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Relative Scarcity of Commodities with a Long-Term Economic Relationship and the Correlation of Futures Returns

Author

Listed:
  • Jaime Casassus
  • Peng Liu
  • Ke Tang

Abstract

This paper finds that the long-term co-movement of commodity prices is driven by economic relationships, such as production, substitution, and complementary relationships. Such relationships imply that the convenience yield of a given commodity depends on its relative scarcity with respect to associated commodities. The economic linkage between two commodities creates a new source of positive correlation between the futures returns of both commodities. We build an empirical, multi-commodity maximal affine model that allows the convenience yield of a commodity to depend on its relative scarcity. We estimate the model using three commodity pairs: heating oil-crude oil, WTI-Brent crude oil and heating oil-gasoline. Our model allows for a flexible correlation term structure of futures returns that matches the upward-sloping patterns observed in the data. The high long-term correlation implied by an economic relationship reduces the volatility of the spread between commodities, which implies lower spread option prices. An out-of-sample test using short-maturity crack spread options data shows that our model considerably reduces the negative bias generated by traditional models.

Suggested Citation

  • Jaime Casassus & Peng Liu & Ke Tang, 2011. "Relative Scarcity of Commodities with a Long-Term Economic Relationship and the Correlation of Futures Returns," Documentos de Trabajo 404, Instituto de Economia. Pontificia Universidad Católica de Chile..
  • Handle: RePEc:ioe:doctra:404
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    File URL: http://www.economia.uc.cl/docs/dt_404.pdf
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    References listed on IDEAS

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    Cited by:

    1. Liu, Peng & Lu, Xiaomeng & Tang, Ke, 2012. "The determinants of homebuilder stock price exposure to lumber: Production cost versus housing demand," Journal of Housing Economics, Elsevier, vol. 21(3), pages 211-222.

    More about this item

    Keywords

    Relative scarcity; correlation term structure; futures returns; long-term economic relation-ships; convenience yield; feedback effect; multi-commodity maximal affine; spread option;

    JEL classification:

    • C0 - Mathematical and Quantitative Methods - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment

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