RDP 2017-03: Financialisation and the Term Structure of Commodity Risk Premiums 2. Related Literature and Theory

This paper is related to two connected literatures: the literature on the existence and determinants of commodity risk premiums; and the literature on the financialisation of commodities markets.

2.1 Commodity Risk Premiums

As discussed above, the net hedging pressure theory suggests that commodity futures prices will be set equal to the spot price participants expect to prevail at the maturity of the contract, less a risk premium. That is:

where Fc,m,t is the futures price for commodity c, at time t, for horizon m; Et indicates expectations at time t; and Sc,t + m is the spot price for commodity c at the maturity date t + m.[8]

The net hedging pressure theory suggests that the key determinant of the risk premium is the net of producers' (short) and consumers' (long) hedging positions – the net hedging position (NHP).[9] This is because an inducement will need to be paid to entice speculators, who have no natural exposure to commodities, to balance the market by taking the offsetting long or short position in futures contracts (Cootner 1960).[10] If the volume of producer hedging outweighs the volume of consumer hedging there will be a net short hedging position and so speculators will need to be enticed to go long to balance the market. To achieve this, the price of the futures contract maturing at time t + m will be set below the price that is expected (at time t) to prevail at time t + m. That is, speculators will agree to buy the commodity in the future at a set price, expecting to be able to onsell it at a higher price. As such, there is a positive expected return to taking a long position in the contract – a positive commodity risk premium. Conversely, if consumer hedging outweighs producer hedging there will be a net long hedging position and so speculators will need to be enticed to go short. Therefore, the price of the futures contract will be set above the expected future spot price, so the speculator is agreeing to sell the commodity in the future at a set price, expecting to be able obtain it from the market at a lower price. As such, there is a positive expected return to taking a short position in the contract – a negative commodity risk premium.

Hirshleifer (1988) provided a formal model. In the absence of market segmentation, the risk premium should reflect only the asset's systematic risk, as there will be a large number of speculators willing to compete and diversify away the market-specific risk (Telser 1958).[11] The systematic risk reflects the correlation between the futures price and other asset prices, which cannot be diversified away by investors. Investors will demand a premium to take on this risk. If the correlation is positive, the premium will be positive; if the correlation is negative, the premium will be negative.[12] The NHP will have no influence on the premium as there will be a large number of speculators competing to balance the market. However, if there is some cost that limits the number of speculators and segments the market, producers and consumers will need to pay an additional ‘residual’ premium related to the degree of hedging pressure and the volatility of prices.

Empirical examination of the net hedging pressure theory has been mixed. Both Bessembinder (1992), and De Roon, Nijman and Veld (2000) found evidence of a contemporaneous relationship between the NHP and returns on commodities futures (an ex post proxy for commodity risk premiums). However, Gorton, Hayashi and Rouwenhorst (2013) found no significant relationship between the ex ante level of the NHP and returns, and suggested that the earlier findings reflected reverse causality (i.e. hedgers adjusting their position in response to price changes). Rouwenhorst and Tang (2012) reproduced a number of earlier papers that found evidence supporting the net hedging pressure theory. Using longer samples and more commodities they found that the evidence is less compelling.

Papers that allow the relationship between the NHP and risk premiums to vary have been somewhat more successful. For example, Basu and Miffre (2013) found evidence that premiums related to hedging pressure are larger when prices are more volatile. This is consistent with the predictions of Hirshleifer (1988). Acharaya, Lochstoer and Ramadorai (2013) found similar results for the energy sub-sector and also showed that risk premiums are more responsive to the NHP when the risk-bearing capacity of broker-dealers is low (i.e. when markets are more segmented).[13] Accounting for this variation could be particularly important, as smaller absolute risk premiums due to decreased segmentation could lead marginal producers and consumers to decide to hedge, leading to endogneity. Acharaya et al (2013) also used a measure of oil producer default risk as a proxy for producer hedging pressure. This avoided issues associated with the Commodities Futures Trading Commission (CFTC) data on commercial positions, which are used frequently in the literature.[14]

2.2 Commodity Market Financialisation

Numerous papers have detailed the financialisation of commodities markets – the significant increase in open interest, trading volumes and commodity fund AUM that has occurred since the mid 2000s (e.g. Domanski and Heath 2007; Irwin and Sanders 2012a). There is an even larger literature examining the effects of financialisation, including on: the correlation between different commodity prices, and between commodity prices and other asset prices (e.g. Dwyer et al 2012; Tang and Xiong 2012); the volatility of commodity prices (e.g. Dwyer, Gardner and Williams 2011); and more generally whether these effects have been beneficial or not.[15]

