An Empirical Analysis of Hedging and Diversification Role of Commodity Futures as a Risk Management Tool

Abstract

Commodity futures have resurged as an excellent portfolio diversifier and hedge against inflation over the last decade. Traditional and alternative asset managers are using commodity futures as an investment vehicle for strategic and tactical allocations. Strategic allocation of commodity futures is highly valued due to the benefits of longterm equity-like returns, diversification benefits due to low correlation with other asset classes and inflation hedging potential. Numerous studies have been conducted to examine the inflation hedging and diversification benefits of commodity futures. These studies have examined the commodity futures as an investment tool for the passive allocation in a portfolio of traditional asset mix such as stocks and bonds. However, they have not focussed on the assessment of regime-dependent inflation hedging and diversification role of commodity futures. In addition to the passive asset allocation, commodity futures are used for the tactical asset allocation by designing the active strategies which use the signals of momentum, hedging pressure and idiosyncratic volatility. With the review of the literature, it is found that there is a lack of study which examines the existence of time-varying conditional profitability of these strategies for the commodity futures market in the Indian context. In order to address these issues, primarily, this thesis aims to evaluate the inflation hedging and diversification benefits of individual commodity futures by using the time-varying dynamics under the regimeswitching approach. Subsequently, it analyses the time-varying conditional profitability of individual and combined strategies which are designed by using the momentum, term structure and idiosyncratic volatility signals for the Indian commodity futures market. The study uses a sample of 13 highly traded commodity futures contracts (gold, silver, copper, zinc, aluminium, nickel, lead, cardamom, mentha oil, cotton, crude palm oil, crude oil and natural gas) and three commodity indices (MCXMETAL, MCXENERGY and MCXAGRI) for the study period of June 2006 to April 2016. It uses the time-varying regime-switching approach of Markov Switching-Vector Error Correction Model (MS-VECM) to assess the inflation hedging potential of these commodity futures and commodity indices. The study results confirm the partial inflation hedging ability of gold, silver, lead and CPO futures and marginal hedging potential of copper and cotton futures. In addition, the hedging and diversification role of these6 commodity futures and indices are analysed using the regime-switching approach of Markov Switching-Vector Autoregression (MS-VAR) model. The results signify that commodity futures are an excellent tool for diversification of the portfolios of traditional assets mix such as stocks and bonds. In addition, the study analyses the time-varying conditional profitability of momentum, term structure and idiosyncratic volatility strategies in the Indian commodity futures market. The average monthly mean returns, Sharpe ratio, transaction costs and time-varying risk-based performance evaluation confirm that strategies based on risk i.e idiosyncratic volatility are more profitable compared to strategies based on momentum returns and term structure yield. In addition, the study designs a combined strategyMomTS which incorporates the methodology of both momentum and term structure strategies and combined strategy-MomIVol which uses the methodology of both momentum and idiosyncratic volatility strategies. The performance evaluation of these strategies confirms that MomIVol strategy gives the highest monthly average return of 25.57 percent compared to momentum, term structure, idiosyncratic volatility and MomTS strategies which yield the average monthly returns of 7.17, 9.54, 11.59 and 16.68 percent, respectively. The major contribution of the study to the existing literature and to the real time practitioner is the design of a combined strategy, MomIVol which gives a better riskadjusted return compared to other strategies. In addition, the design of this kind of active strategies plays an important role in the investment decision of institutional investors and professional money managers such as hedge funds and commodity pool operators. The findings of this study provide significant guidance to the investors in the tactical allocation of commodity futures in their portfolio, not only to diversify their portfolio but also to earn an exceptionally high abnormal returns.