Probability weighting in commodity futures markets

Abstract

AbstractProbability weighting refers to the behavioral bias in which irrational investors have a propensity to overweigh small probability tail events. In this study, we empirically investigate the asset pricing implications of probability weighting in commodity markets. We find that commodities with a high probability‐weighting value significantly underperform their low‐value pairs by 11% per annum. Neither conventional commodity risk factors nor existing characteristics explain this predictability. The predictability is more pronounced when arbitrage constraints are more binding. Commodities with a high probability‐weighting value also attract excess demand from non‐commercial traders. Collectively, these findings support a prospect theory‐based explanation for the cross‐section of commodity returns.