What Explains the Growth in Commodity Derivatives?

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JANUARY/FEBRUARY 2011 37

What Explains the Growth in Commodity Derivatives?

Parantap Basu and William T. Gavin

This article documents the massive increase in trading in commodity derivatives over the pastdecade—growth that far outstrips the growth in commodity production and the need for deriva-tives to hedge risk by commercial producers and users of commodities. During the past decade,many institutional portfolio managers added commodity derivatives as an asset class to their port-folios. This addition was part of a larger shift in portfolio strategy away from traditional equityinvestment and toward derivatives based on assets such as real estate and commodities. Institu -tional investors’ use of commodity futures to hedge against stock market risk is a relatively recentphenomenon. Trading in commodity derivatives also increased along with the rapid expansion oftrading in all derivative markets. This trading was directly related to the search for higher yieldsin a low interest rate environment. The growth was both in organized exchanges and over-the-counter (OTC) trading, but the gross market value of OTC trading was an order of magnitude greater.This growth is important to note because a critical factor in the recent crisis was counterpartyfailure in OTC trading of mortgage derivatives. (JEL G120, G130, G180)

Federal Reserve Bank of St. Louis Review, January/February 2011, 93(1), pp. 37-48.

not been monitored. On July 21, 2010, PresidentObama signed the Dodd-Frank Wall StreetReform and Consumer Protection Act into law.As of this writing, the regulatory rules have yetto be finalized, but the proposed regulations areintended to limit the use of derivatives by banksand make OTC trading more transparent.

The market failure that led to the recent finan-cial crisis was centered in the opaque, bilateralOTC trading by firms that policymakers at theFederal Reserve and the Treasury considered toobig to fail. Because of the potential risks involved,it is important to understand mechanisms thatlarge financial firms can use to exploit the govern-ment’s safety net. In this article, we documentthe massive increase in trading in commodityderivatives over the past decade. This growth far

T he recent financial crisis was causedby large financial firms taking on toomuch risk (leverage) using complicatedinstruments in opaque trading environ-

ments.1 Commodity derivatives trading was onesuch area. Commodity derivatives include futuresand options traded on organized exchanges aswell as the forwards and options traded over thecounter. Organized exchanges monitor tradingof standardized contracts and require marginaccounts that protect investors against counter-party risk. The exchange is the counterparty inall trades. Over-the-counter (OTC) trades arebilateral exchanges of customized contracts.Margins are not required and such trading has

1 See remarks by Gensler (2010).

Parantap Basu is a professor of macroeconomics at Durham University, Durham, U.K. William T. Gavin is a vice president and economist atthe Federal Reserve Bank of St. Louis. The authors thank Kevin Kliesen and Kenji Wada for helpful comments.

© 2011, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect theviews of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced,published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts,synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.

http://research.stlouisfed.org/econ/gavin/

outstrips the growth in commodity productionand the need for derivatives to hedge risk by com-mercial producers and users of commodities.

During the past decade, many institutionalportfolio managers added commodity derivativesas an asset class to their portfolios. This additionresulted in substantial growth in the use of com-modity derivatives—growth out of proportionwith the historical levels associated with commer-cial hedging. This shift was part of a larger changein portfolio strategy away from traditional equityinvestment and toward derivatives based onassets such as real estate and commodities.

Trading in derivatives does not affect thefundamentals of supply and demand in any obvi-ous way. The derivative trades sum to zero—forevery winner there is a loser, for every gain thereis an equal loss. Financial firms can write an arbi-trarily large number of contracts betting on a futureprice without necessarily affecting the level ofthat price. However, an arbitrarily large numberof contracts means that there can be an arbitrarilylarge number of losers. The important policy ques-tion is whether the taxpayer is at risk for counter-party failure in OTC trading when some financialfirms incur large losses. If a large portion of theseinvestments is made by financial firms that wouldlikely fall under the protection of the government’ssafety net, then the firms that win will retain theirprofits while those that lose may shift the burdenof their losses to the taxpayer. There is a publicinterest in preventing large-scale betting by insti-tutions protected by the government’s safety net.It is not a zero-sum game for the taxpayer.

