Detangling Risk Premiums: Common and Idiosyncratic Components of Crude Oil, Corn, and Ethanol Futures

Abstract

Applying a no-arbitrage term structure model, we analyze how risk premiums in crude oil, corn, and ethanol futures have evolved amid their increasingly synchronized price movements. Specifically, the model estimates a common factor that summarizes the information driving the three futures prices simultaneously and one idiosyncratic factor that captures distinct information in each market. The common risk prices are more strongly linked to macroeconomic observables, whereas market-specific factors Granger cause the risk prices of both common and idiosyncratic components. We find that financialization negatively impacts the overall level of risk premiums. The risk premiums for crude oil, corn, and ethanol risk premiums all increased from the financialization period to the post-financialization period. While financialization significantly affected the level of risk premiums, its influence on their comovement across markets may have been limited. In contrast, uncertainty surrounding biofuel policy may have affected the linkage between corn and ethanol risk premiums.