Intermediary asset pricing in commodity futures returns

• Author: Liyan Han,Libo Yin,Jing Nie
• Date: 01 November 2020
• DOI: http://doi.org/10.1002/fut.22099
• Published date: 01 November 2020

J Futures Markets. 2020;40:1711–1730. wileyonlinelibrary.com/journal/fut © 2020 Wiley Periodicals, Inc.

|

1711

Received: 10 January 2020

|

Accepted: 12 January 2020

DOI: 10.1002/fut.22099

RESEARCH ARTICLE

Intermediary asset pricing in commodity futures returns

Libo Yin

1

|

Jing Nie

1

|

Liyan Han

2

1

School of Finance, Central University of

Finance and Economics, Beijing, China

2

School of Economics and Management,

Beihang University, Beijing, China

Correspondence

Libo Yin, School of Finance, Central

University of Finance and Economics,

39 South College Road, Haidian District,

100081 Beijing, China.

Email: yinlibowsxbb@126.com

Funding information

National Natural Science Foundation of

China, Grant/Award Numbers: 71671193,

71871234; Program for Innovation

Research in Central University

of Finance and Economics; the “Young

talents”Support Program in Central

University of Finance and Economics,

Grant/Award Number: QYP1901

Abstract

This paper assesses the extent to which intermediary capital (IC) risk

contributes toward explaining commodity futures returns. We find that the

IC effect is substantially positive and continues to grow as the financialization of

commodities deepens. Positive and negative IC risks play asymmetric roles,

with the effect of negative IC strengthening in recent subperiods. We further

confirm the heterogeneous roles of IC across individual commodities by cross‐

section analyses. Overall, the effect of the positive IC risk factor varies

significantly. Portfolios with low basis, low open interest, low momentum, and

low liquidity earn significantly higher returns than counterparty portfolios.

KEYWORDS

commodity futures, financialization of commodities, intermediary capital risk

JEL CLASSIFICATION

G12; G14

1

|

INTRODUCTION

The broad surge in commodity prices in recent years has stimulated renewed interest in commodity markets, which has

led researchers to explore the factors that might impact the behavior of commodity futures prices. Despite the effects of

strong global growth on the demand for commodities from emerging economies (Fattouh & Mahadeva, 2014; Hamilton,

2009; Kilian, 2009), much of the literature attributes the boom‐and‐bust cycle to the elevated participation of

institutional investors in commodity markets (Büyükşahin & Robe, 2014; Cheng, Kirilenko, & Xiong, 2014; Henderson,

Pearson, & Wang, 2015; Singleton, 2013; Yin & Han, 2016). Beginning around 2004, the rapid influx of money into

commodity markets that is attributed to institutional investment grew sharply from less than $15 billion in 2003 to more

than $350 billion in 2018. This influx has the potential to dramatically affect commodity futures trading volumes, prices,

and volatility, as well as the performance of managed futures funds. As argued by Adams and Glück (2015),

commodities have become part of the investment strategy of institutional investors, who continue to channel funds into

commodity markets.

Admittedly, a close connection has always existed between financial institutions and commodity markets. Producers

and consumers often use financial institutions as intermediaries to manage the commodities exposure associated with

their day‐to‐day operations and long‐term investment projects, through physical or financial markets, as hedging risks

allows for greater liquidity, price stability, and certainty of execution (Strongin, Hindlian, & Lawson, 2009). Therefore,

financial intermediaries serve as a bridge between commodity producers, consumers, and investors, mirroring their

market‐making in purely financial instruments (Henderson, et al., 2015; Liu, Han, & Yin, 2018). Further, when

releasing macro forecasts, financial institutions adjust their strategies, which could indirectly lead to revisions in

investor expectations regarding the price paths of commodity futures (Triantafyllou & Dotsis, 2017).

While the existing literature on the financialization of commodities is rich and has far‐reaching implications, studies

on the role of institutional investors remain scarce. There are only two exceptions, both of which focus on how

institutional investors enter commodity futures markets. One of these studies is by Basak and Pavlova (2016), who

document that institutional investors care about their performance relative to commodity indices and identify the

economic mechanisms through which institutions may influence commodity futures prices. The other is by Henderson

et al. (2015), who show that investor flow into commodity‐linked notes (CLNs) is passed through to the futures markets

by the hedging trades executed by CLN issuers. In this study, we aim to contribute to the empirical literature by

investigating the extent to which financial institutions play a systematic and significant role in determining commodity

prices.

