Diversification benefits of commodities in portfolio allocation: A dynamic factor copula approach

Gaete, Michael and Herrera, Rodrigo (2022): Diversification benefits of commodities in portfolio allocation: A dynamic factor copula approach.

Abstract

This study provides a thorough analysis of the dynamics of volatility and dependence between seven international equity and 20 commodity markets across different sectors, highlighting the hedging role played by the latter. We explain volatility using a specification that distinguishes between the short and long term, while the dynamics of the dependence structure, or copula, are modeled by means of a latent factor structure, which can be split into commodity sectors such that there is homogeneous dependence within each sector. The dynamic of both models is captured through a score-driven specification. Moreover, we solve the risk aversion portfolio optimization problem to determine the existence of diversification benefits when constructing portfolios made up of a mix of commodities and stock markets. The main results of the study show that the dependence between the commodity and equity markets is variable over time and that the diversification potential of commodity markets is limited. Further, the factor copula approach is the best specification in terms of Sharpe ratio independent of portfolio settings for the different rebalancing periods.

• Item Type: MPRA Paper
• Language: English
• Keywords: volatility; commodity markets; dynamic factor copula; dependence; portfolio optimization
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C10 - General; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G17 - Financial Forecasting and Simulation

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