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It is generally accepted that futures markets provide insurance to hedgers by ensuring the transfer of price risk to speculators. The insurance that net hedgers are willing to pay equals the premium earned by speculators for this risk bearing. As commodity futures returns directly relate to the propensity of hedgers to be net long or net short, it becomes natural to design an active strategy that buys mostly backwardated contracts and shorts mostly contangoed contracts - the strategy which exploits the term structure in commodities.
The general message is that producers and consumers of the underlying commodity transfer the risk of price fluctuations to speculators, who are willing to undertake this risk in the hope of a large positive return.
The contracts in each quintile are equally-weighted. The investment universe is all commodity futures contracts. Tactical Allocation in Commodity Futures Markets: Combining Momentum and Term Structure Signals http: 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 With an abnormal return of This double-sort strategy can additionally be utilized as a portfolio diversification tool. Interestingly, the abnormal performance of the double-sort portfolios cannot be explained by a lack of liquidity or data mining and is robust to transaction costs and to different specifications of the risk-return trade-off. The Fundamentals of Commodity Futures Returns http: Commodity futures risk premiums vary across commodities and over time depending on the level of physical inventories, as predicted by the Theory of Storage.
Using a comprehensive dataset on 31 commodity futures and physical inventories between and , we show that the convenience yield is a decreasing, non-linear relationship of inventories.
Price measures, such as the futures basis "backwardation" , prior futures returns, and prior spot returns reflect the state of inventories and are informative about commodity futures risk premiums.
The excess returns to Spot and Futures Momentum and Backwardation strategies stem in part from the selection of commodities when inventories are low. Positions of futures markets participants are correlated with prices and inventory signals, but we reject the Keynesian "hedging pressure" hypothesis that these positions are an important determinant of risk premiums. Investors face a number of challenges when seeking to estimate the prospective performance of a long-only investment in commodity futures.
For instance, historically, the average annualized excess return of individual commodity futures has been approximately zero and commodity futures returns have been largely uncorrelated with one another.
However, the prospective annualized excess return of a rebalanced portfolio of commodity futures can be equity-like. Certain security characteristics, such as the term structure of futures prices, and some portfolio strategies have historically been rewarded with above average returns. This is the unabridged version of our publication in the Financial Analysts Journal.
Returns to the Commodity Carry Trade http: This paper investigates the returns to the commodity carry trade, a speculation strategy in which an investor buys commodity futures if the underlying commodity market is in backwardation and sells commodity futures if the underlying commodity market is in contango.
We demonstrate that this strategy, if applied to a portfolio of 28 commodities, is characterized by high returns and high Sharpe ratios which are uncorrelated with conventional risk factors. We find that the returns to the hedged carry trade are also on average large and uncorrelated with traditional risk factors, and in fact in sample are surprisingly higher than the unhedged version.
We also investigate the hedging pressure hypothesis, under which returns to this sort of trade could just be compensation for insuring natural hedgers against price movements.
The data here are not as clean as one would hope, but preliminary investigation does not suggest that this hypothesis can fully explain the returns to the commodity carry trade. This paper investigates dynamic trading strategies, based on structural components of returns, including risk premia, convenience yields, and net hedging pressures for commodity futures. Significant momentum profits are identified in both outright futures and spread trading strategies when the spot premium and the term premium are used to form winner and loser portfolios.
The existence of profits from active trading strategies based on momentum is consistent with behavioral finance and behavioral psychology models in which market participants irrationally underreact to information and trends. Profits from active strategies based on winner and loser portfolios are partly conditioned on term structure and net hedging pressure effects.
High returns from a popular momentum trading strategy based on a ranking period of 12 months and a holding period of one month dissipate after accounting for hedging pressure effects, consistent with the rational markets model. This paper examines the informational content of commodity futures term structures over time. Time series of commodity prices and returns are analyzed by means of static and rolling principal component analysis.
We use weekly data from January to July of 23 commodity underlyings from Energy, Metals, Agriculture and Livestock. We find high stability of the principal components and their explanatory power over time.
The first component identified as a level factor is paramount for the interpretation of term structure dynamics for most underlyings. This result suggests that an investor can exploit the information contained within the term structure and revealed by principal component analysis. We formulate three distinctive investment strategies based on term structure information which optimize roll yields.
