Non-ferrous metals price volatility: a component analysis

This paper examines the conditional volatility of daily non-ferrous LME settlement prices over the period 1972–1995. Previous research has indicated that metals volatility, whilst stationary and therefore ultimately mean-reverting, is highly variable over time, possibly as the result of being conditioned by two broad factors. The first, common to all financial markets, relates to the impact of new market information and hedging or speculative pressures, which are typically short-run in nature. The second, more fundamental influence, is specific to commodity markets where stocks can become low, and is more medium to long-run in nature. This paper considers these factors in the context of an empirical model of conditional volatility which provides an explicit decomposition of volatility into its long-run and short-run components, and which is shown to be superior to the standard model of conditional volatility widely applied in modelling financial market volatility. On the basis of the reported model, we also provide further evidence on the conjecture that common factors may condition the long-run conditional volatility component. Our results confirm the relevance and significance of the decomposition of metals price volatility, and the presence of three separate principle components driving underlying metals volatility, one of which is common to all six of the metals considered. These findings carry practical implications for risk management, the hedging activities pursued by market participants, and for the pricing of derivative assets.