In this article, we explore the reasons for theexplosive growth in trading in commodity deriv-atives and advance two main reasons for thatgrowth. First, investors used commodity futuresto hedge against equity risk. Both academic andindustry economists argued that a negative corre-lation between returns on equity and commodityfutures offered an unexploited hedging opportu-nity in using commodity derivatives as an assetclass.

Second, trading in commodity derivativesincreased along with the rapid expansion of trad-ing in all derivative markets. This trading wasdirectly related to the search for higher yields in

a low interest rate environment. The search forhigher yields refers to the tendency of both indi-vidual and institutional investors to choose riskierassets when the return on safe assets is low.2

Jiménez et al. (2008) used a large dataset fromthe credit register in Spain to show that bankborrowers are more likely to default if the loansare made when central bank interest rates arerelatively low. They also showed that (i) the priceof risk tends to be low when short-term interestrates are low and (ii) if the interest rate is low fora long time, the economy’s “portfolio” of loanstends to be riskier.

Many derivative instruments that grew rapidlyafter 2000, such as commodity futures index fundsand derivatives on mortgage-backed securities(MBS) such as collateralized debt obligations,were developed in the 1980s and 1990s. Dybvigand Marshall (1997) described the newly devel-oped risk-management processes that includedever more-complex derivatives. Their descriptionnoted the possibility of the good, the bad, andthe ugly outcomes of using such financial instru-ments. The good is the new opportunity for more-precise hedging and risk reduction.3 The bad isthe possibility that CEOs and portfolio managersmay not fully understand the ramifications ofusing these complex new instruments. The uglyis the possibility that firms could use OTC deriv-atives to intentionally take risks that could not beobserved by regulators or other market partici-pants. All three outcomes have been evident overthe past decade, but it is the ugly outcome thatis most responsible for the worldwide financialcrisis.

The paper is organized as follows. The secondsection documents some facts about growth incommodity futures and provides indirect evidencethat the rise in derivatives trading was associatedwith institutional investors using commodityderivatives as an asset class. The third sectionadvances arguments why a negative correlation

Basu and Gavin

38 JANUARY/FEBRUARY 2011 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

2 See, for example, Rajan (2005), Ferguson et al. (2007), and Gerlachet al. (2009).

3 See Banerji and Basu (2009) for an example showing how bankscould use new and creative contracts to offer new risk-bearingservices that would be expected to reduce the risk premium inequity markets.

between stock and futures returns may not nec-essarily offer a hedging opportunity to investors.The concluding section discusses the reformlegislation and prospects for continued tradingin commodity derivatives.

TRADING IN COMMODITYDERIVATIVES: THE FACTS

The large increase in trading in commodityderivatives was not due to a large increase in hedg-ing by commercial users. It is important to dis-tinguish between the commercial hedgers whoproduce and use commodities and the institu-tional investors who use commodity futures tohedge equity and bond risk. For example, com-modity futures index funds were marketed toinstitutional investors as an asset class. Figure 1Adepicts the growth of these funds using year-enddata for 1994 to 2008. Contracts for these fundsare an investment in a long position in a value-weighted portfolio of commodity futures. In 2002,there were fewer than $20 billion in these index-fund contracts. At year-end 2008 these funds hadgrown to more than $250 billion, about one-fourthto one-third of the notional amounts of commod-ity futures traded on organized exchanges. In 2007the Commodity Futures Trading Commission(CFTC) began collecting information on theamount of funds invested in these index funds.Figure 1B reports the CFTC data throughSeptember 2010. Note that the exchange tradingof commodity futures has rebounded and hasnearly recovered to the peak achieved in June of2008.

