This chapter discusses the motivations for seeking exposure to commodity returns, practical issues with obtaining commodity exposure, and the evidence regarding risks and returns to commodity exposure.
There are two primary motivations for seeking exposure to commodity returns: diversification and return enhancement. This section is about diversification as a motive. The exact meaning of diversification depends on how risk is defined. We begin with a discussion of commodities and their diversification with traditional assets.
Commodities are often viewed as an asset class that helps diversify a portfolio of traditional assets (stocks and bonds) through a lack of return correlation between commodities and traditional assets. Here we discuss four reasons why commodity returns may have low correlation with stock prices and bond prices.
First, unlike financial securities, commodities have prices that are not directly determined by the discounted value of future cash flows. Accordingly, commodity prices are not as directly related to changes in forecasted cash flows and changes in market discount rates. Instead, commodity prices are evaluated primarily on forecasts of the commodity's supply and demand. Since commodity prices are driven by different economic fundamentals than are stocks and bonds, they should be expected to have ...