Sunday, December 20, 2015

Dempster and Tang, Commodities

Commodities, edited by M.A.H. Dempster (University of Cambridge) and Ke Tang (Tsinghua University), is part of the CRC Financial Mathematics Series. Over 700 pages long, it contains 31 papers written mostly by academics. It is organized into four parts: oil products, other commodities, commodity prices and financial markets, and electricity markets.

Recently, most commodities have been cratering. Natural gas hit a 14-year low, oil prices collapsed from $105 down to $35 in a little over a year with Goldman Sachs standing by its prediction of a low of $20 a barrel, even milk is selling at only about 60% of its peak in the late summer of 2014. Understandably, investors have sold down their positions. Commodities have lost their appeal as a way to diversify a portfolio.

At some point, of course, commodities will rebound, even if not fully. While they wait for a better entry point, investors can use their time to learn more about the ins and outs of some of these markets. For the quantitatively inclined, the Dempster-Tang book is a perfect way to gain valuable insights.

I can’t, of course, survey the entire book here. Instead, I’ll simply share some bullet points from the section on commodity prices and financial markets that I think may be of general interest.

First, oil price shocks are the only variable with forecasting power for stock returns at horizons of one to three quarters. (That may be an overstatement, but if we get rid “the only” it’s a hypothesis worth studying.)

Second, oil prices lead oil volume, and S&P 500 trading volume leads S&P 500 prices. Moreover, over a 28-year period of study, “there is a persistent positive association between crude oil futures prices and S&P 500 futures prices.” (p. 354)

As for portfolio diversification, adding the spot commodity “considerably improves the value of the portfolio.” (p. 433) But investing in calendar spreads, using distant futures contracts in conjunction with the near end of the commodity term structure, gives poor results.

Long-short commodity funds are meaningful portfolio diversifiers.

Finally, from a paper on the dynamics of commodity prices that especially interested me, some findings on volatility in the six major commodity markets and the S&P 500. “[W]ithin the stochastic volatility framework, the models that allow for jumps provide a considerably better fit to the data than those that do not, although there is little to choose between the models allowing for jumps in returns only and those allowing for jumps in both returns and volatility.” In the relationship between returns and volatilities for various commodities the signs are “negative for crude oil and equities, close to zero for gasoline and wheat, and positive for gold, silver, and soybeans.” The intensity and frequency of jumps varies considerably among commodities, “although all commodities are found to exhibit more frequent jumps than the S&P 500.” (p. 502)

These are just a few of the many intriguing takeaways from this thoroughly researched book. Commodities gives investors with quantitative skills an opportunity to study a range of modeling tools. It gives commodity traders some unexpected ways to seek alpha. And it offers portfolio managers ideas for improving their returns. All in all, a wealth of information.

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