Trading in OTC commodity derivatives mar-kets also grew rapidly during the period, as shownby the gross market value of commodity deriva-tives (Figure 2A). Gross market value is a measureof the funds that investors have at risk on bothsides of the bet; for example, it includes funds atrisk on both the long and short sides of a forwardcontract. Figure 2A also depicts the gross marketvalue of equity derivatives contracts. The grossmarket value of commodity derivatives rose by afactor of 25 between June 2003 and June 2008—reaching $2.13 trillion in June 2008. Figure 2B

shows the gross market values of commodityderivatives (excluding precious metals) and goldderivatives.4 Traditionally, institutional investorshave used gold as a hedge against inflation andother risks. There was no surge in the volume of gold derivatives as there was for other commodities.

Figure 3 shows prices for the Standard andPoor’s (S&P) Goldman Sachs Commodity Index(GSCI), gold, and two ABX indexes that are forderivatives on insurance contracts for MBS.5

From the day the S&P GSCI peaked, July 3, 2008,to the day Lehman Brothers filed bankruptcy,September 15, 2008, the S&P GSCI price indexfell 37 percent (Figure 3).6 Investors with a shortposition made large profits, but investors with along position lost hundreds of billions of dollars.These were investments traded over the counter,so it is difficult to know what part, if any, theselosses played in the financial panic that accom-panied Lehman’s default.

Oil was about 40 percent of the weight in theS&P GSCI and drove the broad pattern in the S&PGSCI. The commodity price index (see Figure 3)rose very sharply with the trading volume of thecommodity derivatives market (see Figures 2Aand 2B) and peaked in July 2008 when oil pricespeaked. It then fell sharply through the secondhalf of 2008. The gold price was much less volatile(see Figure 3), with no unusual rise in the tradingvolume of gold derivatives (see Figure 2B). Notethat the gold price and the commodity priceindex rose together until mid-March 2008 (seeFigure 3), when the Federal Reserve rescued thecounterparties to Bear Stearns. The commodityprice index (see Figure 3) and trading volume ofcommodity derivatives then grew very rapidlywhile the trading volume of gold derivatives wasflat to down a bit (see Figure 2B). The commodityprice index started falling 10 weeks before finan-cial markets panicked with the Lehman bank-

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4 Non-gold precious metals were a small percentage relative to goldand are ignored here.

5 The gold price is a monthly average of the London PM fix; thesource for all prices is Haver Analytics.

6 We assume that the S&P GSCI represents the market price for theunderlying asset in the OTC commodity contracts.

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1994 1996 1998 2000 2002 2004 2006 20080

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Commodity Index-Fund Investment (year-end)

NOTE: 2008 data are through March only.

SOURCE: Masters (2008, Chart 1).

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Figure 1B

Notional Long Positions Invested in Commodity Futures Index Funds

SOURCE: CFTC.

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SOURCE: Bank for International Settlements derivatives statistics.

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Figure 2B

OTC Trading in Commodity Derivatives (gross market value)


ruptcy filing. The fourth quarter of 2008 was verybad for the economy and financial markets. Afteryear-end, the prices of gold and other commoditiesas measured by the S&P GSCI began an upwardtrend that continued through to December 2010.

It is possible that the unusual spike in pricesand trading volume for commodity futures wasinfluenced by the loss of confidence in MBS andassociated derivatives. Figure 3 shows the loss ofconfidence in both the highest-rated (AAA) andlowest-rated (BBB–) mortgage derivatives. TheABX BBB– index—for derivatives on mortgageinsurance for subprime MBS—began to decline

in December 2006 and had fallen 60 percent byAugust 2007 when the possibility of a wider finan-cial crisis became apparent. By that time, confi-dence in the highest-rated mortgage paper was alsofalling. The prices and trading volume of com-modity derivatives rose sharply as confidence inthe market for subprime mortgages collapsed.

The sharp spike in the price of commodityfutures in July 2008 and subsequent collapse bythe end of that year is hard to explain. The S&PGSCI was driven mainly by oil prices. Althoughthe longer-term rise in oil prices is often attrib-uted to rising demand associated with growth

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Figure 3

Prices on Commodities and ABX Contracts

NOTE: The gold index and the S&P GSCI are each equal to 100 on January 19, 2007. The indexes for the price of ABX contracts areequal to 100 when they are launched. AAA and BBB– are the highest- and lowest-rated mortgage derivatives, respectively. The ABX-HE-BBB– 06-2 is an index for the value of mortgage loan insurance derivatives on the riskiest of the subprime mortgages originatedbefore the second half of 2006. The launch date for an index depends on when the underlying mortgages were originated; the 06-2index was launched on July 19, 2006, and the 07-1 index on January 19, 2007.

