RETURN, VOLATILITY AND LIQUIDITY SPILLOVERS:

THE CASE OF EQUITY AND COMMODITY MARKETS

Master Thesis
June 2007

Dalia Lasaite1
MSc in Finance

Supervised by:
Prof. Michael Rockinger

University of Lausanne

1
I am very grateful to my supervisor, Prof. Michael Rockinger, for his valuable support and patience. I would also
like to thank Maria Khodorkovskaya, Mustafa Karaman, Ji Hyung Noh, Elzbieta Lukenskaite, and other fellow
students for their valuable help, mind-blowing discussions, and entertainment. My sincerest gratitude goes to my
family and Tomasz Sinicki, who supported me throughout the way. All the remaining errors are mine.
 ABSTRACT

We investigate the interactions between equities and six commodity assets using vector
autoregression (VAR) and identification through heteroskedasticity (IH) techniques and find
evidence of spillovers within commodity markets, but also between equity, oil and precious
metals. Each commodity asset is mostly negatively auto-correlated in returns and positively in
volatility and liquidity, and the spillovers within commodity markets usually occur through the
latter channels. Spillovers between equities in commodities, however, are slightly different,
resulting in positive relationship in returns and liquidity between equities, precious metals and
oil. From equity investor point of view, precious metals and oil therefore are not the best
choice for diversification purposes, as they experience both return falls and liquidity squeezes
at the same time as the equity market does. Comparison of 1998-2001 and 2004-2007 periods
suggests increasing integration between metals, oil and equities, but the evidence is rather
weak. Inclusion of liquidity parameter versus return and volatility estimation does not alter the
picture dramatically, only slightly strengthening persistence in volatility. We were unable to
detect contemporaneous effects with the daily data either because of parameter instability, lack
of such interactions, or noise. The study has important implications for portfolio management
and diversification.
TABLE OF CONTENTS

1 INTRODUCTION................................................................................................................. 4
2 LITERATURE REVIEW .................................................................................................... 6
2.1 Market liquidity ........................................................................................................... 7
2.2 Liquidity spillovers ...................................................................................................... 9
2.3 Commodities as a portfolio investment ..................................................................... 10
3 METHODOLOGY ............................................................................................................. 11
3.1 Liquidity proxies........................................................................................................ 11
3.2 Vector Autoregression Model.................................................................................... 13
3.3 Identification through heteroskedasticity................................................................... 13
3.4 Implementation .......................................................................................................... 17
3.5 A note on methodology.............................................................................................. 17
3.6 Data ............................................................................................................................ 18
4 RESULTS ............................................................................................................................ 19
4.1 VAR: Single asset results........................................................................................... 19
4.1.1 Gold.................................................................................................................... 19
4.1.2 Silver .................................................................................................................. 19
4.1.3 Copper................................................................................................................ 19
4.1.4 Aluminium ......................................................................................................... 20
4.1.5 Zinc .................................................................................................................... 20
4.1.6 Oil ...................................................................................................................... 20
4.1.7 Equities .............................................................................................................. 20
4.2 VAR: Multiple asset results ....................................................................................... 21
4.2.1 Commodities ...................................................................................................... 21
4.2.2 Commodities and equities.................................................................................. 22
4.2.3 Time dependence ............................................................................................... 23
4.3 Identification through heteroskedasiticity: Commodity reaction to stock market..... 24
5 CONCLUDING REMARKS ............................................................................................. 26
6 REFERENCES.................................................................................................................... 28
1 INTRODUCTION

Diversification is at the heart of many portfolio management strategies. Investors, seeking for
diversification opportunities, have explored markets across the globe, and once highly
specialized investments, such as asset-backed securities or emerging market equities, have long
entered mainstream. There is some evidence, however, that as investors start chasing
diversification opportunities, correlations tend to increase and diversification gains diminish.
Indeed, recent decades have seen an increase in correlations among geographically distinct
equity markets (see Quinn & Voth (2006)). While globalization provides clear economic
reasons for this trend, alternative views suggest that the increase in correlations was caused by
either increasing inadequacy of benchmarks used (see Diermeier and Solnik, 2001) or by
endogenous reasons as portfolio holdings become more similar, resulting in liquidity-based
correlation (Acharya and Schaefer (2006)).The latter view is somewhat supported by evidence
of increasing correlations during periods of market stress, when fundamentally different assets
tend to move in-sync and liquidity dries up throughout diverse markets (see for instance
Longin and Solnik (2001)). Recent examples of such behaviour include the infamous Long
Term Capital Management collapse and, on a smaller scale, recent market corrections in May
2006 and February 2007.

Obviously, these trends are important when forming portfolio strategies. High correlation in
market crises hinders investor possibilities of realizing diversification gains if they are forced
to sell prematurely. It is particularly pronounced when investors are leveraged and face margin
calls or experience fund withdrawals if their performance falls below a threshold (see Vishny
and Shleifer (1997), Vayanos (2004)), thereby facing forced sales and propagating the crisis
further. Absolute majority of investors, however, are leveraged and/or performance-concerned,
which gives rise to self-enforcing mechanism of crises. This interrelation between correlation
risk and liquidity risk is well discussed in Acharya and Schaefer (2006). They suggest that
correlation shock depresses the collateral values of financial intermediaries’ assets, thereby
forcing them to sell their holdings across a variety of markets, which increases the correlation
further. Allen and Gale (1994) coined the term “cash-in-the-market” pricing to refer to such
situations. Therefore, if much of diversification benefits can be wiped out because of lack of
liquidity during volatile times, it is important to take these effects into account when estimating
the portfolio risk.
This paper sets out to explore this phenomenon by examining a special case: the co-behaviour
of equity and commodity markets. During recent years, commodities have come into fashion
and experienced substantial inflows from the financial sector. Increasing availability of
commodity index trackers gave more ways of investment that are available not only to highly
specialized investors but also to an average Joe. Major selling point of commodity investment
has been their low correlation to other asset classes, especially equities (outstanding
commodity returns after the technology boom also helped). Commodities generally represent
real assets with fixed supply, thereby conserving purchasing power. This perception has been
particularly evident in the case of gold, which traditionally has been a hedge against inflation
that harms both stocks and bonds, whereas oil is used to hedge against political instabilities in
oil producing regions. Since 1998, the value of OTC commodity derivatives grew 14-fold up to
$6.4 trillion (BIS Survey (2007)).

Fundamental factors of equity and commodity markets are not very related and are unlikely to
become more interrelated over time (contrary to the relation between developed and emerging
equity markets). This sets a good historical case for examining what is the interplay between
the two markets and how has it evolved over time. If the mechanism suggested by Acharya and
Schaefer (2006) is in place, one should also find that as more investors hold commodity assets,
the shocks are propagated much easier across the two markets and correlations should increase.
Consequently, the research questions of the paper are the following:
1. Are shocks to commodity markets transmitted to equities and vice versa? Has this
transmission been stable over time?
2. Can the liquidity effect explain some of the transmission in return and volatility
shocks?

