Impact of geopolitical risk on the volatility of natural resource commodity futures prices in China

Abstract

Volatile natural resource prices greatly affect economic growth, economic volatility, and financial market. Analyzing the factors affecting price volatility is of great significance for policymakers to formulate regulations, for financial institutions to control financial risks and for investors to improve their investment returns. We study the impact of geopolitical risk on the price volatility of coal, copper, crude oil, gold, and iron ore in the Chinese futures market. The paper uses the Geopolitical Risk (GPR) index, the Geopolitical Threat (GPT) sub-index and the Geopolitical Action (GPA) sub-index developed by Caldara and Iacoviello to measure geopolitical risk in broader sense. We utilize the closing prices of the most recently expired futures contracts from their starting trading date to 1 August 2022 to determine volatility represented by conditional variance. The GARCH and CGARCH models are built with the help of the Kalman filtering method and a TVP-VAR-SV model. The results of GARCH model show that geopolitical risk significantly increases the price volatility of coal, iron ore, and crude oil futures; significantly decreases the price volatility of gold; and has no significant effect on the price volatility of copper futures. By CGARCH model, we illustrate that geopolitical risk significantly increases the overall volatility, persistent volatility, and temporary volatility of crude oil; significantly increases the overall volatility and temporary volatility of coal and iron ore futures; significantly decreases the overall volatility and persistent volatility of gold futures; and has no significant impact on all three types of volatility of copper futures prices. The results of the Kalman filter analysis uncover that the response of each commodity volatility to changes in geopolitical risk increases when geopolitical risk is high. Additionally, geopolitical risk has the most effect on the price volatility of copper and crude oil with high external dependence. Estimates from the TVP-VAR-SV model reveal that the short-term impact of geopolitical risk shocks on the volatility of each the futures prices of each commodity is large and of long duration, and the response of commodity futures volatility to the same level of geopolitical risk shocks is higher and longer when major geopolitical events occur such as Paris Terrorist Attack, USA/Iran Tension Escalation, Syria Missile Attack, and Russian-Ukraine War. Moreover, geopolitical shocks have the most effect on the energy commodities of crude oil and coal.