The charts above display the prices for different commodities relative to each other.
Commodities are predominantly traded as futures contracts. There are a handful of exchanges that cover most of trading volume. They include the Intercontinental Exchange (ICE), the Chicago Mercantile Exchange (CME), the COMEX, the Chicago Board of Trade (CBOT), and the New York Mercantile Exchange (NYMEX). All these exchanges but the first one are owned by the CME Group.
A commodity futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price on a specific date in the future. Future contracts are either cash-settled or physically delivered upon the expiry date of the contract. When a contract is cash-settled, the net cash position of the contract on the expiry date is transferred between the buyer and the seller. In physical delivery, the seller is required to provide the asset at the defined time and place - and the buyer must receive it. However, in order to avoid settlement, most futures contracts are actually offset or rolled-over prior to expiration. When the forward curve is in contango, rolling-over can induce signifant cost. For this reason, in order to get exposure to commodities, long-term investors often choose to invest in equities rather than in futures contracts.
The chart above shows a heat map depicting the correlation coefficients among various commodities. Each commodity is represented on both the x and y axes, with intersections indicating the strength and direction of their correlation. A correlation coefficient of +1 signifies a perfect positive correlation, suggesting that two commodities moved in the same direction during the specified time window. On the other hand, a coefficient of -1 signifies that the commodities moved in opposite directions. Colors range from deep blue, indicating a negative correlation, to bright red, signifying a strong positive correlation.
The correlation coefficient is important to consider for diversification because it helps investors assess the potential benefits of including different assets in their portfolios. Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
The minimum spanning tree (MST) simplifies the data from the correlation matrix above by retaining only the strongest correlations between the commodities. If two commodities are connected, it means that they are positively correlated and that they tend to move in tandem. By analyzing the structure of the MST, one can identify clusters of commodities that move together. This visual tool is especially beneficial when considering commodity portfolio diversification. In fact, Marti, Gautier, et al. (2017) found that the optimal Markowitz portfolio is located at the outskirts of the tree and that the tree shrinks during a crisis.
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