We use vector autoregression (VAR) technique for estimation and test for stability of
parameters using identification through heteroskedasticity (IH) methodology by Rigobon
(2002), which circumvents simultaneity and omitted variable biases and takes advantage of
heteroscedasticity in the data. This procedure is superior to other contagion/shock propagation
estimation techniques, which use much more stringent assumptions regarding innovation
processes. To our knowledge, there has not been a study focusing on liquidity transmission
between commodities and equities.
Our results show that while volatility almost does not spill over between equities and
commodities, there is some evidence on return and liquidity spillovers between the two
markets, yet the extent is rather limited. Industrial metals experience more cross-movement in
volatility and liquidity, whereas lagged returns only influence the returns of the asset itself and
have a negative influence (i.e. there is return reversal behaviour in the data). The results are
rather distinct for precious metals, especially gold. Gold returns are positively influenced by
lagged equity returns, implying that a fall in equity prices also suggests a fall in gold prices and
vice versa. Liquidity spillovers are also persistent for gold and oil; therefore if the market dries
up in equities, it also tends to dry up in gold and oil markets. This suggests that the effective
diversification for equity portfolios is somewhat limited in gold and oil markets, and investors
should rather choose investments in aluminium or zinc, that do not exhibit such patterns.

Heteroskedasticity analysis shows no clear pattern, and, in all cases, strongly rejects the
hypothesis that parameters are stable. This may occur due to non-linearities in parameters or
violations of other assumptions. It may be the case that other shocks are not homoskedastic, as
required by the model, which may skew the results. Alternatively, it may well be the case that
the interaction between the markets is much more pronounced during crises, therefore the
parameters shift as the variance increases. This partially supports the ideas outlined in Acharya
and Schaefer (2006), who claim that the markets operate under different – liquidity and
illiquidity – regimes. Further research is clearly needed in this area and higher quality data on
liquidity indicators, such as bid ask spreads, volume, and order imbalances would be helpful.

The paper is organized in the following way. Section 2 describes theoretical literature and the
empirical studies in the field. Section 3 presents the methodological approach and the data
used. Section 4 presents the estimation results and analysis. Section 5 concludes.

2 LITERATURE REVIEW

This paper builds on numerous studies, related to several strands of academic research. Given
the nature of the study, we combine theoretical and empirical studies on liquidity, which have
been quite vast, and empirical studies on interrelation between commodities and equities,
which are emerging rapidly. The following sections will review each field in detail. Literature,
related to the methodological approach, is reviewed in the methodology section.
2.1 Market liquidity

Even though a substantial body of academic literature has accumulated on issues related to
liquidity, many issues still remain unresolved. There still is no unanimous definition of
liquidity and liquidity risk, and most studies adopt a somewhat loose concept of “the ease of
trading”, which we also use here. Research is also encumbered by the fact that liquidity is not
an observable variable, and proxies have to be estimated, while the data availability is rather
limited, especially for the less developed markets.

One approach of researching issues related to liquidity is to compare pairs of liquid and illiquid
assets with very similar remaining characteristics and see the difference in returns. A classic
example of the liquidity premium is the price behaviour of on-the-run Treasury securities (i.e.
issued in the most recent auction) and off-the-run Treasury securities (i.e. issued in the
previous auctions), which share very similar maturities and risk characteristics, yet trade at
different yields. The yield difference for two-year Treasury bills may rise up to 12 basis points
in volatile periods, such as autumn 1998 (see Furfine & Remonola (2002)). Silber (1991)
examines the discount of shares with trading restrictions as compared to freely traded shares
and finds that the illiquidity discount is on average 30%. Chan, Jain and Xia (2005) examine
closed-end single country funds and find that the fund premium is positively affected by the
target country market illiquidity. Chen and Xiong (2001) find that illiquidity discount for
Chinese restricted institutional shares, for which trading activity is highly regulated, is on
average 80%. Gagnon and Karolyi (2004) find that the price differences between ADRs and
their foreign listed primary securities can be explained by illiquidity in the U.S. and foreign
markets. Clearly, these results suggest that investors appreciate more liquid investments versus
the illiquid ones. Scholes (2000) has also suggested that liquid assets have embedded
optionality to raise cash in times of market turbulence, which illiquid assets do not have, and
therefore deserve a premium.

It is not trivial, however, what is the mechanism of incorporating liquidity to returns, and
several theoretical studies deal with this issue. Kyle (1985) has been one of the pioneers in the
literature, in his seminal work he uses a sequential auction model to show how liquidity
emerges in a dynamic setting with information asymmetry. In his model, liquidity is a result of
inventory risk as the market makers are dealing with asymmetric information.
Acharya and Pedersen (2001), also construct a general equilibrium model, where the relation
between illiquidity at individual security and market level as well as security and market
returns is investigated. They find that (1) covariance between the security illiquidity and
market illiquidity has positive effect on asset returns, (2) covariance between individual stock
returns and market illiquidity has negative effect on returns, (3) covariance between individual
security’s illiquidity and market return has negative effect on returns. In other words, investors
appreciate assets that are liquid when the market is illiquid, assets that have high returns when
market liquidity is low, and assets that have high liquidity when the market is down. Applying
their model to Center for Research in Security Prices data for the period 1964 – 2000, they find
empirical support for their results. Overall, annualized liquidity risk premium of holding
portfolio of illiquid securities against portfolio of most liquid stocks amounts to 1.1%, which is
statistically significant.

Another important contribution by Vayanos (2004) uses a general equilibrium model to show
that during volatile times, liquidity premium increases, investors become more risk averse,
assets’ pair-wise correlations may increase and illiquid assets’ market betas increase. The
defining characteristic of their model is that investors are fund managers and their clients are
withdrawing their funds if the performance falls below a threshold. This assumption is in-line
with the influential paper by Vishny and Schleifer (1997), who argue that certain asset price
misalignments cannot be arbitraged away, as the arbitrageurs, managing client portfolios and
involved in long-term arbitrage trades, face fund outflows when the misalignments deepen.
Kyle (2001) reaches similar conclusions by modelling the wealth effect of the arbitrageurs – as
the wealth of the arbitrageurs falls, they become reluctant to pursue the risky arbitrage strategy
further.

