Liquidity effects on price and return co-movements in commodity futures markets

Abstract

Commodity price comovement is an important research area in finance, and previous studies have investigated the determinants of price comovement using low-frequency (monthly or quarterly) macroeconomic data. In comparison, our paper attempts to scrutinize the liquidity effect on commodity prices and return movements based on daily data. Our findings contribute to the literature in three ways. First, we find significant positively correlated price movements across different commodity markets on a daily basis, and such comovement is driven by the cross-sectional liquidity spillover effect. Second, we observe that a cointegration relationship between individual commodity prices and the global price index can be established only if the liquidity effect is controlled. Finally, instantaneous daily liquidity shocks (i.e., innovation) exert a negative impact on daily commodity returns. However, liquidity shocks do not have a significant impact on monthly returns. Our findings are robust and have significant implications for macroeconomic policymaking, such as managing inflation risk.