Commodity tail risks

• Published date: 01 February 2023
• Author: Manuel Ammann,Mathis Moerke,Marcel Prokopczuk,Christoph Matthias Würsig
• Date: 01 February 2023
• DOI: http://doi.org/10.1002/fut.22381

Received: 7 December 2021

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Accepted: 12 September 2022

DOI: 10.1002/fut.22381

RESEARCH ARTICLE

Commodity tail risks

Manuel Ammann

1

|Mathis Moerke

1

|Marcel Prokopczuk

2,3

|

Christoph Matthias Würsig

2

1

School of Finance, University of St.

Gallen, St. Gallen, Switzerland

2

School of Economics and Management,

Gottfried Wilhelm Leibniz University of

Hannover, Hannover, Germany

3

ICMA Centre, Henley Business School,

University of Reading, Reading, UK

Correspondence

Mathis Moerke, School of Finance,

University of St. Gallen, Unterer Graben

21, CH‐9000 St. Gallen, Switzerland.

Email: mathis.moerke@unisg.ch

Abstract

In this study, we investigate the cross‐section of option‐implied tail risks in

commodity markets. In contrast to findings from equity markets, left and right

tail risks implied by option markets are both large. Commodity‐specific

variables exert the largest influence on tail risk, while there is no evidence of

systematic commodity factors that are linked to tail risk. Additionally, we find

strong links to the equity markets, but also comovements to macroeconomic

factors. Left or right tail risks are largely independent of variance risk

premiums. Finally, both left and right tail risks are priced in the cross‐section

of commodity futures returns.

KEYWORDS

commodities, dependencies, tail risks

JEL CLASSIFICATION

G10, G17, G12, C58

1|INTRODUCTION

Commodity markets exhibit regularly reoccurring “supercycles”and “busts.”

1

These cycles are generally

accompanied by sharp increases or declines in prices due to various events, such as supply disruptions, demand

shocks, political instabilities, or natural catastrophes. For market participants these risks are very crucial, beca use

they represent high marginal utility events. Moreover, commodities are important for the real economy as

production and consumption goods. Hence studying these events and understanding their dynamics constitutes an

important analysis.

Whereas concerns regarding left tail risk dominate in equity markets, left and right tail risks play an equally important

role in commodity markets. For commodity producers, negative price jumps (left tail risk) might have devastating

consequences, akin to the role of left tail risks for market participants in stock markets. For commodity consumers

though, for example, companies that process commodities, right tail risks matter more. This is especially true when they

need to fulfill long‐term contracts with a lack of future market supply of raw materials. Tail risks in commodity markets

are also important for countrieswhose exports mainly rely oncommodities. Moreover,commodity markets, and especially

tail events, have a large influence on inflation and consumer spending (Garratt & Petrella, 2019). Thus an understanding

of tail risks in commodity markets is crucial to understanding movements in the cross‐section of commodity market

returns and overall extreme risks in the market.

J Futures Markets. 2023;43:168–197.wileyonlinelibrary.com/journal/fut168

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© 2022 Wiley Periodicals LLC.

1

The Economist—Commodity prices are surging, January 12, 2021.

The contribution of our paper is twofold: First, we seek to identify the determinants of option‐implied tail risk in

commodity markets. We consider option‐implied left and right tail risks for a wide cross‐section of 19 commodities. In

doing so, we control for past tail risk to account for the autocorrelation in time series. We draw upon previous studies,

including jumps under the physical measure, and posit multiple possible factors that may influence the tail risk in

commodity markets and order them into the following groups: commodity‐specific factors, commodity market factors,

equity market factors, and macroeconomicfactors. We focus on option‐impliedtail risks instead of physical jumpsfor two

reasons. On the one hand, physical jumps are notoriously difficult to estimate and identify due to their rare occurrence,

whereas options on commodity futures are traded daily in large quantities. On the other hand, option prices are

inherently forward‐looking as they reflect investors' expectations of the underlying's future return distribution.

