Time-Varying Risk Premiums and Term Premiums in Commodity Futures

Abstract

T he term structure of futures prices has a strong impact on the returns earned by investors in those markets. For example, the literature shows that buying futures in backwardation and selling futures in contango is, on average, a profitable strategy. In other words, the risk premium of commodity futures is timevarying and can be forecasted by the slope of the term structure (basis or roll yield). 1In upward-sloping term structures (contango), contract prices have a tendency to fall as time passes and contracts approach expiration. In downward-sloping term structures (backwardation), the exact opposite argument is true: contract prices have a tendency to go up as contracts approach expiration.This article shows that the term structure of futures prices contains significantly more information than just its slope. As in the fixed-income literature, individual segments of the term structure can be used to extract the extra information. For instance, when the first segment of the term structure has a steeper slope than the second segment, this suggests that the price of the first contract has a stronger tendency to fall than the price of the second contract. A simple strategy to benefit from this configuration would be to hold a long position in the second contract and a short position in the first one. The expected return differential between the long-dated contract and the short-dated one is defined as the term premium-one of the main variables of interest in this article.From a practical point of view, we use commodity futures to study whether risk premiums and term premiums are predictable in the time series or in the cross section. Based on these results, we then proceed by constructing trading strategies that explore the predictability in risk and term premiums of different commodities, taking long positions in those with high expected values and short positions in those with low expected values. The Sharpe ratios of the trading strategies based on term premiums are significantly higher than the Sharpe ratios of the risk premium strategies usually studied in the literature (Erb and Harvey [2006], Gorton and Rouwenhorst [2006]). Moreover, these two types of trading strategies are uncorrelated; portfolios combining them enjoy significant diversification benefits and earn even higher Sharpe ratios.From a theoretical point of view, our predictability tests are motivated by a solid foundation developed in the fixed-income literature and extended here to investigate the term structure of futures contracts. This approach has two important benefits. First, it guides the selection of variables and significantly reduces the criticisms that our predictability tests and trading strategies are the result of data mining. Second, as we show later, even a lack of predictability in risk and term premiums would be interesting theoretically, because it indicates strong predictability in other important variables, such as changes in spot prices and changes in the basis. Fama and French [1987] divided the theories of commodity fu...