Do country risk and financial uncertainty matter for energy commodity futures?

• DOI: http://doi.org/10.1002/fut.21976
• Author: Donald Lien,Chi‐Chuan Lee,Chien‐Chiang Lee
• Date: 01 March 2019
• Published date: 01 March 2019

Received: 4 November 2017

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Revised: 24 September 2018

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Accepted: 24 September 2018

DOI: 10.1002/fut.21976

RESEARCH ARTICLE

Do country risk and financial uncertainty matter for

energy commodity futures?

Chien‐Chiang Lee

1

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Chi‐Chuan Lee

2

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Donald Lien

3

1

Department of Finance, National Sun

Yat‐sen University, Kaohsiung, Taiwan

2

Institute of Development, Southwestern

University of Finance and Economics,

Chengdu, China

3

Department of Economics, College of

Business, University of Texas at San

Antonio, San Antonio, Texas

Correspondence

Donald Lien, Department of Economics,

College of Business, University of Texas at

San Antonio, San Antonio, TX 78249.

Email: Don.Lien@utsa.edu

Funding information

Ministry of Science and Technology of

Taiwan, Grant/Award Number: MOST

106–2918‐I‐110‐002

Abstract

Using an instrumental variable quantile regression technique, this paper

assesses whether country risk and financial uncertainty exert an impact on

energy commodity futures prices under different commodity conditional return

distributions over the period from January 1994 to July 2017. We also discuss

whether the correlations change with different dimensions of country risk, that

is economic, financial, and political. The results reveal that country risk and

financial stress do have a significant impact on energy commodity returns of

futures contracts with different maturities, but their direction, intensity, and

significance differ, caused by the distinct market situations and divergent

channels of country risk.

KEYWORDS

country risks, energy commodity futures, financial uncertainty, instrumental variable quantile

regression

JEL CLASSIFICATION

C31, C58, G13, Q43

1

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INTRODUCTION

This paper extends the existing literature on the rapidly growing energy futures markets by examining how different

dimensions of country risks (economic risk, financial risk, and political risk) and financial uncertainty affect three major

energy commodity futures (crude oil, heating oil, and natural gas). We utilize International Country Risk Guide (ICRG) data

and an instrumental variable quantile regression (IVQR) to assess the effects of country risks on energy commodity futures

under different commodity conditional return distributions over the period from January 1994 to July 2017. This topic

deserves a valuable investigation, because environmental risk, for example, political stability, economic volatility, financial

turbulence, and so forth impacts the investment behavior of commodity traders, thereby altering commodity prices.

It is widely recognized that many economic activities consider energy as the most important required input in the

productive process and as the economy is driven by increasing energy demands (Doran & Ronn, 2008; Gatfaoui, 2016;

Lee, Lee, & Ning, 2017). As energy commodity price continue soaring and fluctuating, energy commodity futures have

experienced an impressive increase in financial investor demand to hedge price risk (Karali & Ramirez, 2014; Koch,

2014; Lubnau & Todorova, 2015). Under this trend of transformation, companies and institutions, investors and risk

managers, as well as scholars are now facing more and more challenges not only from selecting the adequate

instrument but also from making risk management strategy. In addition, empirical evidence has identified the impact of

energy markets on the financial market through different channels of shocks such as price, volatility, liquidity, and

economic events (Aspergis & Miller, 2009; Lee & Lee, 2018b; Narayan & Gupta, 2015). These mechanisms have been

widely discussed and even become one of the key topics in the currently existing literature.

J Futures Markets. 2019;39:366–383.wileyonlinelibrary.com/journal/fut366

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© 2018 Wiley Periodicals, Inc.

The large inflow of investment into energy commodity markets has increased the linkage between commodity and

financial markets over the past few decades and generated a heated debate on the impacts of macroeconomic fluctuations

and financial factors on commodity prices (D’Ecclesia, 2016; Narayan, Narayan, & Sharma, 2013; Reboredo & Uddin,

2016). Many analysts argue that financialization substantially influences energy commodity prices, because of increased

speculation inthe markets affecting volatility and informationsharing (Adams & Glück, 2015; Büyükşahin & Robe, 2014).

