Diversification Effect of Commodity Futures on Financial Markets

Abstract
This paper examines the portfolio diversification effect of commodity futures on financial market products introducing a comprehensive evaluation standard of risk standardization, robustly small correlations, and risk-return tradeoffs. Regarding risk standardization, we propose a definition of portfolio diversification as how much the distribution of portfolio returns is close to a normal distribution. It is shown by using α-stable distribution that if the commodity price return distribution has the opposite sign of skewness parameter β to financial portfolio’s β, commodity diversification effect exists. The empirical studies using S&P500, U.S. 10-year bond and DJ-AIG commodity index are conducted to investigate the portfolio diversification effects. The parameter estimation results of portfolio return distributions, the conditional correlations using the dynamic conditional correlation model with financial exogenous variables, and the efficient frontier from the mean-CVaR portfolio optimization all suggest that commodity futures have a diversification effect on financial markets.