COMMODITY INCOME
Figure 6: Historical Oil Shocks Price in 2010 dollars per barrel, 1860-2010
Third, skewness is higher in oil than in S&P stocks,
both in return distributions and in the tails. Absent government price controls (which seem out of the question for the time being), or a large supply shock, the oil price rise is expected to continue, with occasional short-duration
corrections reductions in demand.
We might well conclude that oil is more volatile but not necessarily more risky than stocks and bonds
Source: James Hamilton, “Historical Oil Shocks” 2011
Figure 7: Rolling 22-Day Volatility Ratio WTI Index Relative to S&P 500 Index
10
Bonds: Nothing But Risky Theory predicts an inverse relationship between uncollateralized, plain vanilla bond prices and their yields. Bond yields primarily fluctuate as interest rates rise and fall. When a bond is issued, its yield to maturity equals the prevailing competitive rates at the time of issue for the bond’s specific maturity and credit risk, reflected in the bond rating. If market interest rates rise, the price of the bond must fall until the expected return becomes equal to the new competitive market level. The low yield conundrum makes it
1
particularly difficult for pension funds to meet their obligations. Populations inexorably age and there is the risk that discount rates will inevitably reverse from current lows. Potential increases in yields may drive some pension funds – the largest institutional owners of assets, holding over $30 trillion – to bankruptcy. It is not extreme to suggest this possibility. Consider this example: The Dow Jones
0.1 Source: Bloomberg
which neither supply, nor demand will flow smoothly. From graphs representing kernel distributions and
drawdowns one can quickly conclude that oil returns are volatile. But should we conclude that they are risky? We can
answer the question by looking at fat tails. First, the excess kurtosis5
value is lower than that of both bonds
and stocks – but kurtosis alone does not discriminate between extreme losses and extreme gains. Second, after scaling S&P returns to achieve the same standard deviation as WTI returns, we plotted the tails for the S&P and oil spot daily returns from the beginning of 2000. Since that date, the standard deviation of daily oil returns has been about twice the standard deviation of S&P daily returns. The tail plots show that (after scaling) oil and the S&P have quite similar tail behaviour. In other words, oil does not have fatter tails than the S&P index. This finding is interesting where a leveraged or a partial exposure to oil price is desired.
60 March 2013
Corporate Bond Index lost 23.3% during and after LIBOR rose from 1% to 5% between May 2004 and July 2006. While LIBOR’s rise stopped and then reversed through 2008 as
banks’ LIBOR manipulation took hold, corporate bond drawdowns continued. This was a sign that “bond vigilantes” were not fooled by conventional interest rates. Such drawdowns may happen again. And soon.
It is quite clear that bond markets ... cause the most concern and present the biggest danger to investors
Also, consider a calculation of what the LIBOR could have been without bank manipulation, inferred from the movements in corporate bonds’ prices (the discontinuous green line in the LIBOR Figure). The finding that LIBOR becomes negative in 2013, as predicted by the Dow Jones Corporate Bond Index, may hint that the latter is overvalued – although we admit to the circularity of the argument. High Yield Bonds (HYB’s or ‘junk’) have triple-risk dimensions: duration (risk of yield increase), equity
caused by temporary
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
Volatility Ratio, Logarithmic Scale
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