On the correlation between commodity and equity returns: implications for portfolio allocation

Working Papers No 420
July 2013

In the recent years several commentators hinted at an increase of the correlation between equity and commodity prices, and blamed investment in commodity-related products for this. First, this paper investigates such claims by looking at various measures of correlation. Next, we assess what are the implications of higher correlations between oil and equity prices for asset allocation. We develop a time-varying Bayesian Dynamic Conditional Correlation model for volatilities and correlations and find that joint modelling commodity and equity prices produces more accurate point and density forecasts, which lead to substantial benefits in portfolio allocation. This, however, comes at the price of higher portfolio volatility. Therefore, the popular view that commodities are to be included in one's portfolio as a hedging device is not grounded.

Keywords: Commodity prices, equity prices, density forecasting, correlation, Bayesian DCC

JEL classification: C11, C15, C53, E17, G17