Broker-dealer risk appetite and commodity returns

Abstract: This paper shows that the risk-bearing capacity of U.S. securities brokers and dealers is a strong determinant of risk premia in commodity derivatives markets. Commodity derivatives are the principal instrument used by producers and purchasers of commodities to hedge against commodity price risk. Broker-dealers play an important role in this hedging process because commodity derivatives are traded primarily over the counter. I capture the limits of arbitrage in this market in a simple asset pricing model where producers and purchasers of commodities share risk with broker-dealers who are subject to funding constraints. In equilibrium, the price of aggregate commodity risk decreases in the relative leverage of the broker-dealer sector. Empirical evidence from fourteen commodity markets lends substantial support to the model?s predictions. Fluctuations in risk-bearing capacity have particularly strong forecasting power for energy returns, both in sample and out of sample.

Keywords: asset pricing; financial intermediaries; commodity prices; futures markets; risk appetite;

JEL Classification: G10; G12; G13; G24;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2010-09-01

Number: 406

Note: For a published version of this report, see Erkko Etula, "Broker-Dealer Risk Appetite and Commodity Returns," Journal of Financial Econometrics 11, no. 3 (June 2013): 486-521.