Intermediary asset pricing theories offer an ideal perspective for understanding risk premia by disentangling the

effects of institutions from traditional consumption‐based models in which the focal pricing kernel is that of the

individual (household). Financial intermediaries, which are broadly defined to include traditional commercial banks as

well as investment banks and hedge funds, fit the assumptions of modern finance theory nicely (He & Krishnamurthy,

2013). He and Krishnamurthy (2013) state that “households' comparative lack of expertise in trading assets, especially

sophisticated ones such as derivatives or commodities, casts doubt on the viability of household marginal utility as a

unified model for jointly pricing the wide array of traded assets in the economy.”Phenomena observed in the 2008

financial crisis have motivated the study of intermediary asset pricing. Theoretically, He and Krishnamurthy (2012,

2013, 2018) document that the marginal values of the wealth of intermediaries contribute to the pricing of a broad class

of assets and provide an informative stochastic discount factor. Empirical evidence has also been extensively

investigated (Brunnermeier & Sannikov, 2014; Etula, 2013; He, Kelly, & Manela, 2017), providing systematic empirical

support for the thesis that intermediary risk contains valuable information about the evolution of risk premia over time

and price variations in assets, including equities and bonds (Adrian, Etula, & Muir, 2014), currencies (He et al., 2017),

options (Chen, Joslin, & Ni, 2018; Garleanu, Pedersen, & Poteshman, 2008), mortgage‐backed securities (Gabaix,

Krishnamurthy, & Vigneron, 2007), and credit default swaps (Mitchell & Pulvino, 2012).

Surprisingly, however, very limited effort has been devoted to examining the effect of financial intermediaries on

commodity markets. This paper therefore, responds to this study gap. We sought to address the following fundamental

questions: Does intermediary risk have any significant effect on commodity prices? What is the direction of the effect? Is

the effect asymmetric? Is there any heterogeneity in intermediary risk effects across commodities? These questions are

crucial to understanding the role of financial intermediaries in commodity futures markets and should, ultimately, be

tested empirically.

Our investigation proceeds as follows. We first conduct a pioneering study focusing primarily on the effect of

intermediary capital risk on two typical commodity indices and 23 individual commodities. The central challenges are

how to identify a set of financial intermediaries and how to construct our measure of intermediary capital risk. In line

with He et al. (2017), we focus on primary dealers, who are natural candidates for analyzing the role of financial

intermediaries and are large and sophisticated enough to operate in virtually the entire universe of capital markets.

Intermediary capital risk is then measured by examining changes to the intermediary capital ratio of primary dealers

(scaled by the lagged capital ratio), which can capture financial shocks that affect the soundness of the financial

intermediary sector. Using this novel, market‐based measurement of intermediary capital risk, we identify significantly

positive prices of risk on the intermediary capital factor in commodity futures returns, supporting the idea that the

institution is a nontrivial player in the commodity market. This means that when an intermediary experience a negative

shock to their equity capital, their risk‐bearing capacity is impaired, and their pricing kernel for commodities rises,

which is consistent with the theoretical framework of He and Krishnamurthy (2012). The explanatory power of this

variable is more substantial during more recent subperiods, indicating the increasing role of intermediary capital risk

over time. In addition, the effect remains robust after controlling for well‐known macroeconomic variables and

commodity‐related factors.

Second, our analysis is further extended to asymmetric models, since the intermediary asset pricing literature

emphasizes a state‐dependent association between risk premium and the degree of financial sector distress (He et al.,

2017). Maggiori (2017) shows that financial intermediaries perform differently due to asymmetric risk sharing. Our

evidence shows that the positive intermediary capital risk factor plays a more significant role in the returns of the

commodity market and most individual commodity futures for the full‐sample period from January 1970 to November

2018 than that of the negative intermediary capital risk factor. However, the effect of a negative intermediary capital

risk factor is increasing and exceeds that of the positive component over more recent subperiods, especially after the

2008 financial crisis. The evidence indicates that deleveraging and capital constraints in the wake of 2008 financial crisis

impair the intermediary's capacity to bear negative intermediary capital risk.

1712

|

YIN ET AL.