Most closely related to this paper is the literature that considers whether the positions of different types of speculators can predict commodity returns – which are often taken as an ex post proxy for risk premiums – and therefore whether financialisation could have affected prices by changing the balance of these participants. A number of dynamics are laid out in the literature to explain how speculators' positions, particularly those of funds that allocate their investments based on major commodity indices (index funds), could affect returns and premiums, including: informational frictions (Singleton 2014); decreased market segmentation (Baker 2016); or increased demand for long positions from index funds (Hamilton and Wu 2014; Basak and Pavlova 2016).

Baker (2016) modelled financialisation as a decrease in the cost speculators have to pay to trade commodity futures. This leads to an increase in their futures positions, as markets become less segmented, and a decrease in the magnitude of risk premiums.[16] Other papers have focused on investment by long-only index funds. These are index funds that only take long positions in commodities markets. As such, the papers model financialisation as a secular increase in demand for long positions. For example, Basak and Pavlova (2016) outline a model where investors benchmark their portfolios to a commodity index. This causes a natural short exposure, which they wish to hedge by going long in the index. The natural short exposure makes them somewhat similar to commodity consumers and so increased participation by these investors results in lower risk premiums.

The majority of papers have been unable to find a significant relationship between the positions of different types of speculators and commodity futures returns (Hamilton and Wu 2015). One notable exception to this is Singleton (2014), who found a significant relationship between changes in index funds' positions and returns on futures contracts.[17] Irwin and Sanders (2012b) criticised the measure of index fund positions used in Singleton (2014). Using a different measure, but similar statistical techniques, they found no evidence of a relationship between index fund positions and commodity futures returns (or premiums).

Hamilton and Wu (2014) avoided issues associated with using potentially noisy measures of index fund positions and risk premiums (i.e. ex post returns) by constructing an affine term structure model of the oil futures curve with latent factors. They found premiums were generally stable and positive until the mid 2000s, after which premiums became more volatile and smaller (and often negative). Moreover, they found that the average risk premium earned by investing in short-maturity oil futures contracts has decreased relative to that earned by investing in longer-maturity futures contracts. They attribute these findings to the sharp increase in oil futures trading volumes for short-maturity contracts associated with the rise of commodity index funds, which tend to invest in short-maturity contracts.


This expression is used for ease of exposition. We actually define the risk premium to be multiplicative, not additive to the expected spot price. For details see Appendix A. [8]

Another theory regarding the determination of commodity futures prices is the theory of storage. This theory argues that the difference between the current spot and futures prices can be explained by the cost that is incurred to store the commodity, the cost of capital – which reflects the opportunity or financing cost associated with buying and holding the physical commodity – and an implied convenience yield. For more detail see, for example, Dwyer, Holloway and Wright (2012). [9]

Implicitly, the theory assumes that producers' and consumers' exposure to commodity prices is ‘non-marketable’. If this were not the case, it could be sold to individual investors who could diversify away the risk, eliminating the need to hedge (e.g. Stoll 1979). [10]

In this case the capital asset pricing model (CAPM) should provide a good approximation of the premium. However, unlike the standard CAPM model, futures contracts will not earn the risk-free rate in addition to the systematic risk component as they do not require an initial capital investment (aside from potentially a margin account). [11]

This negative premium reflects the fact that the asset actually allows investors to diversify away their risk, rather than adding to their risk. [12]

The latter result built on Etula (2013), which showed that the risk-bearing capacity of broker-dealers is an important determinant of the level of risk premiums in the energy sub-sector. [13]

These data include the positions of swap dealers, who act as intermediaries in commodities markets. While they often act as intermediaries for producers and consumers, they can also act as intermediaries for speculators. [14]

For detailed literature reviews, see Irwin and Sanders (2012a) or Cheng and Xiong (2014). [15]

Baker suggests risk premiums will decrease. However, this reflects the assumption that risk premiums are positive before financialisation. A generalisation of the arguments put forward in the paper would suggest the magnitude of risk premiums becomes smaller. [16]

Somewhat relatedly, Hong and Yogo (2012) find a positive relationship between total open interest and commodity futures returns. However, they suggest that this reflects the fact that total open interest provides a more reliable signal about future economic activity than the futures price. [17]