Finance and Economics Discussion Series: Commodity Index Trading and Hedging Costs

Trading by commodity index traders (CITs) has become an important aspect of financial markets over the past 10 years. We develop an equilibrium model of trader behavior that relates uninformed CIT trading to futures prices. The model predicts that CIT trading reduces the cost of hedging. We test the model using a unique non-public dataset which precisely identifies trader positions. We find evidence, consistent with the model, that index traders have become an important supply of price risk insurance.