Allen and Gale (2004) developed a model, where in an incomplete-market setting, financial
intermediaries are forced to sell assets in order to obtain liquidity. As supply and demand for
liquidity may be inelastic in the short term, a small degree of aggregate uncertainty may cause
major fluctuations in the short run. This demand for liquidity is not met by the arbitrageurs,
since holding liquid assets entails significant opportunity costs, which can only be recovered
during crises. They conclude that financial crises in incomplete markets may occur purely
because of small liquidity shocks.
Acharya and Schaefer (2006) present a conceptual link between liquidity risk and correlation
risk, backed by a survey of risk managers. Their start with the observation that both liquidity
and correlation shocks are frequently preceded by a large negative asset price shock. This
shock reduces the net worth of financial intermediaries, thereby pushing them towards their
capital and collateral constraints. The intermediaries then sell their assets to meet these
constraints, which depresses asset prices and liquidity further. In this way, correlation between
seemingly unrelated assets increases and the asset prices do not reflect fundamentals anymore.

Finally, a study by Morris and Shin (2003) uses a three period model with a risky asset and two
types of traders (long horizon risk-averse traders and institutional traders) to examine the
phenomenon of sharp temporary fall in asset prices, known as liquidity black holes. They find
that as institutions impose stop-loss limits to traders, their trading horizons become shorter. If
the price falls towards the trading limits, which are commonly known, the incentives to sell
increase for all traders because of the expectation that others would sell as well. In essence, this
model is similar to the models of bank run, when withdrawals (sales) become mutually
reinforcing. Thereby, liquidity black holes come into existence.

These studies have far reaching implications for portfolio and risk management. As correlation
rises and liquidity dries up upon large negative shocks, diversification benefits decrease
substantially when they are most needed, and shocks during crises are transmitted across
otherwise uncorrelated asset classes. Also, even if asset prices do not fall during a crisis, lack
of liquidity across different markets may make them do so, thereby making it extremely
difficult to realise diversification benefits. We now turn to examine the literature on liquidity
spillovers across different assets and markets.

2.2 Liquidity spillovers

Academic work on liquidity spillovers is rather limited. Chordia, Sarkar & Subrahmanyam
(2006) examine liquidity spillovers across market-capitalisation based stock portfolios. They
use vector autoregression model and find that return and volatility spillovers persist even if
liquidity spillovers are accounted for. They also find that liquidity and volatility innovations in
small-cap portfolios are informative when predicting large-cap liquidity and vice versa.
Goyenko (2005) examines the joint dynamics of stock and bond market liquidity. Again, using
vector autoregression model, he finds that stock and bond market liquidity goes in both
directions, and is more dependent on returns than volatility. Liquidity and return innovations
are negatively correlated, and monetary policy has significant impact on bond market liquidity.
Tang and Yan (2006) analyze liquidity spillovers to credit default swap (CDS) markets. They
find significant liquidity spillovers from bond, stock, and option markets. Chordia, Roll and
Subrahmanyam (1999) find that there exists commonality in liquidity, i.e. that there exist
market-wide factors that affect the liquidity of all assets in the market. Newman and Rieson
(2004) find that in the European telecom sector illiquidity of newly issued bonds spills over to
other bonds in the sector. Overall, however, literature on interaction of liquidity among
different asset classes is quite scarce. We have not encountered a study which would focus on
liquidity spillovers between commodity and equities markets. The section below provides an
overview of literature on commodity markets and their role in portfolio diversification.

2.3 Commodities as a portfolio investment

Increasing importance of commodities has attracted more academic research into commodity-
related fields. There has been a wide debate on whether commodities are an asset class or not,
and some studies attempted to look at their historical returns. Erb and Harvey (2006) present
evidence that some features of commodities, such as term structure, may provide equity-like
returns over long term. Jensen et al (2002) suggests that if commodities are a hedge for
inflation, they should be correlated with monetary policy. They find that commodities provide
beneficial diversification opportunities during times of restrictive monetary policy, but not
during times of expansive monetary policy. Other studies mostly focus on commodity term
structure (see Lautier (2005)) or commodities in isolation, which are less relevant for our
study.

This study, in its spirit, is the most similar to Woelfle (2006). Woelfle measures the volatility
mechanism of information transmission between commodity and equity markets using
GARCH. They find no evidence of spillovers between equity and commodity markets, except
for energy sector, which is largely driven by the end-consumer side. Gold also stands out as a
hedge for energy crises; therefore its interdependence does not coincide with other metals, such
as silver or copper. Woelfe (2006), however, does not include liquidity factors in his analysis,
and therefore we would like to fill this gap in the literature.
Given the literature above, we combine insights both from liquidity and commodity research to
date. Commodity investments provide extremely interesting case study for the liquidity
literature. Investments in commodities have been emerging rapidly during recent years, while
research of correlation behaviour is mostly based on historical returns. If the link between
correlation and liquidity exists, as suggested by Acharya and Schaefer (2006), then spillovers
should increase as more investors enter the market. In addition, gold and oil should be more
interrelated to equity markets, due to their relative popularity as compared to industrial metals.

3 METHODOLOGY

3.1 Liquidity proxies

One harbinger in liquidity-related research is that liquidity is not an observable variable.

Numerous proxies have been suggested in the literature, many of them, however, are quite
data-intensive.

Quoted bid-ask spread. Bid-ask spread is the most readily available proxy for liquidity. It has
several flaws however, as some trades occur inside the quotes, which is not reflected in the
spread, thereby potentially underestimating illiquidity during crises. In their analysis, Chordia,
Sarkar and Subrahmanyam (2006) use quoted spread, defined as the difference between bid
and ask prices, and relative quoted spread, which is defined as quoted spread divided by the
midpoint of bid/ask prices, thereby eliminating the price level effects in the data. They also use
order imbalance indicator, which, unfortunately is not always available.

Effective spread proxies. Effective spread proxies aim to estimate the average cost of a round-
trip (buy and sell) transaction. Since bid-ask spreads do not always indicate the effective
transaction cost, academic literature has generally attempted to estimate the effective spread
from available data.

One measure of effective spread, developed in Roll (1984), is extremely simple, but relies on
several assumptions. The market is assumed to be informationally efficient and the observed
price changes have a stationary probability distribution. In addition, all customers trade
through a market marker, who maintains a constant spread. Finally, successive transactions are
sales or purchases with equal probability. Roll’s measure is estimated in the following way:

RM  2  Cov(pt , p t 1 )

Roll’s measure carries several limitations, for instance, it may underestimate illiquidity during
periods of market stress. In addition, the measure is undefined if the prices are serially
correlated. It is, however, widely used in the literature, and was shown to correlate well with
other high-frequency data liquidity measures (see Goyenko, Holden, Trzcinka and Lundblad
(2006)). Yet, as suggested by Bryant and Haigh (2007), it does not entirely fit commodity data
due to violations of the last assumption.

Another measure of effective spread was developed by Thompson and Waller (1988). It is
based on non-zero price change days and estimates the nominal spread. It is estimated in the
following way:
1 T
TWM   pt
T t 1
The estimate, however, does not filter out the real price changes. Both estimates discussed
above are more appropriate when tick-by-tick data is available.

