Diversification effect of commodity futures on financial markets

Abstract

This paper examines the portfolio diversification effect of commodity futures on financial market products introducing a comprehensive evaluation standard of risk standardization, robustly small correlation, and risk-return tradeoff. Regarding risk standardization, we propose a definition of portfolio diversification as how much the distribution of portfolio returns is close to a normal distribution. It is shown by using an ɑ-stable distribution that if commodity price return distribution has the opposite sign of skewness parameter β to financial portfolio’s β, commodity diversification effect exists. The empirical studies using S&P 500, U.S. 10-year treasury notes, and DJ-AIG commodity index are conducted to investigate the portfolio diversification effects. The parameter estimation results of portfolio return distributions, the conditional correlations using the dynamic conditional correlation model with financial exogenous variables, and the effcient frontier from the mean-CVaR portfolio optimization all suggest that commodity futures have a diversification effect on financial markets.

Keywords

• diversification effect| commodity futures| ɑ-stable distribution| dynamic conditional correlation model with exogenous variables| mean-CVaR portfolio optimization