Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

According to Hotelling's Theory, what should happen to the prices of exhaustible commodities over time?

1. They should remain stable regardless of market conditions.

2. They should decrease by the prevailing nominal interest rate.

3. They should increase by the prevailing nominal interest rate.

4. They should fluctuate randomly based on demand.

The correct answer is: They should increase by the prevailing nominal interest rate.

Hotelling's Theory, also known as Hotelling's Rule, posits that the prices of exhaustible resources should increase over time at a rate equal to the prevailing nominal interest rate. This is based on the idea of opportunity cost; as a resource becomes scarcer, the incentive is to conserve it for future use when it may provide greater economic value. When the nominal interest rate is used as a benchmark, it reflects the opportunity cost of not extracting and selling the resource today versus in the future. Therefore, if an operator has the option to either extract and sell the resource now or wait to sell it later, the expectation is that holding onto that resource (and selling it later) will yield a return that is compounded over time at the risk-free interest rate. As a result, the price at which a resource is sold today should incrementally rise, mirroring the growth rate of the nominal interest rate. This foundational aspect of economic theory identifies a predictable path for the pricing of these commodities, highlighting the relationship between scarcity, time, and value which is central to understanding market dynamics for exhaustible resources.