Financial Connectedness of Energy and Commodity Markets and Systemic Risk

Abstract

The aim of this study is to investigate the existence of financial connectedness (FC) between energy& commodity markets (EMs&CMs) together with systemic risks. The time-domain spillover approach and the frequency-domain spillover approach are used to investigate the financial interconnectedness across submarkets, i.e., CMs versus AMs. Data was taken from the Rogers International Commodity Index (RICI) and its energy sub-index (RICI-E) and commodity sub-index (RICI-M) respectively. Based on the best of our knowledge; it is important to stress that the reviewed empirical works do not analyze the volatility connectedness (spillovers) between the two markets. Hence, an analysis of the connectedness between those markets is the missing part in the literature. In this paper, the related contribution is made to the literature by implementing such an analysis. There is an asymmetric connectedness between energy&commodity markets. Hence, the relationship between the financialized EMs and CMs cannot be estimated by standard approaches. The connectedness between these two markets is an important source of impact, leading to the explosion of SR. It is a fact that financial stress leads to the SR, which can increase rapidly to significant size due to high spillover effects between financially connected submarkets. The determination of FC is essential for market players who invest in portfolio of assets to decide portfolio allocation, risk management, hedging and pricing strategies. Estimating the FC map of sub-markets provides valuable information for financial stability and energy price stability in the long run. Particularly, the submarket specific stress and its influence on other submarkets as well as FC in time can provide information for containing overall SR in the markets. This approach is essential to limit partial financial stress in the submarkets before it evolves into a SR and posing a severe threat to financial stability in the economy. In this study, it is revealed that there is a FC between the EMs&CMs depending on the analysis of these relations.KeywordsFinancial connectednessSystemic riskEnergy marketsCommodity markets