Reconciling Theoretical Hedging Models with the Experience of Cotton Merchants in March 2008

Analysis of the cotton futures price spike and its effects on commercial hedgers suggest that we do not completely understand the behavior of markets and firms in periods of extreme volatility. After presenting the story of the cotton futures price spike, this paper argues that explanations related to the funding liquidity of firms and the liquidity of the markets themselves may help us better understand market volatility. A simple model of futures market equilibrium in the presence of liquidity constraints demonstrates how prices can spike as fast as they did and why such spikes can drive firms to exit.