Bad Volatility Is Not Always Bad: Evidence from the Commodity Markets
45 Pages Posted: 10 Jul 2019
Date Written: July 8, 2019
Using exchange-traded fund (ETF) options data, we examine return predictability of variance risk premium in four commodity markets: crude oil, natural gas, gold and silver. We also analyze return predictability of upside and downside variance risk premiums using a decomposition model conditional on the direction of the underlying market movement. We find that both the undecomposed and decomposed variance risk premiums are able to predict commodity prices. The decomposed variance risk premiums, however, outperform the undecomposed premium. The importance of upside and downside variance risk premiums differs across markets, related to hedging demand. In energy markets, both upside and downside premiums have strong predictive power, while in precious metal markets, only the upside premium is predictive.
Keywords: Commodity markets; Upside and downside variance risk premiums; Asymmetric risk; Prediction
JEL Classification: C53; G11; G14; G17
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