Broker-dealer risk appetite and commodity returns

This paper shows that the risk-bearing capacity of securities brokers and dealers is a strong determinant of risk premia and the volatility of returns in commodity markets. I measure risk-bearing capacity as the fraction of broker-dealer financial assets relative to the total financial assets of broker-dealers and households. This variable has particularly strong power to forecast energy returns, both in sample and out of sample: It forecasts approximately 30 percent of the variation in quarterly crude oil returns. These findings are rationalized in a simple asset-pricing model where the economic role of broker-dealers is to provide insurance against commodity price fluctuations. 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.