Swedish Equity Sectors Risk Management with Commodities : Revisiting dynamic conditional correlations and hedge ratios

Abstract: The purpose of this study is to investigate changes in dynamic conditional correlations between Swedish equity sector indices and commodities using oil, gold, copper and a general commodity index. Additionally the purpose is to evaluate which of the two methods, DCC- GARCH or GO-GARCH that is more efficient in estimating correlation for hedge ratio calculation. Daily data on the FTSE30 index of Sweden and its sector indices have been studied between the years 1994 and 2017. A DCC-GARCH (1,1) and GO-GARCH (1,1) model with one autoregressive term AR(1) using multivariate Student t- and Multivariate Affine Negative Inverse Gaussian distribution were used to estimate conditional correlations. Correlations between Swedish FTSE30, its sector indices and commodities are considerably lower than previous research has found American or emerging markets correlation with commodities to be. This suggests better diversification opportunities with commodities for the Swedish market. Optimal hedge ratios (OHR) was calculated and back tested using a rolling window analysis with 1000 days forecast length and 20 days re-estimation window and evaluated using a calculated hedge effectiveness index (HE). Determined by HE, copper is the best hedge for the Swedish composite FTSE30 and sector indices using conditional correlation from the GO-GARCH during the data period. Gold is considered as a semi-strong safe haven due to its negative correlation with all sectors. Additionally, this study identifies a temporarily large increase in the correlation between the Swedish equities sectors and composite index with commodities around the years 2015/2016. This study also emphasizes the difference between stressful and calm periods in the market.