Correlation and Commodity Risk Premia
J. H. Fan, Ting Zhang
We document a novel correlation premium in commodity futures. A long-short correlation portfolio delivers positive average returns but is largely spanned by exposures to the aggregate market, hedging pressure, and skewness factors. The correlation premium reflects compensation to liquidity providers for absorbing hedger-driven market impact in illiquid markets, as high comovement signals market-wide flows and hedging pressure that amplify systematic risk. Factor performance is state-dependent, with momentum underperforming in high-comovement and high-volatility regimes while hedging pressure strengthens. Overall, our findings explain the absence of commodity low-volatility premia, clarify why volatility-managed factors often fail, and establish average correlation as a conditioning variable for cross-sectional and conditional commodity returns.
Read on ELI