The correlation length of commodity markets 2. Theoretical framework

The second of this series of two papers is devoted to a theoretical analysis of spatial interaction between commodity markets. The theoretical framework that we present is referred to as the stochastic spatial arbitrage model (SSAM); it accounts for most of the empirical regularities observed in the first paper. Two basic mechanisms are found to be responsible for spatial inter-market interaction, namely (i) spatial arbitrage and hedging conducted by traders, (ii) spatial correlation between local shocks; the latter is favored by a similar economic and cultural environment. The SSAM includes both effects and offers a wide range of predictions about price volatility, trade, price correlations, price differentials. Statistical tests display a convergent array of evidence in favor of the model. However several predictions cannot be tested by lack of statistical evidence, a circumstance which shows that yet additional “experimental” work is r! equired. Received 17 May 1999 and Received in final form 31 May 1999