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On the correlation between commodity and equity returns: implications for portfolio allocation

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  • Marco Jacopo Lombardi

Abstract

In the recent years several commentators hinted at an increase of the correlation between equity and commodity prices, and blamed investment in commodity-related products for this. First, this paper investigates such claims by looking at various measures of correlation. Next, we assess what are the implications of higher correlations between oil and equity prices for asset allocation. We develop a time-varying Bayesian Dynamic Conditional Correlation model for volatilities and correlations and find that joint modelling commodity and equity prices produces more accurate point and density forecasts, which lead to substantial benefits in portfolio allocation. This, however, comes at the price of higher portfolio volatility. Therefore, the popular view that commodities are to be included in one's portfolio as a hedging device is not grounded.

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  • Marco Jacopo Lombardi, 2013. "On the correlation between commodity and equity returns: implications for portfolio allocation," BIS Working Papers 420, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:420
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    Cited by:

    1. Balcilar, Mehmet & Katzke, Nico & Gupta, Rangan, 2017. "Do precious metal prices help in forecasting South African inflation?," The North American Journal of Economics and Finance, Elsevier, vol. 40(C), pages 63-72.
    2. repec:eee:eneeco:v:66:y:2017:i:c:p:337-348 is not listed on IDEAS
    3. Nguyen, Duc Binh Benno & Prokopczuk, Marcel, 2017. "Jumps in Commodity Markets," Hannover Economic Papers (HEP) dp-615, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    4. Sensoy, Ahmet & Hacihasanoglu, Erk & Nguyen, Duc Khuong, 2015. "Dynamic convergence of commodity futures: Not all types of commodities are alike," Resources Policy, Elsevier, vol. 44(C), pages 150-160.
    5. repec:sgh:gosnar:y:2018:i:1:p:103-135 is not listed on IDEAS
    6. Deepa Datta & Benjamin K Johannsen & Hannah Kwon & Robert J Vigfusson, 2017. "Oil, equities, and the zero lower bound," BIS Working Papers 617, Bank for International Settlements.
    7. Turhan, M. Ibrahim & Sensoy, Ahmet & Ozturk, Kevser & Hacihasanoglu, Erk, 2014. "A view to the long-run dynamic relationship between crude oil and the major asset classes," International Review of Economics & Finance, Elsevier, vol. 33(C), pages 286-299.
    8. repec:eee:ejores:v:265:y:2018:i:2:p:685-702 is not listed on IDEAS
    9. Andrew Filardo & Marco Jacopo Lombardi, 2014. "Has Asian emerging market monetary policy been too procyclical when responding to swings in commodity prices?," BIS Papers chapters,in: Bank for International Settlements (ed.), Globalisation, inflation and monetary policy in Asia and the Pacific, volume 77, pages 129-153 Bank for International Settlements.
    10. Giampietro, Marta & Guidolin, Massimo & Pedio, Manuela, 2018. "Estimating stochastic discount factor models with hidden regimes: Applications to commodity pricing," European Journal of Operational Research, Elsevier, vol. 265(2), pages 685-702.
    11. Marta Giampietro & Massimo Guidolin & Manuela Pedio, 2015. "Can No-Arbitrage SDF Models with Regime Shifts Explain the Correlations Between Commodity, Stock, and Bond Returns?," BAFFI CAREFIN Working Papers 1619, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.

    More about this item

    Keywords

    Commodity prices; equity prices; density forecasting; correlation; Bayesian DCC;

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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