Volatility Interrelationship between Commodity Futures, Shanghai Stock and 10 Year Bond Indices in China

Abstract

This article studies the conditional means of 9 commodity futures in China from Dec, 2006 to Jan, 2010 period and finds that they are significant, which indicating that risk transfers do occur in commodity futures markets between speculators and hedgers. The paper also finds that the conditional correlation falls in period of recession; namely, when market risk rises, which is good news to asset managers since it is precisely when market volatility is high that the benefits of diversification are most appreciated. On the other hand, the negative correlation between the Government 10 year bond and commodity futures Indices rises with the bond volatility, suggesting that, unlike stocks, a bond and commodity portfolio should be tilted more towards commodity futures in periods of high bond volatility. This paper is trying to find such interrelations in Chinese commodity futures Market, Stock Market and Bond Market during 2006-2010 period, utilizing the econometrical (GARCH, ARCH) models produced by Bollerslev (1986) and Engle (1982). Keywords:Chinese commodity futures Market, Stock Market, Bond Market, Conditional correlation, Conditional volatilities, Risk, Market volatility, Diversification, Hedging IntroductionAs the latest alternative asset class in fashion, commodity futures have recently attracted a substantial amount of interest among asset managers. There are at least four reasons for this curiosity. First, because of their low correlation with other asset classes, commodity futures are excellent portfolio diversifiers (Jensen, Johnson, and Mercer, 2000). Second, unlike stocks and bonds, commodity futures prices rise in inflationary periods, making them a good hedge against inflation (Bodie and Rosansky, 1983). Third, as only the initial margin needs to be posted when the position is open, commodity futures can be collaterized, earning substantial interests, dividends, and/or capital gains on the mandate that is not used to margin the contracts. Fourth, commodity futures present characteristics (high liquidity, complete transparency, and low transaction costs) that may make them more attractive than alternative asset classes such as hedge funds. For these reasons, commodity futures could be used to enhance traditional portfolio strategies. Jensen, Johnson, and Mercer (2002) for example show that by tactically investing in (shorting) commodity futures in periods of rising (falling) interest rates, asset managers could enhance the performance of a portfolio of unmanaged commodity futures. Similarly Vrugt, Bauer, Molenaar, and Steenkamp (2004) successfully develop a timing strategy in commodity futures markets that is based on past information. On a less positive note, commodity futures generate a return that is slightly lower than that of equities for a risk that is slightly higher and thus offer risk return characteristics that make them undesirable as stand alone investments (Edwards and Park, 1996; Jensen, Johnson, and Mercer, 2000) Traditionally, commodity prices have been considered too vola...