SOURCE: Haver Analytics.

in emerging market economies, a secular rise indemand cannot explain the 2008 boom andbust.7

Figure 4 shows the outstanding notionalamounts of commodity derivatives contracts(their face value): The amount tripled betweenJune 1998 and June 2003 and then rose 19-foldin the next 5 years, peaking at $13 trillion in June2008. During this period, trading in commodityderivatives grew to exceed trading in equity deriv-atives. Note that, in contrast to trading on organ-ized exchanges, OTC trading in commodityderivatives has continued to decline since thesummer of 2008.

To provide some perspective on the size ofderivative positions, consider that world GDProse from $30 trillion in 1998 to $61.1 trillion in2008.8 Commodity prices almost quadrupledover the decade before their peak in July 2008.Even at 2008 prices, the total output of com-modities was less than half the notional value ofoutstanding commodity derivatives contracts

(nearly $13 trillion).9 The ratio of the notionalamount of commodity derivatives contracts inJune 1998 to world GDP rose from 1.5 percentin 1998 to 21.6 percent in 2008. Over the sameperiod, the ratio of equity derivatives to worldGDP rose from 4.2 percent to 16.7. At first glance,this shift appears to be consistent with the risinguse of commodity derivatives as an asset class ininstitutional portfolios.

TWO EXPLANATIONS FOR THERISE IN COMMODITY DERIVATIVES TRADING

One explanation for the rise in commodityderivatives trading is that it was simply part of awidespread increase in risky investing duringthe past decade that was attributed to a “searchfor yield.” A second explanation for the rise is

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7 See, for example, Kilian (2009).

8 We are using World Bank estimates of world gross domestic product(GDP) in U.S. dollars.

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OTC Trading in Derivatives (notional amounts)


9 Even at its peak price in July 2008, total world production of oilin 2008 was less than $4.5 trillion. Oil constitutes the largest shareof total commodity production. For example, the estimated world-wide production of corn, wheat, and soybeans in 2009 was lessthan $100 billion. See, for example, www.nue.okstate.edu/Crop_Information/World_Wheat_Production.htm.

www.nue.okstate.edu/Crop_Information/World_Wheat_Production.htm

www.nue.okstate.edu/Crop_Information/World_Wheat_Production.htm

that it was driven by a mistaken notion that aninvestment in commodity futures can be used tohedge equity risk. An early paper by Greer (2000)and later papers by Erb and Harvey (2006) andGorton and Rouwenhorst (2006) found a negativecorrelation between returns to a passive longinvestment in commodity futures and returns toequity.

The Search for Yield Hypothesis

The term “search for yield” is somewhatvague. In an efficient market model, all investorsare assumed to optimize over combinations ofrisk and return. One should not choose more riskunless the expected returns also rise. One way tointerpret the search for yield is to argue that, atlow interest rates, investors are willing to take onrelatively more risk for only small increases inreturn. In such a case, investors will bid up theprice of risky assets and, all else equal (includingdefault probabilities), the price of risk will decline.This search for yield may explain why risk pre-miums were so low in 2003 and 2004 and offersone reason (among many) for the high leverage inhousehold mortgages and financial institutions.

During the period of rapid growth in com-modity derivatives, managers of pension funds,university endowment funds, and other institu-tional funds began to include commodity deriva-tives as an asset class in their portfolios. Therewas a shift out of domestic equities into commodi-ties.10 One argument was that investing in suchreal assets could increase returns without addingmuch risk. This leads us to the second hypothesis:Brokers and dealers selling commodity deriva-tives also argued that commodity futures couldbe used to hedge equity risk.

