Commodity Investing Are There Potential Risk Reduction essay

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Commodity Investing

Are there potential risk reduction and diversification opportunities in adding commodities to a Norwegian investor's asset portfolio?

Recent global economic turmoil has inspired investors all over the globe to look for ways to protect their portfolios and to continue to make them grow despite a weak economy. Investments in commodities have been suggested as a solid hedge against future turmoil in the markets. The question is whether this is good advice or not for investors of all types and operating in different home economies. It is difficult to make a suggestion that will work for every investor and in all parts of the world. Therefore, the potential for commodity investing as a hedge against future instability is a question that must be answered for every country in the world on an individual investor basis. This research will explore whether commodity futures can be added to the portfolios of a Norwegian Investors as a means to reduce risk and to diversify opportunities for growth in the future.

1.1 Background of the Problem

Several reasons exist for this sudden interest in commodity markets. With fluctuations and market uncertainty on a global scale, diversification and risk reduction have become key topics of interest. Investors are now exploring all types of investments as potential options. Commodities can be volatile, but so can stocks, bonds, and other investments in the current global economic climate. Commodities can provide high returns, but they also carry high risk as well. Commodities are not traditionally considered the investment of choice for those that are not afraid to take risks. In some markets, commodities are negatively correlated with bonds, but show very little correlation with stocks. In these markets commodities can be an excellent diversification tool (Stoll and Whaley, 2010). However, to what extent this is true in other market situations is the question that must be asked in order to understand the importance and roll of commodities in creating a balanced and diversified portfolio.

Li, Zhang, and Du (2011) addressed a similar issue concerning commodity- equity correlation. Their research differed from other researchers of the same topic in that they examined both short-term fluctuations and long-term trends. For this reason, their research would pertain to a greater variety of investors. They found that when volatility increases in equity markets it also causes an upward spike in commodity futures. Their findings demonstrated that commodity futures are volatile in the short run, but if one looks at long run trends, commodities appear to be less volatile. This would suggest that whether one goes short or long in their investment strategy can be a determing factor in whether commodities are a smart investment.

Chueng and Miu (2010) also explored the diversification benefits of commodity futures. They found that although literature supports the diversification benefits of commodity futures. Based their research on findings, no empirical work had been performed to support these opinions. They surmise that due to a lack of empirical evidence claims that commodity futures have benefits for diversification are unfounded. Their study asked several questions that are relevant to the present research study. They asked, first, whether diversification benefits are statistically significant and to what extent. They explored the resource-based economy of Canada and the effect of adding commodities to their portfolio. They found in their literature review that correlations exist between international equity returns more so during bear markets than in bull markets. They wanted to find out if the same types of switching regimes exist in commodity futures. They surmised that when investors are in a bearish market at home they will receive lower diversification benefits from International investments. They wanted to find out if the commodity futures would have the same or similar switching behavior. They also explored what types of investor should hold commodities.

According to Rafiee (2011), the correlation between the commodities market and other types of investment tools has been a topic of study by many researchers. Rafiee explored numerous studies on the topic. The overall conclusion was that the correlations, both negative and positive, differed from country to country. One cannot make a general statement that would apply to every situation around the world. Rafiee's study also found that certain sectors can have a greater impact on correlation between commodities and other stocks, depending on the nature of the economy. Given these differences, it is difficult to make a generalization that will hold true for every situation around the world. Each country must be taken on a case by case basis, and in accordance with consideration of their major products and services.

Rafiee's findings concur with those of Chueng and Miu, as well as those of Li, Zhang, and Du, The market conditions, major products, and the individual situation of the investor all have an impact on whether commodities represent a suitable investment instrument for diversification and risk management.

1.2 Discussion of the Problem

As one can see, whether commodities futures are an excellent strategy to hedge against risk and to provide diversification to portfolios is not an easy question to answer. Many factors must be considered in making this investment decision. As one can see, the economy of the home country plays a significant role in the effectiveness of a commodity-based diversification strategy. To launch a comprehensive, all-encompassing study that included results from different countries would be a difficult task. Not only would it be a difficult task, the results of such a study would not provide an accurate picture of the effects of commodity investment on various markets and situations. Advice based on such a study would not result in advice for the investor. For this reason, studies have focused on a certain country as the basis for this study. This is a better approach to this research question, but it too has caveats. The first is that the results obtained for one country do not necessarily apply to another.

Commodities are an interesting topic in the Norwegian economy. This is because the Norwegian economy depends on a commodity as a major income producer. Norway's largest economic sector lies in oil products and other industries that are intertwined in this industry, such as refining and shipping. Volatility in the oil industry has a major effect on the health of the Norwegian economy. This makes commodity investing an important topic for those who wish to obtain a portfolio on the Norwegian Stock Exchange.

Lately, Norway's, oil industry has been called a "sunset industry" (Karasu, 2009). Norway gained rights to control North Sea oil in 1963. Since that time it has been able to establish huge oil fields and become one of the top world oil producers. However, it seems that the oil wells are beginning to decline in production and the North Sea seems to have reached its capacity for production. Norway needs another big oil strike or the oil industry may be on a decline, according to Karasu. If this happens, it could have a devastating effect on the Norwegian economy that has become dependent upon oil to support a growing sovereign nation.

Conclusions are mixed as to whether diversification can be achieved through commodity futures for the reasons previously mentioned. Rafiee's performed a study that used quantitative methods to determine if commodities were an acceptable strategy for investors in Sweden. This study concluded that the commodities were not an acceptable risk reduction strategy in the Swedish markets because correlations were inconsistent, at best. Commodities were not the sole answer to risk reduction in portfolios containing stocks on the Swedish market. This research will explore a similar set of research questions, only it will focus on the oil commodity-based market of Norway.

1.3 Contribution

This study will investigate how the commodity market correlates to the Norwegian stock market and will explore various explanations for its findings. The risk tolerance of the investor will play a significant role in determining whether the investor utilizes commodities as a diversification strategy or whether they choose other options. This study will assume that home bias will define the set of investors for this study. That is to say that Norgwegian investors will hold a majority of their portfolio in Norwegian stocks.

This study will contribute to the knowledge base on commodity investment tools by exploring their usefulness in a commodity-based economy that depends largely on oil as its major product. The impact of the oil industry on whole market volatility will be further discussed in the literature review. The Norwegian market is a unique world market due to its dependence on primarily two major product categories, oil and shipping. It will fill the gap in knowledge by answering how commodities will perform as a diversification tool in a market that is heavily commodity based, and more subject to market shocks do to its size and dependence on these tow key industries

1.4 Research Questions

This study will explore the following research questions.

1. How does the Norwegian stock market correlate with the commodity market?

2. Does a correlation exist between the Norwegian stock…[continue]

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