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 among 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 terms. At the same time, the dependence structure is modeled through a time-varying conditional factor copula model, 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-averse portfolio selection to determine the existence of diversification benefits when constructing portfolios comprising commodities and stock markets. The main results of the study show that the dependence between the commodity and equity markets is variable over time. The best strategy in the minimum variance portfolio is obtained by incorporating a mix of commodities into the stock market portfolio, especially industrial metals. Furthermore, the factor copula approach is the best specification in terms of the Sharpe ratio independent of portfolio settings.