Price impact measures. Price impact measures aim to estimate the impact that a given trade has
on the price. The measure developed by Amihud (2002) is the most widely used in this class:
 rt 
ILLIQ  Average 

 Volumet 
The ratio is calculated for positive volume days, since it is undefined for zero volume days.
This measure captures the illiquidity of the market and is designed to measure the daily price
response associated with one dollar of trading volume.

Several studies have compared the accuracy of various liquidity measures (see Goyenko,
Holden, Trzcinka and Lundblad (2006)). They have found that Amihud (2002) and Roll (1984)
perform well for monthly intervals. A more specific study, applying effective spread measures
to commodity markets, finds that Roll’s and other serial correlation based measures do not
perform well compared to absolute price change estimators, such as TWM (Bryant and Haigh
(2007)). Major problem, however, is that the microstructure data in commodity markets is
scarce and expensive, and the above mentioned estimates based on daily data can only be
obtained for monthly frequency, which dramatically reduces the sample size. With the above-
outlined caveats in mind, we will use quoted bid-ask spread in our analysis, since it is available
on a daily basis while other proxies are not.

3.2 Vector Autoregression Model

We first estimate Vector Autoregression Model (VAR), which is widely used in the literature.
VAR estimates the dynamics jointly, thereby showing the interactions between multiple
variables. The following functional form is specified:

Yt  c   ( L)Yt   ( L) X t   t

where Yt is a vector consisting of endogenous parameters: Yt  rt ST ,  tST , tST , rtCM ,  tCM , CM
t .
r denotes daily log-returns,  denotes volatility, estimated as the absolute value of daily log-
returns, and  stands for the liquidity parameter, while superscripts ST and CM stand for stock
and commodity markets respectively.  (L) is a lag operator,  (L) is a lag operator with
contemporaneous variables, and X t stands for exogenous factors. We estimate this model for
stock and commodity markets, as well as for each asset separately.

While this model is useful to examine the lagged influence of one market on the other, it does
not capture the contemporaneous influence of endogenous variables. In addition, VAR does
not provide an opportunity to test the stability of parameters across different variance regimes.
In order to deal with this issue, we use identification through heteroskedasticity method by
Rigobon (2000) and specify an alternative model in the next section.

3.3 Identification through heteroskedasticity

Although widely applied, VAR models may miss out the contemporaneous influences between
the dependent variables. Since we use daily data in our estimations, and a trading day is a
sufficient period of time to transmit the shocks in one market to another, it is could be the case
that the contemporaneous influence is present. Contemporaneous interactions are infamously
hard to identify, and identification through heteroskedasticity solves this problem without
imposing restrictive assumptions. We will illustrate the methodology by the following
example.

Assume for now that the sole objective of the study is to investigate the reaction of commodity
returns to shocks in stock market. Mathematically, this could be defined in the following way:

ct   st  xt   t
where c is daily commodity return, s is Standard & Poor’s 500 index daily return, x includes
lags of stock market returns and other observable control variables, and ε is the residual term.
Commodity market reaction to shocks in the equity market is then captured by variable β.
Alternatively, one can estimate the reaction function of the stock market to shocks in
commodity markets. This is represented in the following form:

st  ct  xt   t
where the reaction of the stock market to shocks in commodities markets is represented by α.
The most obvious approach of estimating these effects is estimating each of the equations
separately. This approach, however, has two fundamental problems, which destroy the validity
of such estimates – simultaneity bias and omitted variables. Simultaneity bias arises from the
fact that not only stock prices influence commodity markets, but also commodities have an
influence on the stock prices. Therefore, the true relation should be written in the following
form:
ct   s t  xt   t
st  ct  xt   t
The first difficulty with this estimation is that both equations are determined simultaneously,
which means that we cannot identify them in this form. There several ways of dealing with this
problem. One way used in the literature for dealing with endogeneity is imposing restrictions
on one of the coefficients. Since we are interested in estimating β, we can only imposed the
restriction of α = 0. This implicitly assumes that there is no reaction of stock prices to
commodity prices, which is unlikely. Another way of dealing with the endogeneity problem is
finding an instrumental variable which would be correlated with stock prices, but uncorrelated
with commodities. While in some cases this technique is very useful, it is difficult to find a
proper instrumental variable in this case, since both commodities and equities are influenced
by numerous economic factors, thus most variables that influence stock prices would likely
influence commodity prices as well. Therefore, none of these approaches work well in this
case.

The second potential bias is omitted variables. Omitted variables represent unobservable
factors, such as risk aversion or liquidity preference, which potentially affect stock prices
and/or commodities. This issue is difficult to deal with, since those factors are not observable,
and therefore their quantification requires proxies which are difficult to find. The third problem
may arise from heteroskedasticity, therefore using simple correlation measures between the
stock market and commodity returns is inappropriate and may bias correlation coefficients. The
bias could be corrected as proposed in Forbes and Rigobon (2002), yet the assumptions
required to make this correction are that there are no omitted variables, which is unlikely in this
case. In order to deal with heteroskedasticity, simultaneity and omitted variables biases,
Rigobon (2002) has proposed identification through heteroskedasticity.

The basic principle of identification through heteroskedasticity relies on the observation that in
a heteroskedastic data series, changes in their variance are related to changes their covariance
with the explanatory variable. In other words, when stock market has low variance, commodity
markets will explain less of the covariance between commodities and stock market. Therefore,
taking into account potential omitted variables bias, a new functional form is specified:
ct   s t  xt  z t   t
st  ct  xt  z t   t
where z represents unobservable shocks such as liquidity preference and risk aversion.

Then, substituting expressions for c and s, a reduced form equation is obtained:

 ct  vc 
   xt   ts 
 st   vt 
where:
      (    ) z t   t   t 
   
 1    v  
c
1   
 and  
t
      v   (  1) z t   t   t 
s

 1     t
 1   
   
This equation can be estimated with vector autoregressive approaches, but one obtains  and
reduced form residuals only. In order to trace back the parameter of interest β, we will use the
fact that data exhibits heteroskedasticity over time. The variance-covariance matrix of the
residuals is the following:

1 (    ) 2  z2   2 2   2 (1   )(    ) z2   2   2 
  
(1   ) 2  . (1   ) 2  я2   2   2 2 

In the estimated matrix, we have three restrictions and six unknowns -  ,  ,  ,  z2 ,  2 ,  2 .

Since the restrictions obtained from variance-covariance matrix are insufficient to identify all
parameters, it is useful to introduce heteroskedasticity in the model. Heteroskedasticty implies
that variance-covariance matrix is not constant over time, which helps to obtain additional
restrictions for the model. For that, one has to assume that there are certain regimes of variance
behaviour in stock markets and commodity markets.

