Understanding the Sources of Risk Underlying the Cross-Section of Commodity Returns

Abstract

We show that a model featuring an average commodity factor, a carry factor, and a momentum factor is capable of describing the cross-sectional variation of commodity returns. More parsimonious one- and two-factor models that feature only the average and/or carry factors are rejected. To provide an economic interpretation, we show that innovations in global equity volatility can price portfolios formed on carry, while innovations in a commodity-based measure of speculative activity can price portfolios formed on momentum. Finally, we characterize the relation between the factors and the investment opportunity set.

Keywords: Commodity asset pricing models, carry, momentum, innovations in equity volatility, speculative activity

JEL Classification: C23, C53, G11, G12, G13, C5, D24, D34