Volatility in Commodity Markets Part 2: Cross-Market Evidence
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
The Numbers Are In
In Part 1, we covered the framework and motivation behind Chau and Deesomsak’s study of volatility transmission across commodity futures markets. Now we get to the results. And they tell a clear story about where risk comes from and where it goes.
The Full-Sample Picture
The total volatility spillover index for the full sample period (April 1990 to December 2016) is 24.8 percent. That means, on average, cross-market volatility spillovers explain about a quarter of the total variation in these nine commodity futures markets. The remaining 75.2 percent comes from each market’s own internal shocks.
So right away, the first takeaway: most commodity market volatility is idiosyncratic. Each market mostly does its own thing. The interconnection exists, but it is not overwhelming on average.
But averages can be misleading. The real story is in the directional flows and how they change over time.
Who Sends and Who Receives
The directional spillover results reveal a clear hierarchy. The biggest transmitters of volatility to other commodity markets are:
- Brent crude oil: transmits 45.7 percent to others
- WTI crude oil: transmits 43.3 percent to others
- Silver: transmits 35.8 percent to others
- Gold: transmits 33.4 percent to others
The biggest receivers of volatility from other markets are also energy and metals:
- WTI: receives 45.4 percent from others
- Brent oil: receives 45.0 percent from others
- Silver: receives 31.3 percent from others
- Gold: receives 30.0 percent from others
So crude oil and precious metals are both the main senders and the main receivers of volatility. They are the most interconnected nodes in the commodity network.
Agricultural commodities are a different story. Corn and soybeans receive volatility spillovers from others (about 23.6 percent each), but they do not send much. They are net receivers. Coffee barely participates at all. It transmits almost nothing and receives almost nothing.
The Isolation of Natural Gas and Coffee
Two markets stand out for being remarkably isolated from the rest of the commodity universe.
Natural gas is the most exogenous market in the sample. A full 97.8 percent of natural gas market variation comes from its own shocks. It barely sends any volatility to other markets and barely receives any. Despite being an energy commodity, natural gas operates in its own world. This makes sense when you think about it. Natural gas supply and demand are heavily driven by weather and domestic heating demand, which are different from the global factors driving crude oil.
Coffee is similarly isolated. It transmits only 1.8 percent of volatility to others and receives only 5.4 percent from others. Coffee prices are driven by weather in producing regions (Brazil, Colombia, Vietnam), currency movements, and crop-specific diseases. These factors have little to do with what is happening in crude oil or gold markets.
For portfolio construction, this is actually useful information. If you want commodity diversification that holds up during stress, natural gas and coffee offer genuinely independent return streams.
The Net Directional Picture
Looking at net spillovers (what a market transmits minus what it receives), the picture simplifies:
Net transmitters (they push volatility outward):
- Silver: +4.5 percent
- Gold: +3.4 percent
- Natural gas: +2.3 percent (though from a very low base)
- Brent oil: +0.7 percent
Net receivers (they absorb volatility from elsewhere):
- Soybeans: -3.8 percent
- Coffee: -3.6 percent
- WTI: -2.1 percent
- Corn: -1.0 percent
- Copper: -0.4 percent
The surprise here is that precious metals are the biggest net transmitters of volatility, not energy. While crude oil transmits and receives the most volatility in absolute terms, it is roughly in balance. Gold and silver push out more than they take in.
This fits with how investors use precious metals. Gold and silver are treated as “safe haven” assets and signals of economic uncertainty. When gold prices spike unexpectedly, markets interpret it as a warning of trouble ahead, which creates volatility in other commodities.
How It Changes Over Time
The static full-sample results tell one story. The time-varying analysis tells a richer one.
Using a 200-week rolling window, the conditional total spillover index fluctuates considerably. In normal times, it hovers between 30 and 40 percent. But during the financial crisis and the Eurozone debt crisis, it jumps sharply and exceeds 50 percent during 2010 and 2011.
That is a big deal. The average spillover of 24.8 percent understates what happens during crises. When things go wrong, commodity markets become much more interconnected. The cross-market volatility spillover roughly doubles from normal levels to crisis levels.
The spillover index also tends to rise rapidly at the beginning of recessions. This means the increase in interconnectedness is a leading indicator, not a lagging one. Volatility spillovers pick up before the worst of a crisis hits.
Directional Shifts Through Time
The time-varying directional spillovers reveal some interesting shifts:
Crude oil became a major net transmitter of volatility to other commodity markets after the 2000s, with particularly high net spillovers around the European debt crisis and the intensification of the financial crisis. Before the 2000s, crude oil’s spillover effects were much smaller.
Gold had its biggest moment as a net transmitter during the burst of the dot-com bubble. At that point, gold was pushing almost 40 percent of its volatility to other markets. But after 2003, gold’s role reversed. By 2006, gold was receiving almost 20 percent of its volatility from other markets instead of sending it.
Agricultural markets were consistent net receivers of volatility spillovers throughout most of the sample period. Corn, coffee, and soybeans absorbed shocks from energy and metals markets but did not send much back.
What This Means for Regulators
Chau and Deesomsak make an important point about regulation. When commodity prices get volatile, the instinct of regulators is to crack down on specific markets. In August 2011, the Chicago Mercantile Exchange raised gold futures margins by 22 percent. The Shanghai Gold Exchange raised margins to 11 percent in the same month.
The authors argue that scapegoating one particular market may not be the right approach. The evidence shows that volatility transmission is a system-wide phenomenon. Crude oil and gold are important nodes in the network, but focusing regulatory attention on just one market might distract from the broader interconnectedness that amplifies shocks.
Their recommendation is to use the directional spillover framework as an early warning system rather than as a targeting mechanism. If net spillovers from a particular market are rising rapidly, that is a signal worth watching. But the policy response should consider the whole system, not just one piece of it.
Robustness of the Results
The authors test their results against different model specifications: changing the forecast horizon from 10 weeks to 5 weeks, using a fourth-order VAR instead of second-order, and shrinking the rolling window from 200 weeks to 100 weeks. The patterns hold up across all variations. The total spillover plot follows similar patterns regardless of these choices, which gives confidence that the findings are not artifacts of particular modeling decisions.
My Takeaway
Three things stand out from this chapter.
First, commodity market volatility is mostly idiosyncratic in calm times. Each market has its own dynamics. But during crises, cross-market spillovers roughly double, and the benefits of diversification within commodities shrink.
Second, crude oil and precious metals are the central hubs of the commodity volatility network. If you want to understand where risk is coming from in commodity markets, watch these four assets: Brent oil, WTI, gold, and silver.
Third, natural gas and coffee are genuinely independent. They do not participate much in the cross-market volatility game. For investors seeking true diversification within commodities, these markets offer something different.
The practical implication is straightforward. During normal times, a diversified commodity portfolio provides real diversification benefits. During crises, those benefits diminish as commodity markets become more interconnected. This is not unique to commodities. The same pattern shows up in equity markets and credit markets. But knowing the specific channels through which volatility spreads in commodities gives you a better shot at managing the risk.
Previous: Volatility in Commodity Markets Part 1: How Shocks Spread