Broker-Dealer Risk Appetite and Commodity Returns

Abstract

This paper shows that the risk-bearing capacity of security brokers and dealers is a strong determinant of risk premia and return volatility in commodity markets. I measure risk-bearing capacity as the fraction of brokerdealer …nancial assets relative to the total …nancial assets of broker-dealers and households. This variable has particularly strong forecasting power for energy returns, both in-sample and out-of-sample: it forecasts approximately 30% of the variation in quarterly crude oil returns. I rationalize the …ndings in a simple asset pricing model where the economic role of broker-dealers is to provide insurance against commodity price ‡uctuations. I estimate cross-sectional prices of risk using an arbitrage-free asset pricing approach and show that broker-dealer risk-bearing capacity forecasts commodity returns because of its association with the price of risk.