On the Time-varying Correlations and Hedging Effectiveness: An Analysis of Crude Oil, Gold, and Stock Market

Abstract

In this paper, we examine the time-varying conditional correlation between international crude oil and gold prices, along with their volatilities, and Indian stock prices, using the DCC-GARCH model. The results suggest that the relationships between stock/oil, stock/gold, stock/oil volatility, and stock/gold volatility are time-varying. We then use the conditional variance and covariance derived from the DCC-GARCH model to measure the optimal portfolio weight and hedge ratios for stock/oil and stock/gold portfolios. Our findings indicate that, to minimize risk without reducing expected returns, investors should hold 37% and 49% of oil and gold, respectively, in their portfolios, relative to stocks. However, there is wide variation in the hedge ratios over time, suggesting that portfolio managers will need to rebalance portfolios frequently. Finally, we analyze correlation coefficients under various deciles of stock market returns, showing that gold can be used as a hedge against stock market declines. Given India's significant improvement in financial indicators, the results of this study will be useful for portfolio managers, risk managers, policymakers, and researchers.