Stock–Commodity Correlations, Optimal Hedging, and Climate Risks

Abstract

Despite the growing importance of integrating climate risks into financial decision-making, there has been limited research on how these risks affect stock–commodity correlations and the optimal hedging performance of commodities. Using four novel climate risk measures related to the US climate policy, international summits, global warming, and natural disasters, we explore the impact of climate risks on conditional correlations between commodity futures and equities. Our results reveal that higher transition risks (US climate policy and international summits) are associated with increased correlations, while higher physical risks (natural disasters and global warming) drive correlations lower in most cases. We also find that the interaction of climate risks with macro factors can exert significant influences on the time-varying correlations. During periods of extremely high climate risk, we generally observe higher hedging costs, reduced portfolio allocations to commodities, and lower hedging effectiveness compared to periods of extremely low climate risk.