Research Discussion Paper – RDP 2017-03 Financialisation and the Term Structure of Commodity Risk Premiums

Commodities, such as oil and wheat, are important inputs into the real economy. They have a significant influence on the welfare of individuals through their role as consumption goods and as inputs into other goods. As such, it is important to understand how commodity prices are set and whether there are any distortions to these prices. One component of commodity futures prices is the risk premium, which reflects the return investors demand to take on producers' and consumers' natural exposures to commodity prices. Therefore, to better understand the determination of commodity futures prices this paper examines commodity risk premiums and their determinants.

We find evidence that commodity risk premiums vary across futures contract maturities, and that the shape of the commodity risk premium ‘curve’ differs across commodities and over time. This suggests information could be contained in the shape of the risk premium curve. We also find strong evidence of a relationship between the net of producers' (short) and consumers' (long) hedging positions – the net hedging position – and risk premiums, as would be suggested by the net hedging pressure theory. The evidence is generally more significant for longer-dated futures contracts.

In addition, we consider whether the large increase in the size of commodity-related financial markets over the 2000s – commodity market financialisation – has affected commodity risk premiums. We find little statistical evidence that financialisation has had a significant effect on the ‘residual’ or idiosyncratic portion of commodity risk premiums for a broad basket of commodities. But we do find some evidence of smaller residual risk premiums for wheat, particularly for short-maturity contracts. This could reflect either decreased market segmentation or a secular increase in demand for long positions. We also find evidence that financialisation increased the systematic portion of commodity risk premiums by increasing the correlation between returns on commodity futures and returns on the ‘market’ portfolio. This was more evident for longer-maturity contracts of 6–18 months.