The data is split into two subsamples: low variance and high variance. While the classification
is fairly arbitrary, it is more likely to fulfil the assumption of the homoskedasticity within a
subsample and yield useful results. The reduced form equation can be estimated for both
regimes separately. In this way two variance-covariance matrices are obtained, which bring
additional restrictions but also additional unknowns (  z2 ,  2 ,  2 for each subsample). In order

to identify the parameters, one needs to make assumptions regarding stability of the variances.
We therefore assume that commodity market shocks (ε) and unobservable shocks (z) are
homoskedastic and uncorrelated with the error term.

In this way, the matrices for each regime are denoted  i for i=1..2, and the difference matrix

has the following form:    2  1 . Then the difference matrix is estimated as follows:

1 (    ) 2  z2   2  2   2 (1   )(    ) z2   2   2 

   2  1   
(1   ) 2  (1   ) 2  z2   2   2  2 

However, since we assume that  z2 and  2 do not change throughout different variance regimes,
the differences of the terms are equal to zero and the difference matrix reduces to:
 2  2 
   
(1   ) 2   1

Then, parameter  can be estimated in two ways:

 11 12
ˆ  and ˆ 
 21  22
This additional restriction helps to test parameter stability, which we discuss together with the
results.

3.4 Implementation

Rigobon and Sack (2002) suggest a convenient instrumental variable interpretation for the
estimation of the following bivariate case:
ct   s t  xt  z t   t
st  ct  xt  z t   t
Define two instrumental variables in the following way:
w1  ( s h  H ) ( s l  L)

w2  (c h  H ) (c l  L)

where H stands for high volatility subsample, and L for the low/usual volatility subsample.
Then, using the standard instrumental variable estimation procedure, estimators take the
following form:
s h ' c h  s l ' c l Cov( s h , c h )  Cov ( s l , c l )
ˆ1  ( w1 ' s) 1 w1 ' c  h h 
s ' s  sl ' sl Var ( s h )  Var ( s l )

ch 'ch  cl 'cl Var (c h )  Var (c l )

ˆ 2  ( w2 ' s) 1 w2 ' c  h h 
c ' s  c l ' s l Cov( s h , c h )  Cov( s l , c l )
These estimators are exactly the same as derived above, since estimators converge to the
variances and covariances that were developed above2. This instrumental variable methodology
makes identification through heteroskedasticity very convenient and easy to implement.

3.5 A note on methodology

Identification through heteroskedasticity is an innovative and useful methodology for

estimating various simultaneous problems. It has been successfully applied to a number of
cases, such as estimating stock market reaction to monetary policy (Rigobon and Sack (2002))
and war risk effects on financial markets (Rigobon and Sack (2003)). However, there are

2
More detailed derivations are available in Rigobon and Sack (2002) and Rigobon (2000).
several cautionary remarks that may make the procedure inapplicable. IH relies on the
following assumptions and if they are not fulfilled, the estimation would be incorrect:
- Parameters are stable throughout different regimes
- Unobservable shocks are homoskedastic and uncorrelated to the residual term
- Commodity market shocks are homoskedastic and uncorrelated to the residual term
These assumptions are less restrictive than the usual OLS or event study assumptions, but by
estimating the model we effectively put these assumptions to test. It is therefore crucial to
divide the subsamples in a way that fulfils the second and third assumptions, and yet there is no
way of testing whether the second and the third assumptions are fulfilled. We discuss this issue
further in the results section.

3.6 Data

The data used for the estimation is obtained from Reuters and Datastream and spans the time
frame of 1998 – 2007. We choose the Standard & Poor’s 500 index as a proxy for equities. In
commodities, the number of available contracts is vast, yet much of the contracts do not report
bid-ask spreads, therefore we apply data availability and liquidity criteria in order to determine
the proxies, which are summarized in the table below.
Commodity Contract maturity Exchange
Gold Spot LME
Silver Spot LME
Copper 3M LME
Aluminium 3M LME
Zinc 3M LME
Oil 1M NYMEX

Each asset has three data series for the whole sample period: log-return, volatility (absolute
return), and illiquidity parameter (relative bid-ask spread)3. The series are adjusted by
regressing them on weekday dummies and trend variables, in order to filter out the effects that
are not relevant to the study. Adjusted time series are used for all estimations. MATLAB codes
are available in the appendix4. The model is estimated with two lags.

3
Unfortunately, we were unable to retrieve liquidity parameters for oil; therefore only returns and volatility are
used in the estimation
4
Some MATLAB codes were taken from www.spatialeconometrics.com, to which we are grateful.
4 RESULTS

4.1 VAR: Single asset results

We first estimate the interplay between returns, volatility and illiquidity for single asset
markets. The results for each asset are discussed below.

4.1.1 Gold
Returns in gold are not persistent and do not spill over to volatility and illiquidity. Innovations
in illiquidity and volatility strongly Granger-cause each other, thereby confirming the intuition
that illiquidity periods tend to be succeeded by periods of high volatility, and vice versa.
Exclusion of illiquidity parameter gives similar results, the only persistent factor being
volatility.

4.1.2 Silver
Silver patterns are slightly distinct from other metals, for that returns are Granger-caused both
by lagged returns and volatility. In addition, returns, volatility and illiquidity play a role in
determining volatility. Higher lagged volatility results in higher volatility and higher returns,
while widening bid-ask spread results in higher volatility. In addition, model without illiquidity
parameter shows similar results, exhibiting substantial persistence in returns and volatility. The
results for gold and silver are summarized in the table below.

Table 1. Granger-causality F-test probabilities

Gold Silver
Returns Volatility Illiquidity Returns Volatility Illiquidity
Returns 0,2537 0,9084 0,1677 0,0000 0,2214 0,3098
Volatility 0,8804 0,0000 0,0180 0,0000 0,0000 0,0000
Illiquidity 0,9073 0,0001 0,0000 0,3276 0,0761 0,3165
N.B. Green (red) variable implies that the relationship is positive (negative)

4.1.3 Copper
VAR results suggest that returns are Granger-caused by return lags, and, to a lesser extent, by
lags in volatility; however, the R-squared is a meagre 0.03, therefore the links are rather weak.
Illiquidity plays almost no role in determining the return behaviour. Volatility exhibits
persistent behaviour and is Granger-caused both by volatility and illiquidity lags - higher bid-
ask spread suggests higher volatility in the next period. Illiquidity variable is significantly
determined by returns, volatility and illiquidity lags. The relationship is most pronounced for
illiquidity, thereby suggesting that illiquidity could behave in a regime-switching fashion. High
volatility results in higher bid ask spreads next periods, while positive returns result in
narrower bid-ask spreads. Exclusion of illiquidity parameter from the estimation does not alter
the results for returns and volatility significantly.

