Financial Crisis and Financialization Acuity on the Diversification Benefits of Commodities: A Stochastic Asset Allocation Framework

Abstract

This research investigates the portfolio diversification benefits of commodities in the backdrop of uncertainty caused by the financial crisis, increased Financialization and speculation in commodity markets. Portfolios are formed out of varied asset classes comprise of equity, bond, infra structure, commodity spot & futures indices and sectoral indices such as agri, metals and energy sectors over a period 2005-2013. It employed stochastic mean-conditional value at risk (CVaR) optimization model. CVaR quantifies downside risk and helps to minimize extreme losses. The ex-post stability of the results and the robustness of the model are validated through back testing. Different performance measures such as Sharpe ratio, modified Sharpe ratio with conditional value at risk, opportunity cost and maximum draw down are employed to compare the results of multi asset portfolios. The results support the evidence of the diversification benefit in commodity futures indices than in spot indices. It also highlighted the significance of Agri commodities in offering portfolio diversification than energy and metal commodities. The diversification benefit of later are found to be reduced with the advent of financial crisis. It also provides empirical evidence that the diversification benefits of energy and metal commodities were reduced during the financial crisis and this can be attributed to the observed increase in Financialization and cross-asset market integration during the crisis period.