Portfolio stress testing applied to commodity futures
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Portfolio stress testing applied to commodity futures Florentina Paraschiv1 · Stine Marie Reese1 · Margrethe Ringkjøb Skjelstad1 Received: 28 November 2019 / Accepted: 10 April 2020 © The Author(s) 2020
Abstract In this article, we construct a portfolio of commodity futures which mimics the Dow Jones Commodity Index and perform an extensive stress testing exercise with a focus on hybrid scenarios. The increased volume of investments in commodities as financial instruments over the last decades underline the importance of a more thorough framework for stress testing of related portfolios. Our study is the first to show comparatively the marginal impact of the model choice for portfolio components versus the marginal role of tail dependence on the portfolio profit and loss in stress testing exercises. We model the distribution of returns of portfolio components with an asymmetric ARGARCH model combined with Extreme Value Theory for extreme tails, and employ multivariate copula functions to model the time-varying joint dependence structure. Our study reveals that indeed, for a realistic stress test, a special attention should be given to the tail risk in individual commodity returns as well as to tail correlations. We also draw conclusions about parameter risk persistent in stress testing exercises. Finally yet importantly, in line with Basel IIIb, the study highlights the importance of using forward-looking hybrid and hypothetical scenarios over historical scenarios. Keywords Stress testing · Commodity futures · Risk measures · Extreme value theory · Copula functions
1 Introduction Financial investments in commodities have grown rapidly over the last decades and became an important asset in portfolios of institutional investors such as pension funds, insurance companies, and hedge funds. The risk associated with weather, storage etc.
Research funded by Adolf Øiens Donasjonsfond, “Energizing new Computional Frontiers” and by the Isaac Newton Institute (University of Cambridge) in the context of the programme “The mathematics of energy systems”, EPSRC Grant Number EP/R014604/1.
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Florentina Paraschiv [email protected] NTNU Business School, Norwegian University of Science and Technology, 7491 Trondheim, Norway
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led to the rise of commodity indices in the early 2000s, providing a hedge opportunity for commodity producers. The volumes of exchange-traded derivatives became 20 to 30 times higher than the physical production of many commodities (Silvennoinen and Thorp 2013; Paraschiv et al. 2015). The vivid interest in this asset class might be attributed to the perceived opinion that commodities show low correlation with traditional assets, and thus, provide diversification benefits in a mixed-asset portfolio (Bhardwaj et al. 2015; Gorton and Rouwenhorst 2006; Paraschiv et al. 2015). The empirical analyses in Silvennoinen and Thorp (2013) and Daskalaki and Skiadopoulos (2011) show increased integration of commodity and financial markets, with higher correlation, especially in bea
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