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.