Following this vein, Henderson, Pearson, and Wang (2015) examine the impact of the flows of financial investors on

commodity futures prices and find evidence that noninformation‐based financial investments have significant impacts on

commodity prices. Manera, Nicolini, and Vignati (2016) analyze the roleof financial speculation in modeling thevolatility

of commodity futures prices and document that speculation significantly affects return volatility.

Compared with financialization wisdom, recent market experience highlights the importance of deepening our

understanding of environmental uncertainty in changing stock and commodity prices. Financial uncertainty and

political uncertainty have been largely considered as main drivers of macroeconomic performances and are strongly

correlated with stock returns through supply‐side and demand‐side channels (Pástor & Veronesi, 2012). Previous

studies highlight that financial uncertainty increase the risk that investors perceive when making risk and portfolio

decisions. Given that commodity futures generally serve as a hedge assets or a safe haven in extreme market conditions,

financial uncertainty may be transmitted to commodity prices via portfolio rebalancing. Connolly, Stivers, and Sun

(2007) investigates how comovement between stock and bond returns varies with stock uncertainty, as measured by the

Chicago Board Options Exchange (CBOE) Volatility Index (VIX), and finds evidence that it negatively impacts these

returns. From the financial stress perspective, Naifar and Hammoudeh (2016) indicate that a higher financial stress

indicator is negatively correlated with stock returns. In addition, Yin and Han (2014) distinguish two types of

macroeconomic uncertainty, policy‐related uncertainty and equity‐market‐related uncertainty, and show that increases

in the volatilities of both policy‐related uncertainty and equity‐market‐related uncertainty lead to positive returns and a

higher level of commodity market volatility. In contrast, increased commodity market volatility only causes higher

policy uncertainty, but exerts no impact on equity uncertainty. Differently, Reboredo and Uddin (2016) examine the

impact of financial stress and policy uncertainty on the price dynamics of commodity futures and indicate that stock

market uncertainty is not crucial in determining commodity futures prices, while financial stress has a negative

contribution to commodity prices.

Although the behavior of commodity prices has been extensively analyzed in the empirical literature, an important

external factor, country risks, has not yet received appropriate attention. From the perspective of asset pricing,

theoretical and empirical studies have explicitly linked country risk and expected equity returns (see, e.g., Bekaert,

Harvey, Lundblad, & Siegel, 2016; Diamonte, Liew, & Stevens, 1996; Erb, Harvey, & Viskanta, 1996; Mariscal & Lee,

1993). That is, country risk is priced in equity returns. As Brooks, Zhang, and Bheenick (2007) note, a simple technique

to characterize country risk is in the context of the capital asset pricing model (CAPM). Earlier studies conducted by

Mariscal and Lee (1993) introduce the country risk variable measured by the spreads of sovereign bonds to the modified

version of international CAPM. As an alternative to the sovereign spread adjustments, Erb et al. (1996) employ the

survey‐based country credit rating to infer expected returns and show that country risk generally contains information

on future equity returns. In addition, country risk has been closely watched by investors, portfolio managers,

policymakers, particularly in the wake of the recent global financial crisis. We therefore hypothesize that country risk is

an important factor to influence commodity futures returns.

Country risk reflects the economic strengths, political stability, and the ability and willingness of a country to service

its financial obligations from a forward‐looking perspective. Awareness has grown that a detailed knowledge of the role

of country risk in financial markets is required to have a proper understanding of its transmission mechanism. Much

attention has been paid to the relationship between country risks and economic activities (Bahadir & Valev, 2015;

Brückner & Gradstein, 2015; Lee & Lee, 2018a; C. Liu, Sun, Chen, & Li, 2016). Although there are some studies

addressing the relationship between commodity prices and the economic policy uncertainty index (Reboredo & Uddin,

2016), the nature of country risk is rather divergent, and cannot be reflected in one single dimension. Up to now, there

is no good understanding of the sources of vulnerability and the awareness of determinants of country risk is lacking. It

remains unknown whether different types of country risk have similar impacts on commodity future price returns. In

an attempt to fill the gap in the literature, this paper looks at the dynamic relationship between energy commodity

futures (crude oil, heating oil, natural gas) and country risks using multifaceted indicators.

The contributions of this paper are five‐fold. First, we simultaneously examine the impact of country risk and

financial uncertainty on the price dynamics of commodity futures in energy markets, which is not explored in prior

studies. Second, with a particular emphasis on its impact on energy commodity futures, country risk is generally

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