Time-varying diversification benefits of commodity futures

Abstract

This paper analyzes the conditional diversification benefits (CDBs) of commodity futures. We utilize three distinct classes of empirical models in order to explore the additional value of commodities in stock portfolios. Firstly, the dynamic equicorrelation model is conducted which allows us to compute the average conditional correlations for a large number of assets. Secondly, we employ the dynamic conditional correlation (DCC) technique to examine pairwise correlations between commodity futures and equity markets. Thirdly, using the time-varying correlations derived from the DCC model, we quantify the diversification benefits through time within the context of CDB measure. By constructing six hypothetical portfolios, our results point out that the portfolio consisting of the commodity futures and the emerging stock markets exhibits the lowest equicorrelation level. The cross-sectional differences in the bivariate correlations show that the energy and metal futures have the highest level of co-movements with the equities. Our findings also reveal that the inclusion of commodity futures into the emerging and developed market portfolios increases the diversification benefits although these benefits deteriorate negligibly in the episodes of financial turmoil. The futures that offer the highest diversification benefits are lean hogs, feeder cattle, natural gas, orange juice, and gold. Our empirical results provide significant insights for portfolio managers and global investors to assess the gains from investments in commodity futures.