4.1.4 Aluminium
In the case of aluminium, all lagged variables tend to predict themselves, while their
interaction is much less significant. Returns appear to Ganger-cause illiquidity and the relation
between returns and bid-ask spread is, somewhat counter-intuitively, positive. Other variables
do not exert any significant effects. Inclusion of the illiquidity parameter, as compared to
returns and volatility only estimation, significantly alters the results and decreases the
persistence of returns and volatility.

4.1.5 Zinc
Zinc exhibits strong positive Granger-causality of volatility and bid-ask spreads in both
directions, implying that a liquidity squeeze is followed by market volatility, and market
volatility is followed by lower liquidity. Lagged returns play a role in explaining future returns
– positive returns Granger-cause negative returns, implying frequent price reversals. Again,
returns play no role in Granger-causing illiquidity or volatility.

Table 2. Granger-causality F-test probabilities

Copper Aluminium Zinc
Returns Volatility Illiquidity Returns Volatility Illiquidity Returns Volatility Illiquidity
Returns 0,0015 0,0020 0,2248 0,0362 0,2299 0,0000 0,1010 0,1341 0,7036
Volatility 0,4357 0,0000 0,0004 0,0000 0,0000 0,0000 0,1856 0,0000 0,0000
Illiquidity 0,0106 0,0001 0,0000 0,4848 0,8600 0,6587 0,0891 0,0002 0,0000
N.B. Green (red) variable implies that the relationship is positive (negative)

4.1.6 Oil
Since data for oil liquidity is not available, the results are quite limited for oil. Volatility seems
to negatively Granger-cause returns, i.e. following high volatility the returns are lower.
Volatility is also persistent and high (low) volatility tends to stay high (low).

4.1.7 Equities
In the case of equities, returns do not exhibit any persistence, and both volatility and illiquidity
do not play a role in return determination. Returns only Granger-cause volatility, implying that
negative returns give rise to high volatility. Both illiquidity and volatility are persistent, thus
high volatility (liquidity) today suggests high volatility (liquidity) tomorrow. Finally, volatility
has a surprising negative relation to illiquidity, but the relation is quite weak. Excluding
illiquidity variable from the estimation has no effect on return persistence, and only strengthens
the persistence in volatility.

Table 3. Granger-causality F-test probabilities

Equities
Returns Volatility Illiquidity
Returns 0,3687 0,4754 0,4008
Volatility 0,0000 0,0000 0,0288
Illiquidity 0,9189 0,0055 0,0000
N.B. Green (red) variable implies that the relationship is positive (negative)

Overall, it seems that returns, volatility and illiquidity are more persistent in their own
domains, and the cross-relations are quite weak. Volatility and liquidity have somewhat
stronger interrelation patterns both for equities and commodities, and, as expected, higher
illiquidity results in higher volatility and the opposite. Exclusion of liquidity parameter
generally has no effect on returns, but somewhat strengthens the persistence in volatility, which
suggests that liquidity plays a role in volatility behaviour.

4.2 VAR: Multiple asset results

4.2.1 Commodities
In this estimation, we estimate the model for all five metals and oil jointly. In this way, one
may see whether returns, volatility and liquidity spill over across different assets. Due to high
space requirements, complete results are available upon request.

Return spillovers are not very persistent, most returns are Granger-caused by lagged own
returns, with the exceptions of copper (caused by aluminium) and gold (caused by silver).
Illiquidity and volatility generally do not play a role in return prediction. Illiquidity and
volatility exhibit more interdependence across different assets, yet the extent is rather limited.
Both parameters are rather persistent within the series of each assets, and more spillovers occur
in these variables than in returns. Copper volatility and liquidity spill over from all metals
except gold, similar pattern is observable for zinc. Silver is influenced only by own lags and
gold volatility, while gold is determined separately and does not experience Granger-causality
from any of the other metals except silver. Oil has no spillovers from other metals as well.
Table 4. Estimation results: Commodities
Asset Code Significantly Granger-caused by*:
Copper Returns CR CR(-), AR(+)
Copper Volatility CV CV(+), CL(+), SV(+)
Copper Illiquidity CL CV(+), CL(+), AV(-), ZL(+)
Aluminium Returns AR AL(+)
Aluminium Volatility AV AR(-), AV(+), AL(+)
Aluminium Illiquidity AL
Zinc Returns ZR
Zinc Volatility ZV CV(+),CL(+), ZL(+), SL(+)
Zinc Illiquidity ZL CV(+), CL(+), ZL(+)
Silver Returns SR SR(-)
Silver Volatility SV SR(-), SV(+), SL(+), GR(+), GV
Silver Illiquidity SL
Gold Returns GR
Gold Volatility GV GV(+)
Gold Illiquidity GL GV(+), GL(+)
Oil Returns OR OV(-)
Oil Volatility OV OV(+)
*At 1% level of significance
As seen from the table above, most spill overs occur through volatility, whereas illiquidity and
returns have slightly less persistent patterns. Illiquidity, however, shows much stronger
persistence than returns. Own returns tend to exhibit reversals and have negative relation to
their lags.

4.2.2 Commodities and equities

Inclusion of equities into the estimation does not change the interactions between the metals
dramatically, yet equities cause some interesting effects. Equity returns play a role in Granger-
causing copper, silver, and gold returns. Contrary to metal own lagged returns, when the
relation is negative (i.e. returns tend to reverse), equity returns have a positive influence on
metal returns, i.e. after a fall in stock prices, metals tend to fall as well. This effect is
particularly pronounced for the precious metals – gold and silver.
Table 5. Estimation results: Commodities and equities
Asset Code Significantly Granger-caused by*:
Copper Returns CR CR(-), AR, ER(+)
Copper Volatility CV CL(+), ZV, SV(+)
Copper Liquidity CL CV(+), CL(+), AV(-), ZL(+)
Aluminium Returns AR AL(+)
Aluminium Volatility AV AR(-), AV(+), AL(+)
Aluminium Liquidity AL
Zinc Returns ZR
Zinc Volatility ZV CV(+),CL(+), SV(+)
Zinc Liquidity ZL CV(+), CL(+), ZL(+)
Silver Returns SR SR(-), ER(+)
Silver Volatility SV SR(-), SV(+), SL(+), GR(+), GV
Silver Liquidity SL
Gold Returns GR ER(+)
Gold Volatility GV GV(+)
Gold Liquidity GL GV(+), GL(+), EL(+)
Oil Returns OR OV(-)
Oil Volatility OV OV(+), EL(+)
Equity Returns ER
Equity Volatility EV ER(-), EV(+)
Equity Liqudity EL EL(+), GL(-)
* Significant Granger-causality is set at the level of 1% or smaller

Equity volatility does not influence commodities at all, the only influence that it has is a lagged
positive effect on equity volatility, supporting the prior academic evidence on volatility
persistence. Equity liquidity, however, has a positive influence on gold liquidity and oil
volatility, thereby implying that after times of low liquidity in the equity markets, liqudity also
dries up in the gold market and volatility rises in the oil market. A speculative explanation
could be that since gold and oil markets are the most popular commodity investments5, a shock
in the equity markets is easily transmitted to these markets. Clearly, this effect is not
particularly desirable when considering diversification opportunities.

