Carry Trades and Tail Risk : Evidence from Commodity Markets

I investigate the relationship between carry trades and tail risk for a panel of commodity futures contracts. Unlike other asset classes, carry in commodities is highly volatile both in the time series and in the cross section. By using a panel quantile regression with commodity fixed effect, I document the tail-specific effect of carry on the conditional distribution of futures returns both in the short-term and in longer-term. The main empirical results show that carry has a significant effect on tail risk mostly in the short term and for the front end of the futures curve. In addition, the empirical evidence shows that such relationship can be explained by the role of non-natural hedgers, such as non-commercial traders, money managers and index traders, which tend to unwind their net-long futures positions when exposed to deteriorating aggregate financial conditions and increasing market uncertainty. This is consistent with existing theoretical models in which speculators and insurance providers are subject to limited risk capacity and financing liquidity constraints