Oil and portfolio risk diversification

Giulio Cifarelli (giulio.cifarelli@unifi.it) and Giovanna Paladino

MPRA Paper from University Library of Munich, Germany

Abstract: The growing presence of financial operators in the oil market has brought about the diffusion of techniques - such as feedback trading - which lead to departures of prices from their fundamental values and increase their variability. Oil price changes are here associated with changes in stocks, bonds and effective USD exchange rate. The feedback trading mechanism is combined with an ICAPM scheme. This original model is estimated in a four asset CCC GARCH non linear framework, where the risk premium and the feedback trading components of the conditional means are multiplicative functions of the system’s conditional variances and covariances. The empirical analysis, which encompasses the 2008-2009 financial crisis, identifies a structural change in the year 2000. From then on oil returns tend to become more reactive to the remaining assets of the model and feedback trading more pervasive. A comparison is drawn between three and four asset minimum variance portfolios in the two sub-periods, 1992-1999 and 2000-2009. Indeed, the trade-off between risk and returns – measured here by the average return per unit of risk index – indicates that in the last decade oil diversifies away the empirical risk of our portfolio.

Keywords: Oil price dynamics; feedback trading; multivariate GARCH; portfolio allocation. (search for similar items in EconPapers)
JEL-codes: G11 G12 Q40 (search for similar items in EconPapers)
Date: 2009-12, Revised 2010-11
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