4.2.3 Time dependence

In order to capture the dynamic changes in the spillover patterns, we estimate the model for
two 3-year periods: 1998 – 2001 and 2004 – 2007. This allows to check whether the
interactions have changed over time. The results of the estimation point to strengthening
liquidity channel and increasing cross-autocorrelations among metals. Influence of equity

5
Crude oil and gold respectively have 93mn and 34.5mn futures contracts and 14.8mn and 2.9mn options
contracts traded by financial market participants in 2005 (BIS survey (2007))
returns became more pronounced for copper liquidity and zinc returns, while equity liquidity
exerted impact on silver liquidity and oil volatility in the second period, but not in the first one.
Overall, there is a trend on more cross-relations and higher role of liquidity towards the second
sample, yet further research is needed in order to find a more conclusive result.
Table 6. Granger-causality: Time dependence
Asset Code 1998 – 2001 R-sq. 2004 – 2007 R-sq.
Copper Returns CR 0.0933 0.0744
Copper Volatility CV 0.0797 0.1260
Copper Liquidity CL CL(+), ZL(+) 0.3003 CL(+), ER(-), AL(+) 0.1977
Aluminium Returns AR AL(+) 0.3048 AL(+) 0.3063
Aluminium Volatility AV 0.1029 CV(+), CL(+) 0.1331
Aluminium Liquidity AL 0.0535 AV(-) 0.0858
Zinc Returns ZR ZL(+) 0.0781 ER(+) 0.0716
Zinc Volatility ZV 0.0702 CL(+) 0.1328
Zinc Liquidity ZL CL(+), ZL(+) 0.3041 ZL(+), EL(-) 0.1625
Silver Returns SR SV(+), ER(+) 0.0795 GR(-) 0.0860
Silver Volatility SV 0.0780 SV(+) 0.1478
Silver Liquidity SL EL(+) 0.1235 SL(+), EL(+) 0.1848
Gold Returns GR 0.0636 GR(-) 0.0801
Gold Volatility GV GV(+), GL(+) 0.1730 SV(+) 0.0914
Gold Liquidity GL GV(+), GL(+) 0.2404 GL(+) 0.2052
Oil Returns OR OV(-) 0.0748 0.0390
Oil Volatility OV ER(+) 0.0795 EL(+) 0.0757
Equity Returns ER 0.0617 0.0581
Equity Volatility EV ER(-), EV(+) 0.1238 ER(+) 0.0816
Equity Liquidity EL EL(+) 0.3839 EL(+) 0.2649

4.3 Identification through heteroskedasiticity: Commodity reaction to stock market

Vector autoregressive estimations are clearly useful, yet they do not capture the
contemporaneous interrelations between the endogenous variables. If contemporaneous
interactions between these markets are substantial, important effects may be hidden if one
relies on VAR method only. Therefore, now we estimate an alternative methodology,
identification through heteroskedasticity (IH).

The intuition behind IH is similar to event study approaches, except that IH assumptions are
much less stringent. In order to reach consistent estimate in the event study methodology, an
implicit assumption of variance of the shock in question being infinitely large compared to
other shocks has to be fulfilled (Rigobon and Sack (2002)). This assumption is dropped in IH
estimation, the only requirement is that the variance of the shock of interest would increase
while other shock variances stay the same. Since we are looking from the point of view of
investor who uses commodities as a tool to diversify his equity holdings, we are more
concerned with the reaction of commodity markets to shocks in the stock market. Therefore,
the primary interest of this section is the simultaneous reaction of commodities to the shocks in
the stock market.

In order to estimate IH, one first has to divide the sample into subsamples based on variance
behaviour, the key condition being that the stock market shocks would be homoskedastic in the
subsamples. The sample is divided based on implied volatility index (VIX) behaviour into high
volatility and low volatility6, since this index shows investor risk aversion and therefore is a
good proxy for stock market shocks. We then estimate the reduced form residuals for each
subsample, obtain variance-covariance matrices, and estimate the parameters using
instrumental variable approach. We estimate IH for each commodity paired with equity
market. The results of the estimation are summarized in the table below.
Table 7. Identification through heteroskedasticity results
Asset Code Beta 1 T-stat Beta 2 T-stat
Copper Returns CR 0.9620 0.3381 5.7083 2.1511
Copper Volatility CV -0.1804 -0.0452 30.4756 1.6006
Copper Liquidity CL -0.0219 -0.0345 6.9185 0.0714
Aluminium Returns AR 8.6527 1.6453 -22.2390 -48.8530
Aluminium Volatility AV 9.9884 0.9968 50.1642 68.1388
Aluminium Liquidity AL 21.1205 1.3696 1416.2517 110.8988
Zinc Returns ZR 1.4070 1.1335 3.0931 4.2582
Zinc Volatility ZV 1.2756 0.2272 16.0873 4.8237
Zinc Liquidity ZL 0.2560 0.1344 490.1365 7.4429
Silver Returns SR 0.8727 0.5573 3.0766 1.6329
Silver Volatility SV 1.5886 0.2022 12.2599 2.3042
Silver Liquidity SL 0.4109 0.7333 -5.1935 -1.4028
Gold Returns GR -0.1345 -0.1466 -16.0532 -3.8669
Gold Volatility GV 11.4232 2.6390 1.3982 6.3252
Gold Liquidity GL 0.3345 1.2321 -4.9327 -4.6875
Oil Returns OR -0.1056 -0.0240 -104.2781 -1.8047
Oil Volatility OV -2.8243 -0.4385 7.5942 2.4017

Clearly, the table above suggests that either the parameters are unstable or some assumptions
of the model are violated. Beta 2 in absolute value is almost always larger than Beta 1,
therefore it is useful to recall how are both parameters estimated:
Cov( s h , c h )  Cov( s l , c l )
ˆ1  ( w1 ' s) 1 w1 ' c 
Var ( s h )  Var ( s l )

6
High volatility sub-sample includes the days when VIX changes by more one standard deviation from the mean,
and low volatility is defined when analogous change occurs one deviation below the mean.
 Var (c h )  Var (c l )
ˆ 2  ( w2 ' s) 1 w2 ' c 
Cov( s h , c h )  Cov( s l , c l )
Examination of the intermediate estimation results suggests that although high and low
variance regimes are quite similar, the shift in commodity variance is substantial, while the
shift in covariances is not. This basically implies that the shocks in one market do not change
the correlation between the two markets, thereby making proper identification impossible and
parameters unstable. Intuitively, this situation resembles the case when in an event study the
event shocks are overwhelmed by usual market activity or shocks from other markets, thereby
decreasing the impact of the shocks. Therefore, we are unable to claim the stability of
parameters, interrelation remains inconclusive, and alternative specifications of variance
regimes could be employed in further research.

