Optimal portfolios in commodity futures markets

We develop a general approach to portfolio optimization in futures markets. Following the Heath–Jarrow–Morton (HJM) approach, we model the entire futures price curve at once as a solution of a stochastic partial differential equation. We also develop a general formalism to handle portfolios of futures contracts. In the portfolio optimization problem, the agent invests in futures contracts and a risk-free asset, and her objective is to maximize the utility from final wealth. In order to capture self-consistent futures price dynamics, we study a class of futures price curve models which admit a finite-dimensional realization. More precisely, we establish conditions under which the futures price dynamics can be realized in finite dimensions. Using the finite-dimensional realization, we derive a finite-dimensional form of the portfolio optimization problem and study its solution. We also give an economic interpretation of the coordinate process driving the finite-dimensional realization.     

Momentum strategies in commodity futures markets

The article tests for the presence of short-term continuation and long-term reversal in commodity futures prices. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies that generate 9.38% average return a year. A closer analysis of the constituents of the long–short portfolios reveals that the momentum strategies buy backwardated contracts and sell contangoed contracts. The correlation between the momentum returns and the returns of traditional asset classes is also found to be low, making the commodity-based relative-strength portfolios excellent candidates for inclusion in well-diversified portfolios.     

Direction-of-change forecasting in commodity futures markets

This paper examines direction-of-change predictability in commodity futures markets using a variety of binary probabilistic techniques. As well as traditional techniques, we apply Variable Length Markov Chain (VLMC) analysis, an innovative technique popularised in computational biology when predicting DNA sequences (Bühlmann & Wyner, 1999). To the best of our knowledge, this is the first application of VLMC in finance. Our results show that both VLMC and technical analysis methods provide strong predictability of the direction-of-change of commodity returns, with annualised mean returns of approximately 8%, substantially higher than the passive long strategy. Our results suggest that a short-term learning effect is present in commodities market which can be exploited using innovative direction-of-change forecasting techniques.     

Regulatory reform and market efficiency: The case of Indian agricultural commodity futures markets

We present the results of two efficiency measures that include intraday return predictability measure based on order imbalance and measures of several variance ratio tests on intraday subsamples of nine major Indian agricultural commodity futures (castor seed, cotton oil cake, rape mustard seed, soybean, refined soya oil, crude palm oil, jeera, chana, and turmeric) quoted in the National Commodity and Derivatives Exchange (NCDEX). We perform the efficiency measures on five subsamples with holding periods of 5, 10, 15, 30, and 60 min over two sample periods following the announcement of the merger between the Forward Market Commission (FMC) and Securities Exchange Board of India (SEBI). We compare results of tests of weak-form market efficiency of futures markets between two periods (pre-merger period and post-merger period). Our results confirm that Indian agricultural commodity futures markets continue to remain inefficient in the short-term during both pre-merger and post-merger periods. Based on these findings, it is likely that profitable trading strategies in the short intraday intervals will be available for traders and market participants during post-merger period. Thus, regulators must focus more on policy initiative so as to enhance market quality in order to address such inefficiencies in Indian commodity futures markets.     

Intraday momentum in Chinese commodity futures markets

In this paper, we study whether the intraday momentum exists in Chinese commodity futures markets. We first construct an open-interest-weighted index with the high-frequency data of all commodity futures traded and then examine the predictability of the last half-hour return with both in-sample and out-of-sample tests. Consistent with findings in other markets, we show that the first half-hour return can readily predict the last half-hour return. We further demonstrate that the magnitude of this intraday momentum varies with volatility, trading volume, trade size, the sign of the first half-hour return, the type of commodity futures, and the launch of night trading. Additionally, this intraday momentum does not result from data snooping but has economic significance and remains robust under different index weighting and predictor calculation methods.     

Financialization and speculators risk premia in commodity futures markets

J.M. Keynes coined the term normal backwardation, a situation where a futures price for a particular expiry month is less than the expected spot price for that month. He argued hedgers pay speculators a risk premium, giving rise to normal backwardation. We study the behavior of commodity futures before and since financialization of the markets, which started about 20 years ago. We find the poor returns to managed futures in recent years are likely due to the impact of financialization and the associated outside money suppressing the futures risk premium.     

Quantile connectedness between Chinese stock and commodity futures markets

In this study, we examine the static and dynamic connectedness between the conventional Chinese stock market and commodity futures (aluminum, gold, copper, steel rebar, natural rubber, and zinc). Our results show that both steel rebar and gold receive whereas zinc and copper transmit changes across all quantiles. However, spillover behavior of aluminum, natural rubber, and CSI 300 vary across different quantiles. Our results have implications for investors who are considering a mix of Chinese conventional stocks and commodity futures in their portfolios. Our findings also provide insights for investing under different market conditions by providing results for static as well as dynamic connectedness between CSI 300 and the commodities market.     

