On the Correlation Between Commodity and Equity Returns: Implications for Portfolio Allocation

Topics: Asset allocation, Stock market, Commodity price index Pages: 36 (8776 words) Published: August 26, 2013
BIS Working Papers
No 420

On the correlation between commodity and equity returns: implications for portfolio allocation by Marco Lombardi and Francesco Ravazzolo

Monetary and Economic Department
July 2013

JEL classification: C11, C15, C53, E17, G17. Keywords: Commodity prices, equity prices, density forecasting, correlation, Bayesian DCC.

BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

This publication is available on the BIS website (www.bis.org).

©

Bank for International Settlements 2013. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISSN 1020-0959 (print) ISBN 1682-7678 (online)

On the correlation between commodity and equity returns: implications for portfolio allocation∗ Marco J. Lombardi† Francesco Ravazzolo‡ July 11, 2013

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.

Keywords: Commodity prices, equity prices, density forecasting, correlation, Bayesian DCC. JEL Classification : C11, C15, C53, E17, G17. We thank seminar participants at the BIS, as well as at the ECB-NB “Modeling and forecasting oil prices”, MMF “Understanding Oil and Commodity Prices”, and CAMP “Forecasting and Analysing Oil Prices” workshops for helpful comments. We also gratefully acknowledge comments by Lutz Kilian and Dubravko Mihaljek. This paper is part of the research activities at the Centre for Applied Macro and Petroleum economics (CAMP) at BI Norwegian Business School. CAMP is supported by Statoil’s research program in petroleum economics. The manuscript was circulated initially with the title “Oil Price Density Forecasts: Exploring the Linkages with Stock Markets”. The views expressed in this paper are our own and do not necessarily reflect those of Bank for International Settlements and/or Norges Bank. † Bank for International Settlements, Centralbahnplatz 2, CH-4002 Basel (Switzerland). Email: marco.lombardi@bis.org ‡ Norges Bank and BI Norwegian Business School, Bankplassen 2, NO-0107 Oslo (Norway). Email: francesco.ravazzolo@norges-bank.no ∗

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Introduction

The past decade has witnessed a broad-based surge in commodity prices, with oil a frontrunner. The upward trend in prices has been ascribed to booming demand at the global level, but fluctuations around it have been substantial, especially after the onset of the Great Recession. Investing in commodities has generated hefty returns and has become increasingly popular, in spite of the high risks associated with this type of investment, due to the inherent volatility of commodity prices. Indeed, most fund managers have started advising their customers to devote a share of their portfolios to commodity-related products as part of long-term diversification strategy. This is often motivated by the fact that, over the long run, commodities are believed to display low...
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