COMMODITYINDICES
WhatEffectDoIndexFlowsHave?
Having discussed the potential drivers
Figure8: NetlengthofIndexPositionsinContracts
&asa%ofTotalOpenInterestforCorn
ofcommodityinvestment,wenextturn
to the trickier question of their effect
on price levels and volatility.
Using absolute measures of financial
index inflows (in US$ billion) does have
positive predictive power for price
returnsandvolatility,thoughtheeffect
isconcentratedinthelessliquidagricul-
tural and precious metals markets, not
the relatively larger and liquid energy
markets. One might argue that these
resultsaretobeexpected.Toadjustfor
the size of the market and eliminate Sources: CFTC
this ‘liquidity’ effect, we can construct
a relative measure of inflow by consid- measure of index inflow discussed above encourage us to seek an
ering the inflow not in absolute dollar alternative econometric approach that eliminates the time-trend
terms but as a percentage size of the effect of increasing market size from the regression. Happily, we
total open interest of the market. can exploit the multiple commodity panel structure of the CIT
When we use this relative measure, datatotestforthepurelycross-sectionaleffectsofincreasedindex
the regression results change dramati- size on both returns and volatility.
cally.Formostcommodities,theimpact Intuitively, rather than considering the effects of increased inflow
coefficients are negative rather than overtimeandobservingtheireffectovertimeonreturnsandvolatil-
positive. But looking at the history of ity,weconsiderdifferencesininflowinvestmentacrosscommodities
this relative measure of index inflow, and try to statistically observe differences in return and volatility
perhapsthesenegativeresultsaretobe behaviour from one commodity to another. Because time variation
expected. For many commodities, the iscapturedindummyvariables,wecanavoidspuriouscorrelationof
relative size of index net positions is theincreasingtrendinreturnsandvolatilitywiththenegativetrends
shrinking even as their absolute size in relative inflow. However, the nature of the panel regression pre-
and prices are increasing. For example, vents any analysis of any specific commodity market.
thenetopeninterestofindexpositions
for corn rose from 260,000 to 420,000
We feel that there is room for further financial
contracts, but their percentage size
innovation in the vehicles available to investors
over the total open interest declined
from 27% to 18% (Figure 8). Indeed, TheresultsarepresentedinTable2.Wefindthata1%increasein
the CFTC and other financial analysts the relative index position over the total open interest over a week
have pointed to the stable or declining increases the weekly rate of return by 22 basis points and the annu-
relative measures as evidence against alised volatility by 54 basis points. Both effects are statistically sig-
index investors’ having any relation to nificantatthe5%level,withthereturneffectsignificantevenatthe
the recent price increases. 1% level.
Given the opposite movement of the
relative compared with the absolute Discussion&Conclusion
measure, the negative coefficients We recognise that indices present an important financial innova-
become more understandable. This tioninopeningupapreviouslyobscureassetclasstoawiderpoolof
asymmetry between the absolute and investors, helping macroeconomic risk management. However,
relativemeasuresoccursbecauseofthe investors should not be lulled into a false sense of security by the
exogenous growth of the commodity recent outstanding performance of commodities. It is important to
markets. recognise the limitations inherent in commodities given their cycli-
The potential flaws in the relative calityandhighvolatility.Furthermore,commodityindicesaresome-
48 SEPTEMBER 2008 COMMODITIES NOW
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