Risks and risk premiums in commodity markets

This thesis investigates risks and risk premiums in several different commodity markets. In commodity markets risks are measured by volatility and risk premiums. Risk premiums are the additional returns required by an investor to hold a risky asset in contrast to a risk free asset, which has a zero risk premium. The thesis follows "the thesis by publication" format and it contains four completed research papers presented in Chapter 2-5. Chapter 2 and 3 provide an empirical analysis of the relationship between spot and futures prices in interconnected regional Australian electricity markets. We find positive and significant risk premiums for several of the considered regions. Using a seemingly unrelated regression (SUR) approach in a general equilibrium model, we find that price levels, as well as skewness and kurtosis of spot prices are determinants of the realized risk premiums in these markets. Applying a dynamic model for the risk premiums, we also find that the observed futures risk premiums tend to increase when: (i) contracts are closer to the beginning of the delivery period, (ii) spot prices are high, and (iii) the frequency of extreme price outcomes such as, e.g. price spikes increases. Chapter 4 examines the impact of explanatory variables such as load, weather and capacity constraints, on the occurrence and magnitude of price spikes in Australian electricity markets. Applying the Heckman correction model, we find that market loads, relative air temperature and reserve margins are significant variables for the occurrence of price spikes. Electricity loads and relative air temperature are also significant variables impacting on the size or magnitude of a price spike. Our results also indicate that the Heckman selection model outperforms classical OLS (Ordinary Least Squares) estimation in explaining the magnitude of the observed price spikes. Chapter 5 presents a comprehensive examination of convenience yield risk premiums in various commodity markets. In a first step, by using a combinaton of long and short commodity futures contracts, we construct delta-neutral portfolios that are only sensitive to convenience yield risk. We find that convenience yield risk premiums are positive and, that risk premiums are very large for metals and grains while there are no significant convenience yield risk premiums for oil and gas. Overall, we find that realized futures premiums in power markets, and convenience yield risk premiums in commodities markets tend to be positive and significant. The finding indicates that market participants in commodity markets are generally risk averse and dislike uncertainties in power prices and convenience yields.