Financial crises and the nature of correlation between commodity and stock markets

Abstract

This paper models time-varying correlations between commodity and stock markets to uncover the dynamic nature of correlations during the financialization of commodity markets and in the aftermath of the recent financial crisis. Particularly, we search for upward trends in correlations and investigate the impacts of global and market volatility, and the news from the markets on the time-varying structure of correlations. The focus is on two commodity sub-indices; agricultural commodity and precious metal. New evidence against the rising trend is found for the agricultural commodity sub-index and empirical results show that high market volatility during financial crises seems to be the main source of high correlations. Moreover, increase in correlation is not a new phenomenon and cannot be attributed to the recent financial crisis. For the precious metal sub-index, market volatility plays crucial role in the dynamic nature of correlation along with rising trend. Furthermore, heterogeneous structure of commodity markets delivers better portfolio diversification opportunities during calm periods compared to turmoil periods. It is empirically shown that the gain of portfolio diversification across commodity and stock markets is not negligible.