By creating portfolios according to a principal component ranking we significantly outperform a long-only benchmark. We call this factor the low-high basis factor, or LHB factor, in short. We first document the significant premium accruing to the LHB factor. We then report a substantial reduction in the pricing errors of factor models. In particular, the zero-intercept hypothesis of factor models is no longer rejected by the data once the LHB factor is included in the model.
Finally, we show that the time-variation in the LHB factor return can be predicted, to some extent, by the implied volatility spread. Alternative Beta Strategies in Commodities http: Alternative beta strategies can serve a variety of different investment objectives, which may include reducing volatility or achieving tilts to systematic risk exposures. It is therefore essential for investors to examine whether these strategies meet their own investment objectives and risk-taking preferences.
Two main approaches to alternative beta are reviewed in this paper: Whilst alternative beta is fairly well established in equity strategy investing, it is still a nascent concept in commodities.
This is not entirely unforseen, as investors now view their investment opportunity in the context of risk premia, rather than individual asset classes. Finally, it should be borne in mind that alternative beta strategies often take substantial active risks, which are largely driven by factor exposures. Factor returns can be volatile, and all alternative beta strategies can experience considerable drawdown at times.
However, as these risk factors have a low correlation with each other, it may be sensible to combine them in order to improve return and reduce risk. In this study we confirm the existence of sizable momentum, carry and low-volatility factor premiums in the commodity market, and argue that investors should consider these commodity factor premiums when determining their strategic asset allocation. The traditional commodity market portfolio, on the other hand, appears to deserve little or no role at all in the strategic asset mix.
Investors should therefore not postpone the consideration of alternative commodity factor premiums to a later stage of the investment process. The aim of this paper is to investigate the impact of the financialization of commodity markets on the profitability of strategies based on momentum and term structure.
Both strategies reveal better performance in case of commodity markets with low financialization level and generate little profits in the markets with a significant participation of investors. The findings of this study can be used for the purposes of tactical and strategic asset allocation.
We show that a model featuring an average commodity factor, a carry factor, and a momentum factor is capable of describing the cross-sectional variation of commodity returns. To provide an economic interpretation, we show that innovations in equity volatility can price portfolios formed on carry with a negative risk premium, while innovations in our measure of speculative activity can price portfolios formed on momentum with a positive risk premium.
Furthermore, we characterize the relation of the factors with the investment opportunity set. Evaluating Commodity Exposure Opportunities http: However, perhaps due to their relative complexity and the large remaining disagreements in the current literature about the fundamental drivers of commodities returns, investors do not universally agree on the merits of commodity investments.
This paper begins by reviewing the existing theories and fundamental drivers of returns from commodity investments to better understand the risks that commodity investors are compensated for bearing. From this perspective we will evaluate existing methods of commodity investing with a focus on why the risk premia these strategies capture are likely to persist in the future.
Benchmarking Commodity Investments http: While much is known about the financialization of commodities, less is known about how to profitably invest in commodities.
We compare a novel four-factor asset pricing model to existing benchmarks used to evaluate CTAs. Only our four-factor model prices both commodity spot and term risk premia.
Overall, our four-factor model prices commodity risk premia better than the Fama-French three-factor model prices equity risk premia, and thus is an appropriate benchmark to evaluate commodity investment vehicles.
Rad, Yew Low, Miffre, Faff: We examine whether and to what extent successful equities investment strategies are transferrable to the commodities futures market. We investigate a total of 7 investment strategies that involve optimization and mean-variance timing techniques. To account for the unique characteristics of the commodity futures market, we propose a novel method of classification based on momentum or term structure properties in the formation of long-short portfolios in conjunction with the quantitative strategies from the equities literature.
Our strategies generate significant excess returns and risk-adjusted performances as measured by the Sharpe and Sortino ratios and the maximum drawdown.
There is no evidence that excess returns are a compensation for liquidity risk. The strategies are robust to transaction costs and choice of model parameters and exhibit stable performance across various market environments including times of financial crises.
Carry Trades and Tail Risk: Evidence from Commodity Markets https: 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.
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