Hedging Hypothesis Fully collateralized commodity futures histori-cally have offered the same return and Sharperatio as U.S. equities. Although the risk pre-mium on commodity futures is essentially thesame as that on equities for the study period,commodity futures returns are negatively cor-

related with equity returns and bond returns.The negative correlation is the result, primarily,of commodity futures’ different behavior overa business cycle (Gorton and Rouwenhorst,2006, p. 47).

While the use of commodities to hedge infla-tion risk was widely appreciated, their use tohedge equity or business cycle risk is more con-troversial. Using data from July 1959 to December2004, Gorton and Rouwenhorst (2006) calculatedthe return to holding a rolling long investment ina value-weighted portfolio of commodity futures.They reported that the correlation was nearlyzero for short horizons and negative, but not sta-tistically significant, for horizons up to one year.This is consistent with research at the CFTC byBüyüksahin, Haigh, and Robe (2008), who foundthat the unconditional correlation between equityand commodity futures returns is near zero. Buttheir results changed as the investment horizonlengthened. Gorton and Rouwenhorst (2006) alsoreported that if this investment was rolled-overfor a longer period, the return was negativelycorrelated with the returns from comparable bondand equity portfolios. They found that the aver-age correlation between returns on equities andcommodity futures was a statistically significant–0.42 if the investments were held for 5 years.

Figure 5 reports a rolling 5-year correlationbetween returns on an index of S&P 500 equitiesand the index of commodities included in theS&P GSCI. When commodity prices peak in June2008, the correlation is negative on average. How -ever, following the collapse of commodity pricesin the summer of 2008 and the subsequent finan-cial panic in September 2008, the correlationbecomes highly positive, reaching a record 0.56in February 2010. Thus, portfolios that includedcommodity derivatives to hedge equity risk didvery badly over the last 2 two years studied. Inthe years building up to the crisis and since,portfolios that included commodity derivativeswere more volatile than equities-only portfolios.The high returns in 2004 through 2006 reflectedvery risky investments—not only those in mort-gage derivatives. Note that this is the first busi-ness cycle following the widespread adoption ofthis new investment strategy.

10 See Cohn and Symonds (2004), Symonds (2004), and Palmeri(2006).

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1978 1983 1988 1993 1998 2003 2008

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Rolling Correlation Coefficient Between Daily Equity and Commodity Returns (5-year windowwith 5-year returns)

NOTE: The equity index is the S&P 500. The commodity index is the S&P GCSI. The returns are calculated as the percent change inthe total return.

SOURCE: Haver Analytics and authors’ calculations.

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Rolling Correlation Coefficient Between Daily Equity and Commodity Returns (1-year window)

NOTE: The equity index is the Wilshire 5000. The commodity index is the S&P GCSI. The oil price is the domestic spot price on WestTexas Intermediate crude oil.

SOURCE: Haver Analytics and authors’ calculations.

Similar changes are seen in the correlation ofdaily returns. Figure 6 reports a rolling correla-tion coefficient between total returns to invest-ments in the Wilshire 5000 and the S&P GSCIusing a 1-year window. The correlation is rela-tively small and generally not significantly differ-ent from zero until the onset of the financial crisis.During and following the crisis, the correlationis very large and positive. Because the S&P GSCIis heavily weighted in oil, we also show the dailycorrelation between the Wilshire 5000 and thedaily spot price of West Texas Intermediate crudeoil. This correlation makes it clear that the S&PGSCI is heavily influenced by the oil market.11

Erb and Harvey (2006) argued that the mostimportant source of expected return from a port-folio of commodity futures comes from diversifi-cation across individual commodities that haveuncorrelated returns. They described the differ-ent schemes used to construct weights to aggre-gate the component commodities and explainedwhy the excess returns depend on there beinglittle correlation among returns for the individ-ual component commodities. They also warnedagainst assuming that historical return correla-tions will persist. Tang and Xiong (2010) showedthat the introduction of index trading led to a risein the correlation among the individual commodi-ties included in an index, thus reducing or eveneliminating the gains to diversification withinindividual index funds. They further showedthat the rise in the correlations among the indi-vidual components began in 2004, well beforethe onset of the crisis, and became higher overthe next few years as open interest in commodityindex futures rose.

