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Carry Trades and Tail Risk: Evidence from Commodity Markets

Last Updated on 10 February, 2024 by Rejaul Karim

In his research paper “Carry Trades and Tail Risk: Evidence from Commodity Markets,” Daniele Bianchi delves into the intricate relationship between carry trades and tail risk within a panel of commodity futures contracts. Unlike other asset classes, the volatility of carry in commodities is notably heightened both within the time series and across different categories.

Through the application of panel quantile regression with commodity fixed effects, the study unveils the specific impact of carry on the conditional distribution of futures returns in both the short-term and longer-term contexts.

The empirical findings underscore the significant effect of carry on tail risk, particularly in the short term and for the near end of the futures curve.

Moreover, the research delves into the role of non-natural hedgers, such as non-commercial traders, money managers, and index traders, shedding light on their unwinding of net-long futures positions during periods of escalating market uncertainty and deteriorating aggregate financial conditions.

This evidence aligns with established theoretical models, reflecting the constraints faced by speculators and insurance providers in managing risks and financing liquidity.

Abstract Of Paper

I investigate the relationship between carry trades and tail risk for a panel of commodity futures contracts. Unlike other asset classes, carry in commodities is highly volatile both in the time series and in the cross section. By using a panel quantile regression with commodity fixed effect, I document the tail-specific effect of carry on the conditional distribution of futures returns both in the short-term and in longer-term. The main empirical results show that carry has a significant effect on tail risk mostly in the short term and for the front end of the futures curve. In addition, the empirical evidence shows that such relationship can be explained by the role of non-natural hedgers, such as non-commercial traders, money managers and index traders, which tend to unwind their net-long futures positions when exposed to deteriorating aggregate financial conditions and increasing market uncertainty. This is consistent with existing theoretical models in which speculators and insurance providers are subject to limited risk capacity and financing liquidity constraints.

Original paper – Download PDF

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Author

Daniele Bianchi
School of Economics and Finance, Queen Mary University of London

Conclusion

In conclusion, Daniele Bianchi’s study, “Carry Trades and Tail Risk: Evidence from Commodity Markets,” offers valuable insights into the complex interplay between carry trades and tail risk within the realm of commodity futures contracts.

With a focus on the highly volatile nature of carry in commodities, the paper applies panel quantile regression with commodity fixed effects to reveal the specific impact of carry on the conditional distribution of futures returns, particularly in the short-term and across the front end of the futures curve.

The empirical findings underscore the substantial influence of carry on tail risk, shedding light on the behavior of non-natural hedgers during periods of heightened market uncertainty and deteriorating financial conditions.

These findings align with established theoretical models, highlighting the constraints faced by speculators and insurance providers in managing risk capacity and financing liquidity. This contributes significantly to our understanding of risk management and empirical asset pricing dynamics within commodity markets.

Related Reading:

Structural Properties of Commodity Futures Term Structures and Their Implications for Basic Trading Strategies

Commodity Return Predictability: Evidence from Implied Variance, Skewness and their Risk Premia

FAQ

Q1: What is the main focus of Daniele Bianchi’s research paper, “Carry Trades and Tail Risk: Evidence from Commodity Markets”?

A1: The main focus of the paper is to investigate the relationship between carry trades and tail risk in a panel of commodity futures contracts. The study explores the unique characteristics of carry in commodities, emphasizing its heightened volatility both in the time series and across different categories. The paper utilizes panel quantile regression with commodity fixed effects to uncover the specific impact of carry on the conditional distribution of futures returns, particularly in the short-term and for the near end of the futures curve.

Q2: What are the key empirical findings regarding the relationship between carry and tail risk in commodity markets?

A2: The empirical findings reveal that carry has a significant effect on tail risk, particularly in the short term and for the front end of the futures curve in commodity markets. The study utilizes panel quantile regression to document the tail-specific impact of carry on the conditional distribution of futures returns.

Q3: How does the research address the role of non-natural hedgers, and what insights are provided regarding their behavior during periods of market uncertainty and deteriorating financial conditions?

A3: The research delves into the role of non-natural hedgers, including non-commercial traders, money managers, and index traders. It sheds light on their tendency to unwind net-long futures positions during periods of escalating market uncertainty and deteriorating aggregate financial conditions. These empirical observations align with existing theoretical models, emphasizing the limited risk capacity and financing liquidity constraints faced by speculators and insurance providers in commodity markets.

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