Carry Trades and Tail Risk: Evidence from Commodity Markets
43 Pages Posted: 19 Sep 2017 Last revised: 18 Nov 2017
Date Written: November 17, 2017
I investigate tail risk for funding-constrained speculators in commodity markets and shed new light on commodities as an asset class for investment decisions. Unlike other asset classes, carry in commodities can be extreme and highly heterogeneous across markets, especially on the long side of the trade. By using a novel panel quantile regression with non-additive fixed effect, I exploit the cross-sectional variation of carry trades across different commodity markets and document the tail-specific effect of carry on the conditional distribution of commodity futures returns. Also, I show that shocks to carry trades and volatility have persistent tail-specific effects which last from four to twelve weeks ahead. The main empirical results are consistent with existing theoretical models in which carry traders are subject to limited risk capacity and liquidity constraints. In this respect, I provide evidence that money managers, index traders, and more generally non-commercial traders tend to unwind their net-long futures positions when exposed to deteriorating aggregate financial conditions and increasing market uncertainty.
Keywords: Commodity Markets, Carry, Quantile Regressions, Tail Risk, Financial Markets
JEL Classification: G12, G17, E44, C58
Suggested Citation: Suggested Citation