The role of index traders in the financialization of commodity markets: A behavioral finance approach

Abstract

This paper investigates the impact of financialization on commodity prices across various markets, particularly over recent decades. We introduce a groundbreaking theoretical model that incorporates both chartist–fundamentalist traders and institutional investors, targeting trading signals in two distinct commodity markets. In alignment with empirical data, our model enables institutional investors to participate in multiple markets simultaneously through index investing. Our findings indicate that the interactions between traditional traders and index investors create price dynamics that closely mirror observed patterns in commodity markets. Specifically, index investors not only cause prices to diverge from their fundamental values but also substantially influence the trading positions of other market actors. Moreover, we elucidate the crucial role of index investors in amplifying market correlations–both among different commodities and between commodities and equities, especially during periods of intense price fluctuations. Our innovative theoretical model goes beyond conventional chartist–fundamentalist frameworks, offering a robust alternative for understanding the complex pricing dynamics of commodities at large.