Hedging and diversification across commodity assets

ABSTRACT

We investigate the conditional cross effects and volatility spillover between equity markets and commodity markets (oil and gold), Fama and French HML and SMB factors, volatility index (VIX) and bonds using different multivariate GARCH specifications considering the potential asymmetry and persistence behaviours. We analyse the dynamic conditional correlation between the US equity market and a set of commodity prices and risk factors to forecast the transmission of shock to the equity market firstly, and to determine and compare the optimal hedge ratios from the different models based on the hedging effectiveness of each model. Our findings suggest that all models confirm the significant returns and volatility spillovers. More importantly, we find that GO-GARCH is the best-fit model for modelling the joint dynamics of different financial variables. The results of the current study have implications for investors: (i) the equity market displays inverted dynamics with the volatility index suggesting strong evidence of diversification benefit; (ii) of the hedging assets gold appears the best hedge for the US equity market as it has a higher hedge effectiveness than oil and bonds over time; and (iii) despite these important results, a better hedge may be obtained by using well-selected firm sized and profitability-based portfolios.

KEYWORDS:

• Equity markets
• GARCH models
• multivariate
• hedging diversification
• commodities

JEL CLASSIFICATION:

• G12
• G14
• G15

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ All data and explanation about the diversified portfolio selection sorted by size and value, as well as the data on the Fama and French momentum factor, are available from the French Data Library at: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html..