Understanding the Sources of Risk Underlying the Cross Section of Commodity Returns

We show that a model featuring an average commodity factor, a carry factor, and a momentum factor is capable of describing the cross-sectional variation of commodity returns. More parsimonious oneand two-factor models that feature only the average and/or carry factors are rejected. To provide an economic interpretation, we show that innovations in equity volatility can price portfolios formed on carry with a negative risk premium, while innovations in our measure of speculative activity can price portfolios formed on momentum with a positive risk premium. Furthermore, we characterize the relation of the factors with the investment opportunity set.

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