Quantitative Finance ISSN: 1469-7688 (Print) 1469-7696 (Online) Journal homepage: http://www.tandfonline.com/loi/rquf20 Return and volatility co-movement in commodity futures markets: the effects of liquidity risk Yongmin Zhang & Shusheng Ding To cite this article: Yongmin Zhang & Shusheng Ding (2018) Return and volatility co-movement in commodity futures markets: the effects of liquidity risk, Quantitative Finance, 18:9, 1471-1486, DOI: 10.1080/14697688.2018.1444562 To link to this article: https://doi.org/10.1080/14697688.2018.1444562 Published online: 23 Apr 2018. Submit your article to this journal Article views: 63 View Crossmark data Full Terms & Conditions of access and use can be found at http://www.tandfonline.com/action/journalInformation?journalCode=rquf20 Quantitative Finance, 2018 Vol. 18, No. 9, 1471–1486, https://doi.org/10.1080/14697688.2018.1444562 Return and volatility co-movement in commodity futures markets: the effects of liquidity risk YONGMIN ZHANG*†‡ and SHUSHENG DING‡ †School of Business, Ningbo University, 818 Fenghua Road, Ningbo, 315000, China ‡Nottingham University Business School China, Centre for Global Finance, University of Nottingham Ningbo China, 199 Taikang East Road, Ningbo, 315100, China (Received 16 January 2017; accepted 7 October 2017; published online 23 April 2018) Commodity markets are a widely researched topic in the field of finance. In this paper, we investi- gate the co-movement of return and volatility measures in different commodity futures markets and how these measures are affected by liquidity risk. First, we find that commodity returns display co- movement and that liquidity risk plays a key role in shaping asset return patterns. Moreover, we show that the volatilities of commodity returns co-move, and we demonstrate the role of liquidity risk in this joint pattern. We also find that the commodity markets we investigated share a common volatility factor that determines their joint volatility co-movement. Because liquidity risk affects both commodity returns and volatility shocks, it might be interpreted as the common causal factor driving both measures simultaneously. Therefore, we affirm the view that liquidity shocks are firmly related to two residual risks originating from both market return and market volatility. Finally, we also show that liquidity spillovers can significantly drive cross-sectional correlation dynamics. Keywords: Commodity futures markets; Price co-movement; Liquidity effects; Volatility co-movement JEL Classification: E30, F00 Introduction and Sanders 2011). Most new investors entering this market were of an institutional nature, which led to an extraordi- Commodity futures prices, such as those related to gold and nary growth and size of commodity market trading volumes oil, have been at the centre of financial and economic news (Domanski and Heath 2007). Consequently, commodity for much of the last decade. The oil price, for instance, markets have attracted much attention and have become a peaked at over US$140 per barrel in 2008, only to fall back much investigated topic of academic interest (see Narayan to less than US$30 per barrel at the beginning of 2016. et al. 2013, Bunn et al. 2015, Sockin and Xiong 2015). Such substantial swings in the price of oil render this mar- Commodity futures prices are crucial for economic analy- ket particularly volatile. This volatility pattern is similar to sis, and the literature documents the integral relationships the evolution of prices of many other assets traded in finan- between commodity prices and the state of economic devel- cial markets. For example, the simultaneous sudden decline opment. Cody and Mills (1991) illustrate a close relationship observed in both commodity and stock prices interacted between commodity prices and economic indicators such as with each other to exacerbate the synchronized downturn in the consumer price index (CPI). Clarida et al.(1998) demon- both markets. Choi and Hammoudeh (2010) identified the strate that commodity prices are firmly linked to inflation, stronger degree of synchronicity between commodity interest rates and output. Stock and Watson (2003) argue that futures markets and stock markets after the financial crisis. commodity prices can serve as a predictor of inflation and Other scholars also documented the various types of inter- output growth. Chinn and Coibion (2014) also note that actions between the stock markets and the commodity mar- understanding the movement and changes of commodity kets (see Vivian and Wohar 2012, Creti et al. 2013). More prices could be helpful in short-term policy deliberations. importantly, the inflow of capital into commodity futures Furthermore, the correlation between asset volatility and markets has soared to new heights in