Investor structure and the informational efficiency of commodity futures prices

This article investigates the impact of the trading positions of hedgers (i.e., producers, merchants, processors, or users of a commodity), speculators (i.e., commodity pool operators, trading advisors, or hedge funds), and swap dealers on the price formation process in the agricultural, metal, and energy futures markets. The hedgers' relative positions exert negative impacts on price efficiency in commodity futures markets. Hedgers are less likely to be information motivated, so their trading delays the price formation process. However, speculators' positions have positive impacts on price efficiency because speculators correct pricing errors. This study also offers evidence that the role of swap dealers, similar to speculators in futures markets, is to provide liquidity and cross-market arbitrage. These findings highlight the role of producers, hedge funds, and swap dealers in price formation processes in commodity futures—information that is beneficial to academics, practitioners, and regulators.     

Adaptive market efficiency of agricultural commodity futures contracts

In this paper we investigate the adaptive market efficiency of the agricultural commodity futures market, using a sample of eight futures contracts. Using a battery of nonlinear tests, we uncover the nonlinear serial dependence in the returns series. We run the Hinich portmanteau bicorrelation test to uncover the moments in which the nonlinear serial dependence, and therefore adaptive market efficiency, occurs for our sample.     

Liquidity effects on price and return co-movements in commodity futures markets

Commodity price comovement is an important research area in finance, and previous studies have investigated the determinants of price comovement using low-frequency (monthly or quarterly) macroeconomic data. In comparison, our paper attempts to scrutinize the liquidity effect on commodity prices and return movements based on daily data. Our findings contribute to the literature in three ways. First, we find significant positively correlated price movements across different commodity markets on a daily basis, and such comovement is driven by the cross-sectional liquidity spillover effect. Second, we observe that a cointegration relationship between individual commodity prices and the global price index can be established only if the liquidity effect is controlled. Finally, instantaneous daily liquidity shocks (i.e., innovation) exert a negative impact on daily commodity returns. However, liquidity shocks do not have a significant impact on monthly returns. Our findings are robust and have significant implications for macroeconomic policymaking, such as managing inflation risk.     

The role of speculation in international futures markets on commodity prices

The role of futures contracts on spot prices has been one of the key focus areas of research since the recent surge in commodity prices and increase in the volatility of commodity returns. However, no consensus arises from this literature, and hence it is difficult to link the use of futures contracts in agricultural commodities by non-hedgers and the growing food insecurity within developing countries. The purpose of this paper is to highlight causal relationships from futures contracts to spot prices of underlying assets, namely agricultural commodities. As research that focus on exchange-traded funds do not provide any clear conclusions, we focus on the imbalance between short- and long-open positions, this imbalance being caused by the exchange traded funds’ participation in futures markets. In this paper, we estimate relationships between financial variables including indicators for speculation in futures markets and the returns of cocoa, corn, soybean, wheat, coffee, rice, and sugar on a weekly basis from 1998 to 2013. Significant results lead to Granger-causality tests that in turn validate the hypothesis of a positive impact of speculation in futures markets to returns on the underlying commodities.     

Information transmission in informationally linked markets: Evidence from US and Chinese commodity futures markets

This paper investigates information transmission and price discovery in informationally linked markets within the multivariate generalized autoregressive conditional heteroskedasticity and information share frameworks. Based on both synchronous and non-synchronous trading information from Chinese futures/spot markets, the New York Mercantile Exchange (NYMEX), Chicago Board of Trade (CBOT), and CME Globex futures markets for copper and soybeans, we show that there is a bidirectional relationship in terms of price and volatility spillovers between US and Chinese markets, with a stronger effect from US to Chinese markets than the other way around. Additionally, the NYMEX and CBOT play a more important role than the CME Globex in the flow of information from US to Chinese markets. Moreover, we find that Chinese copper market adjusts more quickly than the NYMEX copper market to correct the disparity between both markets. However, the converse is true in the case of soybeans. Finally, our results highlight the remarkable role of Chinese futures markets in the price formation process, though NYMEX and CBOT futures markets are the main driving force in price discovery.     

Does the stock market drive herd behavior in commodity futures markets?

This paper contributes to the debate on commodity financialization by extending tests of herd behavior to commodity futures markets. Utilizing a regime-switching model, we test the presence of herd behavior in a number of commodity sectors including energy, metals, grains and livestock during the low and high market volatility states. We find significant evidence of herd behavior in grains only during the high volatility state. We also find that large price movements in the energy and metal sectors significantly contribute to herd behavior in the market for grains. Finally, we find no significant effect of the stock market on herd behavior in the commodity futures market. Our findings in general do not support the much debated commodity financialization hypothesis.     

