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Working Paper 205 - Volatility and Co-movement in Commodity Prices- New Evidence




In this paper we show that commodity price co-movements between petroleum and other commodities, although infrequent, are not unique to recent periods, as alluded to in the current literature. We find that much of the volatility in commodity prices over long time spans is caused by economic fundamentals. Conditional covariances of unrelated commodities are very small in ordinary circumstances, as expected. After accounting for economic fundamentals, we find no evidence of excess co-movement between groups of commodity pairs. In a framework where commodity prices are influenced by common macroeconomic variables that determine the supply and demand for commodities, we show that conditional covariances of pairs of unrelated commodities are, as expected, stable and small with infrequent periods of uncharacteristic spikes. We hypothesized that these infrequent spurts are associated with sharp expected declines in asset prices associated with the probability of economic downturns and financial leverage (credit stress). The probability of a downturn is likely to be associated with expectations of lower short term interest rates and falling marginal costs of holding inventory (larger convenience yields) which in turn spur simultaneous demand for speculative or anticipatory commodity inventories. Likewise, excessive financial leverage is associated with rising risk of defaults and declining asset values. This is likely to lead to periods of deleveraging and lower economic activity. As a rational response to declining asset prices, risk neutral speculators are likely to shore up commodity inventories in search of arbitrage opportunities as a. We tested this hypothesis by looking at the relationship between pair-wise conditional covariances of the commodity pairs and indicators of uncertainty. The likelihood of recessions and financial leverage were found to be positively related to spurts of joint commodity price movement.

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  • Mthuli Ncube & Daniel Zerfu Gurara & Dawit B. Tessema, 2014. "Working Paper 205 - Volatility and Co-movement in Commodity Prices- New Evidence," Working Paper Series 2135, African Development Bank.
  • Handle: RePEc:adb:adbwps:2135

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