This is no easy task. Sanders and Irwin (2010) review theory and evidence. They suggest three logical inconsistencies in the arguments made by bubble proponents as well as five instances where the bubble story is not consistent with observed facts. The first problem is that money flows are not the same as demand. With equally informed market participants, there is no limit to the number of futures contracts that can be created at a given price level. These contracts are essentially just bets on future prices, so why should a bet affect an actual price outcome? Second, although theoretical models show that uninformed/noise traders can drive a wedge between market prices and fundamental values, index fund buying is very transparent, so it seems highly unlikely that other large rational traders would hesitate to trade against an index fund if they were driving prices away from fundamental values. Third, speculation is not excessive when correctly compared to hedging demands.


Fourth, index investors do not participate in the futures delivery process or in the cash market; nor do they engage in the purchase or hoarding of the cash commodity (Headey and Fan 2008). However, Gilbert (2010) argues that increased long futures positions could be viewed as a positive shock to inven-


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