Conditional Correlation and Volatility in Commodity
Futures and Traditional Asset Markets

Abstract

The impressive rise in commodity prices since 2002 and their subsequent fall since July 2008 have revived the debate on the role of commodities in the strategic and tactical asset allocation process. Commonly accepted benefits include the equity-like return of commodity indexes, the role of commodity futures as risk diversifiers, and their high potential for alpha generation through long-short dynamic trading. This article examines conditional correlations between various commodity futures with stock and fixed-income indices. Conditional correlations with equity returns fell over time, which indicates that commodity futures have become better tools for strategic asset allocation. The correlations between the S&P 500 Index and several commodities also fell in periods of above-average volatility in equity markets. This is desirable for long institutional investors as they need the benefits of diversification most in periods of high volatility in equity markets. Similarly, the results suggest that adding commodity futures to T-bill portfolios reduces risk further in volatile interest rate environments.

TOPICS: Commodities, futures and forward contracts, portfolio construction, performance measurement