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

Jaime Casassus (), Peng Liu and Ke Tang ()

No 404, Documentos de Trabajo from Instituto de Economia. Pontificia Universidad Católica de Chile.

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.

Keywords: Relative scarcity; correlation term structure; futures returns; long-term economic relation-ships; convenience yield; feedback effect; multi-commodity maximal affine; spread option (search for similar items in EconPapers)
JEL-codes: C0 G12 G13 D51 D81 E2 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ene
Date: 2011
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