Academic journal article Academy of Accounting and Financial Studies Journal

Crude Oil Hedging with Precious Metals: A Dcc-Garch Approach

Academic journal article Academy of Accounting and Financial Studies Journal

Crude Oil Hedging with Precious Metals: A Dcc-Garch Approach

Article excerpt

INTRODUCTION

The increased association between commodity markets has always attracted the interest of researchers, investors and policymakers. In one of the earlier studies on commodity price movements, Pindyck and Rotemberg (1990) observed a pattern in price movements between unrelated commodities. This finding led to several studies analysing this phenomenon and the debate was further intensified with the financialization of commodity markets during early 2000s. For example, Soytas, Sari, Hammoudeh and Hacihasanoglu (2009) argued that the excess comovement among commodities could be attributed to the similar influence of macroeconomic variables on all commodity markets. Nevertheless, among all commodities, crude oil has acquired unprecedented importance because of its share in the energy sector across nations. Most economies are exceedingly reliant on crude oil for their energy needs and as a result it could result in huge import bills for crude oil importing nations. Besides, such economies could find it difficult to sustain their trade balances because of price fluctuations in international crude oil markets. Therefore, the importance of the commodity markets like crude oil, underlines the need to investigate the crude oil price fluctuations to safeguard the interest of numerous stakeholders.

The uncertainty in crude oil markets may trigger investments in other assets or in hedging instruments like precious metals. For example, Melvin and Sultan (1990) reported that the increase in crude oil prices is usually associated with increased investment in gold. The linkages between crude oil and precious metals like gold may be because reserve portfolios of oil exporting countries generally comprises gold. Tiwari and Sahadudheen (2015) argue that some of the oil importing countries pay through gold and therefore, there exists a relationship between crude oil and gold through import channels. Kanjilal and Ghosh (2017) suggest a lead-lag relationship between crude oil and gold. There is also an evidence of increased investment in gold during the periods of market uncertainty (Jain & Biswal, 2016). Moreover, during financial crisis or periods of high volatility, gold was found to be uncorrelated with other financial assets (Baur & Lucey, 2010; Baur & McDermott, 2010). These properties of gold have also motivated researchers to consider the relationship between crude oil with other precious metals. For example, Sari, Hammoudeh and Soytas (2010) suggested that silver prices are better predictor of oil price movements in comparison to other precious metals. Jain and Ghosh (2013) indicated some dependence between oil prices and precious metals. Bildirici and Turkmen (2015) argue that recent periods of uncertainty have resulted in the renewed relationship between crude oil and precious metal prices.

Motivated by the earlier literature, the primary objective of this study is to investigate the dynamic correlation between crude oil and precious metals (gold, silver, platinum and palladium) using Dynamic Conditional Correlation-Generalized autoregressive conditional heteroscedasticity (DCC-GARCH) approach proposed by Engle (2002). Second, the covariance and variance structure obtained from DCC-GARCH framework were used to generate the hedging ratios and portfolio weights between crude oil and precious metals. Kroner and Sultan (1993) approach was used to construct the hedging ratios and Kroner and Ng (1998) approach was used to construct the portfolio weights. Several authors have used the hedging ratios and portfolio weights to investigate the dynamics between different markets, for example, Baser & Sardorsky (2016), Ku et al. (2007) and Maghyereh et al. (2017). Third, to check the robustness and asymmetric characteristic of the relationship, the investigation was also carried out using Asymmetric DCC.

Rest of the paper is structured as follows: Next section explains the methodology. …

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