Capturing the risk premium of commodity futures: The role of hedging pressure (original) (raw)
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Hedging Pressure and Returns in Futures: Evidence Across Asset Classes
2018
The hedging pressure hypothesis contends that commodity futures prices depend on the net positions of hedgers. This paper adopts a time-series and cross-sectional analysis to revisit this hypothesis in the context of commodity markets and additionally to test its empirical validity in equity, currency and fixed income futures markets. Our analysis provides evidence of a significant hedging pressure risk premium in commodity, equity and currency futures markets. The premium correlates with general market movements and with the well-known momentum and carry factors and increases in economic conditions, consistent with the concurrence of greater hedging demand and a lessening of speculator capital flows. In contrast with the currency and fixed income factors, we find that the commodity and equity hedging pressure factors have crosssectional pricing ability across asset classes, beyond traditional risk factors. JEL classifications: G13, G14
The predictive performance of commodity futures risk factors
Journal of Banking & Finance, 2016
This paper investigates the time-series predictability of commodity futures excess returns from factor models that exploit two risk factors-the equally weighted average excess return on long positions in a universe of futures contracts and the return difference between the high-and low-basis portfolios. Adopting a standard set of statistical evaluation metrics, we find weak evidence that the factor models provide out-of-sample forecasts of monthly excess returns significantly better than the benchmark of random walk with drift model. We also show, in a dynamic asset allocation environment, that the information contained in the commodity-based risk factors does not generate systematic economic value to risk-averse investors pursuing a commodity stand-alone strategy or a diversification strategy.
Hedging long‐term commodity risk
Journal of Futures Markets, 2003
This study focuses on the problem of hedging longer-term commodity positions, which often arises when the maturity of actively traded futures contracts on this commodity is limited to a few months. In this case, using a rollover strategy results in a high residual risk, which is related to the uncertain futures basis. We use a one-factor term structure model of futures convenience yields in order to construct a hedging strategy that minimizes both spot-price risk and rollover risk by using futures of two different maturities. The model is tested using three commodity futures: crude oil, orange juice, and lumber. In the out-of-sample test, the residual variance of the 24-month combined spot-futures positions is reduced by, respectively, 77%, 47%, and 84% compared to the variance of a naïve hedging portfolio. Even after accounting for the higher trading volume necessary to maintain a two-contract hedge portfolio, this risk reduction outweighs the extra trading costs for the investor with an average risk aversion.
Hedging and diversification across commodity assets
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We investigate the conditional cross effects and volatility spillover between equity markets and commodity markets (oil and gold), Fama and French HML and SMB factors, volatility index (VIX) and bonds using different multivariate GARCH specifications considering the potential asymmetry and persistence behaviours. We analyse the dynamic conditional correlation between the US equity market and a set of commodity prices and risk factors to forecast the transmission of shock to the equity market firstly, and to determine and compare the optimal hedge ratios from the different models based on the hedging effectiveness of each model. Our findings suggest that all models confirm the significant returns and volatility spillovers. More importantly, we find that GO-GARCH is the best-fit model for modelling the joint dynamics of different financial variables. The results of the current study have implications for investors: (i) the equity market displays inverted dynamics with the volatility index suggesting strong evidence of diversification benefit; (ii) of the hedging assets gold appears the best hedge for the US equity market as it has a higher hedge effectiveness than oil and bonds over time; and (iii) despite these important results, a better hedge may be obtained by using well-selected firm sized and profitability-based portfolios.
An Anatomy of Commodity Futures Risk Premia
The Journal of Finance, 2014
We identify two types of risk premia in commodity futures returns: spot premia related to the risk in the underlying commodity, and term premia related to changes in the basis. Sorting on forecasting variables such as the futures basis, return momentum, volatility, inflation, hedging pressure, and liquidity results in sizable spot premia between 5% and 14% per annum and term premia between 1% and 3% per annum. We show that a single factor, the high-minus-low portfolio from basis sorts, explains the cross-section of spot premia. Two additional basis factors are needed to explain the term premia.
Hedging vs. speculative pressures on commodity futures returns
2011
This study introduces a non linear model for commodity futures prices which accounts for pressures due to hedging and speculative activities. The linkage with the corresponding spot market is considered assuming that a long term equilibrium relationship holds between futures and spot pricing. Over the 1990-2010 time period, a dynamic interaction between spot and futures returns in five commodity markets (copper, cotton, oil, silver, and soybeans) is empirically validated. An error correction relationship for the cash returns and a non linear parameterization of the corresponding futures returns are combined with a bivariate CCC-GARCH representation of the conditional variances. Hedgers and speculators are contemporaneously at work in the futures markets, the role of the latter being far from negligible. In order to capture the consequences of the growing impact of financial flows on commodity market pricing, a two-state regime switching model for futures returns is developed. The empirical findings indicate that hedging and speculative behavior change across the two regimes, which we associate with low and high return volatility, according to a distinctive pattern, which is not homogeneous across commodities
The Journal of Index Investing, 2011
Commodities Exchange Traded Funds (ETFs) have become popular investments since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodities ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodities ETFs compared to changes in commodity prices calls into question the effectiveness of these ETFs for diversification or hedging. This paper examines the sources of the deviation between futuresbased commodities ETF returns and the changes in commodity prices using crude oil ETFs. We show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. We conclude that only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs. Diversification is a fundamental principle of prudent investment management. By mixing a variety of different investments, diversification reduces the overall risk of a portfolio without reducing expected portfolio returns. Bodie and Rosanky [1980] show that by investing in commodity futures, investors can decrease the volatility of an allstock portfolio without reducing their expected return. Gorton and Rouwenhorst [2006] demonstrate that returns to investments in commodities futures from 1959 to 2004 were negatively correlated with returns to S&P 500 stocks and long-term corporate bonds and yet positively correlated with inflation.
Measuring the hedging effectiveness of commodities
Finance Research Letters, 2019
Our study examines the dynamic correlations, portfolio weights and hedging effectiveness of adding commodities to international equity portfolios. The data covers the 2014/2015 commodities price crash. We compare commodities as a hedge for developed, emerging and frontier equities. Based on a DCC-GARCH framework, we show that forming hedged portfolios, including emerging, rather than developed and frontier market equities and commodities, has better hedging effectiveness in