Tail Risk in Term Structure Based Strategies in Commodities

A new financial research paper related to:

#22 – Term Structure Effect in Commodities

Authors: Bianchi

Title: Carry Trades and Tail Risk: Evidence from Commodity Markets

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3035453


In this paper I document that carry trades in commodity markets are subject to potential large and infrequent losses, that is, tail risk. Also, I show that shocks to carry trades and volatility have persistent tail-specific effects which last from four to twelve weeks ahead. The main empirical results are consistent with existing theoretical models in which carry traders are subject to limited risk capacity and liquidity constraints. In this respect, I provide evidence that money managers, index traders, and more generally non-commercial traders, tend to unwind their net-long futures positions when exposed to deteriorating aggregate financial conditions and increasing market uncertainty. Methodologically, I make use of panel quantile regressions with non-additive fixed effects, which allow to identify the tail-specific effect of carry on the conditional distribution of commodity futures excess returns.

Notable quotations from the academic research paper:

"Carry can be defined as the component of a position’s returns that comes from something other than spot price changes. In the case of currencies, where the concept of carry is more familiar, carry trades arise from the differential of interest rates between foreign and domestic currencies. In equity and fixed income carry can be thought of as the dividend yield and the coupon payment which is earned regardless changes in the bond prices, respectively. Similarly, commodity investors can earn returns even with constant spot prices as the futures contract they are holding rolls down (or up) the futures price curve.

However, there are at least three reasons why carry is even more important for commodities compared with other asset classes.

First, while bond and equity carry are mostly positive, commodity carry, like currencies, can be either negative or positive depending on the shape of the futures curve. Backwardated (negative-sloping) curves imply positive carry because if the spot price do not change than the futures contract is expected to roll up the futures price curve over time. In this respect, the roll yield is expected to more than cancel out the effect of flat, or even slightly negative, spot returns.

Second, commodity carry can be highly volatile relative to other asset classes. Carry of energy commodities such as Crude oil and Copper, and agricultural, such as Wheat, has clusters of high volatility and frequently switches sign. Dividend yield for equity, coupon payments in bond markets, and interest rates differentials are arguably much less volatile.

Third, commodity carry can be extreme and be quite heterogeneous across sectors, especially on the long side of the trade. Carry trades, on average across commodities, has positive skewness, that is, carry tends to be extreme and trades are more likely to be net long than net short.

The high volatility and instability is possibly due to the fact that, unlike fixed income and currencies, commodity markets do not have a dependable “BearWhale” like a central bank that is prepared to buy commodity assets at any resort and in the process manipulate forward expectations. In this respect, unlike fixed income and currencies, carry in commodities can hardly be stabilized by regulators and policy makers alike.

In this paper, I investigate tail risk for funding-constrained speculators in commodity markets, in an attempt to shed new light on the importance of commodities as an asset class for investment decisions. The empirical analysis focuses on commodities spanning the energy, metals (industrial and precious) and agricultural sectors. For each of these commodities, I calculate excess returns using a rolling strategy on both first- and second-nearby contracts, which represent the most liquid maturities. To compute the carry, I consider the slope between the nearest-to-maturity contract and the next-to-nearest available futures contract on the same commodity, depending on the maturity of the excess returns.

The results show that carry trades are significantly negatively correlated with the left tail of the conditional distribution of one step ahead futures excess returns, that is carry trades are subject to a significant tail risk.

Although with a lower statistically significance, the net long futures positions of money managers and non-commercial traders more generally, are positively correlated with carry in the crosssection, consistent with the idea that futures positions by speculators might represent a proxy for their propensity on carry trades. These findings are consistent with existing theories of financing constraints and preferences for skewed returns.

These financing constraints are likely to be particularly important during downturns in financial conditions and aggregate liquidity when speculators, insurance providers and more generally non-commercial traders face capital losses and increasing margin calls.

I test the direct effect of global risk and financial dislocations by investigating the interaction between carry trades and the implied volatility of S&P500 options, i.e. the VIX, the Financial Stress Index maintained by the St. Louis Fed and the National Financial Conditions Index held by the Chicago Fed. The empirical evidence shows a significant negative correlation between deteriorating aggregate financial conditions and speculators’ positions, that is carry traders tend to unwind their net long positions when facing increasing global risk and possibly lower risk tolerance.

Finally, I make use of local projection methods as indicated by Jord`a (2005) to document the average longer-term effect of shocks to carry, futures positions and volatility, on tail risk by estimating aggregate impulse responses. I show that the effect of carry trades is highly significant in the left tails of the distribution of excess returns up to several weeks ahead. Similarly, I show that a one unit shock to speculators’ futures positions does not affect tail risk, while on the opposite shocks to contidional volatility have a persistent effect on tail risk up to three months ahead."

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