5 CONCLUDING REMARKS

The study is aimed to investigate the interaction between equity and commodity markets.
Empirical results suggest that shocks in equity and commodity markets are responding to
shocks in one another to a certain extent. While intra-commodity market effects are mostly
transferred through volatility and liquidity, relationship between equity and commodity
markets is transmitted through return and liquidity channels. These effects are more
pronounced for precious metals and oil. These transmission channels seem to be leaning
towards more interaction in recent years as compared to 1998-2001, however, the results are
not clear-cut and require caution when interpreting. It also seems that liquidity channel is
playing increasingly larger role, but this result has to be cross-checked with other proxies for
liquidity.

Determining simultaneous interactions between the two markets did not yield any consistent
results. It could be the case that the transmission parameters are unstable with regard to the
variance in the stock market, or additional shocks prevented estimation the contemporaneous
influences. This may also imply that the markets do not interact contemporaneously, as the
change in commodity market variance does not cause major shifts in correlation patterns
between the two markets. Therefore, interactions may not be substantial on a daily time frame,
but prevail in the longer term.
Inclusion of liquidity parameter into the estimation alters the results only slightly. Volatility is
still very persistent, which is in line with previous results in the literature, and returns are
negatively auto-correlated for some metals. Equity returns have a positive relationship with
gold, silver and copper, and equity liquidity positively Granger-causes volatility in the oil and
gold markets. This undermines the effectiveness of diversification in those markets, therefore
an investor willing to diversify her equity holdings should rather choose aluminium or zinc
investments.

Implications for further research include, first of all, search for better data and better liquidity
proxies for commodities, since the reported bid-ask spread is quite a noisy indicator. Research
on spillovers and their relationship to the share of financial speculator participation in
commodity markets would also be very interesting, and the liquidity channel effects clearly
deserve further study. In addition, effective diversification could be estimated for investors
who face funds withdrawals as the performance falls below a threshold based on the historical
data. Somewhat speculatively, these results suggest that in order to reap diversification
benefits, a leveraged investor should invest into markets which are liquid, but also, in which
most investors have different portfolios and different trading motives than the investor, such as,
for instance, hedging. This would minimize the risk of liquidity squeezes that occur
endogenously. All these issues merit further research, which would usefully complement the
literature on portfolio management in frictionless markets with insights from a more realistic
perspective.
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APPENDIX: MATLAB CODES

Implementation: VAR

close all
clear all
clc

CopperRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'Copper');

CopperAdj = [];
j=1;
for j=1:3
Results = ols(CopperRaw(:,j),CopperRaw(:,4:end));
CopperAdj(:,j)=Results.resid;
end

AlRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'Aluminium');

AlAdj = [];
j=1;
for j=1:3
Results = ols(AlRaw(:,j),AlRaw(:,4:end));
AlAdj(:,j)=Results.resid;
end

ZincRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'Zinc');
j=1;
ZincAdj = [];

for j=1:3
Results = ols(ZincRaw(:,j),ZincRaw(:,4:end));
ZincAdj(:,j)=Results.resid;
end

SilverRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'Silver');

SilverAdj = [];
j=1;
for j=1:3
Results = ols(SilverRaw(:,j),SilverRaw(:,4:end));
SilverAdj(:,j)=Results.resid;
end

GoldRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'Gold');

GoldAdj = [];
j=1;
for j=1:3
Results = ols(GoldRaw(:,j),GoldRaw(:,4:end));
GoldAdj(:,j)=Results.resid;
end

SPRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'SP');
SPAdj = [];
j=1;
for j=1:3
Results = ols(SPRaw(:,j),SPRaw(:,4:end));
SPAdj(:,j)=Results.resid;
end

OilRaw = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\alle.xls', 'Oil');

OilAdj = [];

for j=1:2
Results = ols(OilRaw(:,j),OilRaw(:,4:end));
OilAdj(:,j)=Results.resid;
end

All = [CopperAdj AlAdj ZincAdj SilverAdj GoldAdj OilAdj SPAdj];

variab =
['CRet';'CVol';'CLiq';'ARet';'AVol';'ALiq';'ZRet';'ZVol';'ZLiq';'SRet';'SVol
';'SLiq';'GRet';'GVol';'GLiq';'ORet';'OVol';'ERet';'EVol';'ELiq'];

answer = vare(All,2);
prt_var(answer,variab)

Implementation: IH
clear all
close all
clc

C = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\all1.xls', 'Copper');
Regimes = xlsread('C:\Documents and Settings\Dalia\Desktop\Master
Thesis\all1.xls', 'Regimes');

S = xlsread('C:\Documents and Settings\Dalia\Desktop\Master

Thesis\all1.xls', 'SP');
%Int = xlsread('C:\Documents and Settings\Dalia\Desktop\Master
Thesis\all1.xls', 'Interest');

C = adjust(C);
S = adjust(S);

C = C(:,2);
S = S(:,2);

C1 = divid(C,Regimes);
S1 = divid(S,Regimes);

C1 = divide(C,Regimes);
S1 = divide(S,Regimes);

CIV = instrumental(C, Regimes);

SIV = instrumental(S, Regimes);
%ahatC = inv(SIV'*S1)*(SIV'*C1)
%ahatS = inv(CIV'*S1)*(CIV'*C1)

answ = ols(S1,SIV);

Shat = answ.yhat;

answ2 = ols(C1,Shat);

%fprintf('Beta = %9.4f \n',answ2.beta);

%fprintf('Beta st.e. = %9.4f \n',answ2.bstd);
fprintf('Beta tstat = %9.4f \n',answ2.tstat);
fprintf('R-squared = %9.4f \n',answ2.rsqr);

answ1 = ols(S1,CIV);

%Shat1 = answ1.yhat;

answ3 = ols(C1,Shat1);

fprintf('Beta = %9.4f \n',answ3.beta);

fprintf('Beta st.e. = %9.4f \n',answ3.bstd);
fprintf('Beta tstat = %9.4f \n',answ3.tstat);
fprintf('R-squared = %9.4f \n',answ3.rsqr);

Support: Adjust
function Adj = adjust(x)

Adj = [];
j=1;
for j=1:3
Results = ols(x(:,j),x(:,4:end));
Adj(:,j)=Results.resid;
end
return
Support: instrumental
function ann = instrumental(x, regime)

len = length(x);
n = [];
z = 1;
a = 1;
b = 1;
for z=1:len
if regime(z,1)>0;
ann(a,:)=x(z,:);
a = a+1;
elseif regime(z,1)<0
ann(a,:)=-x(z,:);
a = a+1;
end
z = z+1;
end