Market efficiency and natural selection in a commodity futures market

While the literature usually justifies informational efficiencyin the context of rationality, this article shows informationalefficiency by applying the evolutionary idea of natural selection.In a dynamic futures market, speculators are assumed to merelyact upon their predetermined trading types (buyer or seller),their predetermined fractions of wealth allocated for speculation,and their inherent abilities to predict the spot price, reflectedin their distributions of prediction errors with respect tothe spot price. This article shows that the proportion of timethat the futures price equals the spot price converges to onewith probability 1.     

Return and volatility co-movement in commodity futures markets: the effects of liquidity risk

Commodity markets are a widely researched topic in the field of finance. In this paper, we investigate the co-movement of return and volatility measures in different commodity futures markets and how these measures are affected by liquidity risk. First, we find that commodity returns display co-movement and that liquidity risk plays a key role in shaping asset return patterns. Moreover, we show that the volatilities of commodity returns co-move, and we demonstrate the role of liquidity risk in this joint pattern. We also find that the commodity markets we investigated share a common volatility factor that determines their joint volatility co-movement. Because liquidity risk affects both commodity returns and volatility shocks, it might be interpreted as the common causal factor driving both measures simultaneously. Therefore, we affirm the view that liquidity shocks are firmly related to two residual risks originating from both market return and market volatility. Finally, we also show that liquidity spillovers can significantly drive cross-sectional correlation dynamics.     

Information content of volume: An investigation of Tokyo commodity futures markets

This study examines the relationship between volume and price changes for Tokyo commodity futures contracts by focusing on the predictive power of volume. The findings indicate a positive simultaneous relation between volume and absolute returns. The relation is not entirely contemporaneous since lagged volume contains predictive power for absolute returns. However, linear and nonlinear causality tests show that volume does not forecast returns. The results are qualitatively the same for contracts traded with different methods.     

Tactical allocation in commodity futures markets: Combining momentum and term structure signals

This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66%, respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, our double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. The abnormal performance of the combined portfolios cannot be explained by a lack of liquidity, data mining or transaction costs.     

Evidence on the arbitrage efficiency of SPI index futures and options markets

This paper is concerned with arbitrage opportunities in the futures and futures option contracts traded on the Sydney Futures Exchange (SFE) within a put-call-futures-parity (PCFP) framework. Tick-by-tick transaction price data are employed so that the futures contracts, the call futures options and the put futures options can be matched within a one-minute interval. This paper also takes into account the realistic transaction costs that an arbitrager has to incur, including the implicit bid-ask spread. A thorough ex post analysis is first carried out. The results reveal a significant number of violations of the PCFP in the sample. Ex ante tests are then conducted whereby ex post profitable arbitrage strategies, signified by the matched trios of futures, put and call contracts, are executed with lags up to 3 min. The ex ante results are similar to the ex post results. However, further analysis reveals that the exploitability of the identified arbitrage opportunities is very limited due to the small trading volumes of the futures and options contracts. Thus, we conclude that there is no strong evidence against the arbitrage efficiency between the SPI index futures and options markets in Australia.      

Asymmetric effect of basis on dynamic futures hedging: Empirical evidence from commodity markets

The dynamic minimum variance hedge ratios (MVHRs) have been commonly estimated using the Bivariate GARCH model that overlooks the basis effect on the time-varying variance–covariance of spot and futures returns. This paper proposes an alternative specification of the BGARCH model in which the effect is incorporated for estimating MVHRs. Empirical investigation in commodity markets suggests that the basis effect is asymmetric, i.e., the positive basis has greater impact than the negative basis on the variance and covariance structure. Both in-sample and out-of-sample comparisons of the MVHR performance reveal that the model with the asymmetric effect provides greater risk reduction than the conventional models, illustrating importance of the asymmetric effect when modeling the joint dynamics of spot and futures returns and hence estimating hedging strategies.     

Diversification benefits of commodity futures

The finance literature seems to be in support of the diversification benefits of adding commodity futures to an existing portfolio. Yet no empirical work has been performed to test whether the benefits are indeed statistically significant. This paper addresses several unresolved issues concerning the potential diversification benefits of commodities. First, we attempt to ascertain whether the alleged diversification benefits exist and are statistically significant. Second, to what extent are the diversification benefits unique to US investors? Would investors of a resource-based economy like Canada also benefit from adding commodities to their portfolios? Third, recent studies indicate that correlations among international equity returns are higher during bear markets than during bull markets. This type of regime-switching correlation behavior will mean lower diversification benefits from international investments when investors face a bearish environment at home. Do commodity futures display the same type of regime-switching behavior? To what extent do commodity futures offer real diversification benefits that are robust over time and across regimes? Finally, commodities may appear to be an asset for the more adventurous investors with higher risk tolerance. We want to know what type of investors should hold commodities. We demonstrate that the diversification benefit of commodities is a far more complex phenomenon than often understood in the finance literature.