the last decade (Irwin asset return has been substantially researched in the finan- cial area (see French et al. 1987, Hamao et al. 1990, *Corresponding author. Email: [email protected] LeBaron 1992). The relationship between trading volume © 2018 Informa UK Limited, trading as Taylor & Francis Group 1472 Y. Zhang and S. Ding and asset volatility has also been investigated in the litera- two previous models. The increase of cross-sectional vari- ture. In futures markets, trading volume can serve as ables does not significantly add explanatory power to the a proxy for market liquidity. Bessembinder and Seguin model, which suggests that most of the explanatory power in (1993) show how trading volume strongly affects price the previous two models overlaps. The variation part that volatility, particularly when there is a volume shock. In fact, cross-sectional volatilities can explain is similar to the part trading activities and investor behaviour in the futures mar- that cross-sectional liquidities can explain. Consequently, it ket play important roles in affecting futures prices and price makes sense to hypothesize that liquidity is an important volatility (Chatrath et al. 1996). Trading activities were transmission channel driving the volatility spillover. An demonstrated to be closely related to market liquidity in the increased level of volatility observed in one commodity mar- stock market (Chordia et al. 2001). Consequently, it can be ket and an ensuing decline in liquidity can result in a similar argued that in the futures markets, liquidity can also play decline in liquidity in other markets, which in turn can also an important role in determine the path of the volatility. render those markets more volatile. More importantly, we Because commodity price volatility constitutes a measure also confirm the positive relationship between liquidity of the dispersion of price changes, policy-makers are there- shocks and volatility shocks. The contemporaneous co-move- fore concerned not only about commodity prices per se but ment of both commodity volatilities and liquidities might also about their volatilities given their potential to add to strengthen the linkage and spillover effects among different inflation pressures (Creti et al. 2013). Volatility of commod- commodity markets. Because the cross-sectional analysis ity prices is therefore a central issue for the global econ- cannot fully explain the volatility co-movement, we illustrate omy. Excessive fluctuations of commodity prices were a that there is a common market volatility factor affecting all widely discussed topic of concern during the 2009 G20 commodity markets and that this factor generates the volatil- meeting. Commodity price volatility is also a measurement ity co-movement of individual commodity markets. of risk, and one of the most important functions of the com- Because liquidity risk affects both commodity return and modity futures market is to transfer price risk (Garbade and volatility shocks, it might serve as a mediator between com- Silber 1983). Thus, volatility plays a key role in hedging modity return and commodity volatility, particularly for the possibilities and in allocating assets in the commodity returns and volatility shocks. When there is a volatility futures markets. Consequently, understanding the origin and shock, the liquidity shock might occur contemporaneously. evolution of price volatility can help investors, particularly Conversely, the liquidity shock is influential in affecting institutional investors, to construct better hedging strategies commodity returns. Consequently, volatility shocks can play and to make better asset allocation decisions. an important role in determining commodity returns via the Because volatility is of pivotal importance in financial liquidity risk effect. Moreover, liquidity shocks are firmly markets, the co-movement of volatility in different commod- related to the residual risks from both asset return and asset ity markets will also be scrutinized. Volatility co-movement volatility after controlling for market return and macroeco- significantly affects risk management, portfolio selection nomic variables. Liquidity shocks are negatively correlated and, more importantly, derivative pricing. Studying the co- with the residual risks from asset return regressions and movement of various volatility indicators can also aid in the positively correlated with the residual risks from asset understanding of financial market issues such as the trans- volatility regressions. mission of shocks throughout the financial system (see Lin Finally, we also show that the level of liquidity plays a et al. 1994, Edwards and Susmel 2003, Calvet and Fisher vital role in time-varying correlations between commodity 2004). Because