Can oil diversify away the unpriced risk of a portfolio?
Version of Record online: 8 APR 2011
Copyright © 2011 John Wiley & Sons, Ltd.
International Journal of Finance & Economics
Volume 17, Issue 1, pages 73–88, January 2012
How to Cite
Cifarelli, G. and Paladino, G. (2012), Can oil diversify away the unpriced risk of a portfolio?. Int. J. Fin. Econ., 17: 73–88. doi: 10.1002/ijfe.447
- Issue online: 29 DEC 2011
- Version of Record online: 8 APR 2011
- Oil price dynamics;
- feedback trading;
- multivariate GARCH;
- portfolio allocation
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 subperiods, 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. Copyright © 2011 John Wiley & Sons, Ltd.