Second, we analyze whether tail risk is priced in the cross‐section of the commodity market. We find that it is. Tail

risk carries a statistically significant risk premium for both, the right and left tail of the return distribution. The effect is

stronger for right tail risk, than for left tail risk, with a return of the long–short portfolio of 10.60% p.a. for the right tail

risk and 8.50% p.a. for the left tail risk, which indicates that there are different risk premia for commodity producers

and consumers to hedge tail risks.

The commodity‐specific factors we identify are returns, skewness under the physical measure, basis, and speculation.

Fernandez‐Perez et al. (2018) find that historical skewness is priced in the cross‐section of commodities partly due to

hedging practices. The basis is the slope of the futures term structure and is, as such, related to the supply and inventory

of commodity markets. The inventory of commodities might influence the tail risk of commodity markets because

speculators and insurance providers face limited risk capacity and financing constraints (Bianchi, 2018). The tail risk

might also be relatedto speculation. Excessivespeculation might be connected to tail riskdue to changes in investors' risk

appetite and demand and supply of out‐of‐the‐money options. Option‐implied tail risk is part of the variance under the

risk‐neutral measure. Therefore we also investigate links to the variance risk premium (Prokopczuk et al., 2017).

We also identify commodity market factors: the average return of the commodity market, the return on a

commodity momentum strategy, and the return on a commodity carry strategy. These factors are motivated by Bakshi

et al. (2017), who find that the average return of the commodity market, the momentum return, and the carry return

can explain up to 71% of the variation in commodity futures returns.

Some authors argue that commodity markets are increasingly integrated with equity markets due to the

financialization of commodities and the following influx of retail investors (Henderson et al., 2014). Hence, we include

equity market factors that might capture links between the equity market volatility, equity market tail risk, and tail

risks in commodity markets. In particular, we consider the left or right tail risk of the S&P 500, and the market return

of the S&P 500 index.

Finally, previous studies have shown the influence of macroeconomic variables on option‐implied higher moments.

Triantafyllou and Dotsis (2017) document that implied skewness and variance are increasing in expansionary monetary

policy. Hence, we include the Federal Funds Rate, the slope of the US Treasury yield curve, inflation, growth in

industrial production, and the dollar index to the set of potential determinants of tail risk in commodity markets. As

Nguyen and Prokopczuk (2019) find that most commodities can act as hedges against US Dollar returns, we include the

trade‐weighted US Dollar Index as an explanatory variable.

We find that commodity‐specific factors and equity market tail risks have the largest influence on left, right, total,

and asymmetry tail risks. Different commodity‐specific factors seem to influence the left and the right tail. First, for the

agricultural and for the softs market we see positive links to returns of the commodities. While for metals and crude oil

periods of distress seem to increase the uncertainty in the tails of the distribution. Second, historical skewness is

negatively linked to left and right tail risks. Third, left and right tail risks are just loosely linked to speculation. Despite

the mitigating effects of speculation on volatility (Brunetti et al., 2016), we cannot extend this finding on the option‐

implied tails of the distribution. Fourth, and in line with the theory of storage, the basis is significantly linked to tail

risks for some commodities.

Commodity market factors are only partially significantly correlated to commodity tail risks. A far greater role is

exerted from equity market factors. Precisely, equity tail risk is positively associated with tail risk for most

commodities. This link is especially pronounced for left tail risks suggesting a tight tail dependence across several asset

classes in times of high uncertainty (Chevallier & Ielpo, 2014).

We also find evidence in favor of statistically significant relations to macroeconomic factors. Most notably, we

document a strong and positive link to the Fed Funds Rates in the case of agricultural commodities. Our results support

the findings of Triantafyllou and Dotsis (2017). However, they also show that this finding is rather specific to

agricultural commodities and cannot be generalized to other commodity sectors. However, for tail risk asymmetry we

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