Commodity correlation risk

Abstract

It is widely observed that primary commodity prices comove. A parallel literature asserts that correlation risk matters for financial returns. Our novel study connects these topics and presents evidence that commodity correlation risk is both non-constant and important for returns. We reconsider therefore the relationship between primary commodities, risk and macro fundamentals, utilising methods that account for parameter uncertainty and stochastic volatility. We show that correlation risk is positively related to commodity returns and the strongest impact of risk upon return is more recent. We also demonstrate that commodity correlation risk is strongly counter-cyclical, correlation risk predicts returns, our risk measure is unrelated to other risk/uncertainty measures, and that correlation risk is linked to commodity financialization.