LAUSR

Abstract This paper investigates the volatility linkage between energy and agricultural futures returns and how this linkage responds to external macroeconomic shocks. A framework combining the VARMA-BEKK-GARCH model and the Permanent-Transitory decomposition technology is employed to detect the volatility transmission, to decompose the volatility linkage into permanent and transitory components, and to examine the underlying determinants of the transitory volatility linkage. We have the following findings. A bidirectional volatility linkage between energy and agricultural futures returns exists and becomes more pronounced in recent years. The bidirectional linkage results from the co-movement effect induced by external shocks rather than from the substitution effect induced by the biofuel industry, and is not weakened by the shale gas revolution. Serving as proxies for external shocks from the world economy, trade, and financial markets, the CRB, BDI, and USDX indices provide strong explanatory power for the transitory volatility linkage, and the futures of these indices can be used to effectively and inexpensively hedge against the risks of the portfolios involving energy and agricultural futures.