Figures 5 and 6 show that the correlationbetween returns to equity and commodity futurescan change sign over time. In a general equilib-rium model in which there are no unexploitedhedging opportunities, it is straightforward toshow that the equilibrium correlation can be

either negative or positive, depending on thenature of shocks to the world economy.12 In par-ticular, the correlations shown in Figures 5 and6 depend on investors’ perceptions about howthe domestic economy and commodity produc-tion will respond to various shocks.

CONCLUSIONWe offer two possible explanations for the

surge in trading commodity derivatives. The firstalso explains the massive increase in trading ofrisky mortgage debt and all financial derivatives:Investors were searching for more substantialyields in an environment with very low returnspaid on safe assets. This also explains whyinvestors moved from real estate derivatives tocommodity derivatives when the problems inthe subprime market became apparent.

The second reason is a prevailing notionamong institutional investors that commodityderivatives are an asset class that can be used tohedge equity risk, a notion we argue is mistaken.Even if the observed correlation between equityand commodity futures returns were reliablynegative, it is likely that this negative correlationwould be an equilibrium arbitrage phenomenonthat should be expected in a world where nounexploited hedging profit opportunity exists.The rise in commodity derivative trading thusposes a challenge to asset-pricing theorists toexplain in a well-articulated rational asset pric-ing model.

The lesson from this financial crisis is notthat the government should prevent firms andinvestment funds from investing in commodityfutures. As we noted, it was the unregulated,opaque OTC trading that was a critical factor inthe financial crisis. The Dodd-Frank Act isintended to limit this type of trading and to makeit more transparent. This outcome is already sug-gested by the incoming data. On organizedexchanges (where traders are monitored andprotected against counterparty failure), tradingof commodity derivatives has nearly recovered

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11 Table 3 in Erb and Harvey (2006) reports the portfolio weights forthree commodity futures indexes as of May 2004. Crude oil is about40 percent of the S&P GSCI and all energy commodities make uptwo-thirds of the weight in the index. This does not include grainsused for ethanol. They also report that 86 percent of the openinterest in commodity futures indexes was in the S&P GSCI. 12 See, for example, Basu and Gavin (2010).

to the peak achieved in June of 2008, while OTCtrading in commodity derivatives has continuedto decline.

A lesson from the crisis is that regulators andpolicymakers should monitor financial innova-tions closely to learn whether they are being usedto take excessive risks—that is, risks firms wouldnot take if they were operating outside the gov-ernment’s safety net. Under new regulations, theCFTC will collect information that should make

trading in commodity derivatives more transpar-ent. Banks argue that they need to use commodityderivatives to help customers manage risks. Thismay be true, but the recent experience in com-modity futures did not reduce risks but exacer-bated them just at the wrong time. The challengeto the government is to prevent too-big-to-fail firmsfrom using current and yet invented derivativesto increase overall risk in the financial system.

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Basu, Parantap and Gavin, William T. “Negative Correlation between Stock and Futures Returns: An UnexploitedHedging Opportunity?” Unpublished manuscript, Federal Reserve Bank of St. Louis, December 2010.

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Cohn, Laura and Symonds, William C. “Striking Gold in Commodities.” Business Week, October 25, 2004.

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Gorton, Gary and Rouwenhorst, K. Geert. “Facts and Fantasies about Commodity Futures.” Financial AnalystsJournal, March/April 2006, 62(2), pp. 47-68.

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Jiménez, Gabriel; Ongena, Steven; Peydró, José-Luis and Saurina, Jesús. “Hazardous Times for Monetary Policy:What Do Twenty-Three Million Bank Loans Say about the Effects of Monetary Policy on Credit Risk-Taking?”Working Paper No. 0833, Bank of Spain, 2008; www.bde.es/webbde/SES/Secciones/Publicaciones/PublicacionesSeriadas/DocumentosTrabajo/08/Fic/dt0833e.pdf.

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What Explains the Growth in Commodity Derivatives?

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