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Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns

Last Updated on 10 February, 2024 by Rejaul Karim

Gurdip Bakshi of the Fox School of Business, Xiaohui Gao of Temple University’s Fox School of Business, and Alberto G. Rossi of Georgetown University present an intriguing study in their forthcoming work, “Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns.”

Their investigation focuses on a model that encompasses an average commodity factor, a carry factor, and a momentum factor to elucidate the cross-sectional variation of commodity returns. In contrast, the study rejects more simplified one- and two-factor models, underlining the nuanced nature of the relationships between factors and commodity returns.

Notably, the research offers an economic interpretation, demonstrating how innovations in global equity volatility and commodity-based measures of speculative activity drive the pricing of portfolios formed on carry and momentum.

The study also delves into characterizing the association between the factors and the investment opportunity set, offering valuable insights into the multifaceted dynamics governing commodity returns.

Abstract Of Paper

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. More parsimonious one- and two-factor models that feature only the average and/or carry factors are rejected. To provide an economic interpretation, we show that innovations in global equity volatility can price portfolios formed on carry, while innovations in a commodity-based measure of speculative activity can price portfolios formed on momentum. Finally, we characterize the relation between the factors and the investment opportunity set.

Original paper – Download PDF

Here you can download the PDF and original paper of Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns.

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Author

Gurdip Bakshi
Fox School of Business; Temple University – Fox School of Business and Management

Xiaohui Gao
Fox School of Business, Temple University

Alberto G. Rossi
Georgetown University

Conclusion

In conclusion, the research by Gurdip Bakshi, Xiaohui Gao, and Alberto G. Rossi offers critical insights into the sources of risk underlying the cross-section of commodity returns. Their comprehensive model featuring an average commodity factor, a carry factor, and a momentum factor effectively captures the nuanced variation in commodity returns, rejecting more simplistic one- and two-factor models.

Crucially, the study unveils the economic interpretation of how innovations in global equity volatility can influence the pricing of portfolios formed on carry, while innovations in commodity-based measures of speculative activity drive the pricing of portfolios formed on momentum.

Additionally, the research delves into characterizing the relationship between the factors and the investment opportunity set, enriching our understanding of the complex interplay of factors shaping commodity returns.

This insightful investigation advances our comprehension of the multifaceted risk dynamics inherent in the cross-section of commodity returns, offering valuable implications for asset pricing models and investment strategies in commodity markets.

Related Reading:

Two Centuries of Commodity Futures Premia: Momentum, Value and Basis

Do Momentum and Reversal Strategies Work in Commodity Futures? A Comprehensive Study

FAQ

Q1: What distinguishes the model proposed in “Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns” from traditional one- and two-factor models in explaining commodity returns?

A1: The model in the study features an average commodity factor, a carry factor, and a momentum factor. This distinguishes it from more simplified one- and two-factor models, highlighting the nuanced nature of the relationships between factors and commodity returns.

Q2: How does the research provide an economic interpretation of the factors influencing commodity returns?

A2: The study offers an economic interpretation by demonstrating that innovations in global equity volatility can price portfolios formed on carry, while innovations in a commodity-based measure of speculative activity can price portfolios formed on momentum. This interpretation connects real-world economic factors to the pricing of commodity portfolios.

Q3: What additional insights does the research provide by characterizing the relation between the factors and the investment opportunity set?

A3: The research characterizes the relationship between the factors and the investment opportunity set, offering valuable insights into the multifaceted dynamics governing commodity returns. This contributes to a deeper understanding of how different factors interact with the investment landscape in commodity markets.

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