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

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

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