Oil and asset classes implied volatilities: Investment strategies and hedging effectiveness.

Abstract

Building on the increased interest in oil prices and other financial assets, this paper examines the dynamic conditional correlations among their implied volatility indices. We then proceed to the examination of the optimal hedging strategies and optimal portfolio weights for implied volatility portfolios between oil and fourteen asset volatilities, which belong to four different asset classes (stocks, commodities, exchange rates and macroeconomic conditions). The results suggest that the oil price implied volatility index (OVX) is highly correlated with the US and emerging stock market volatility indices, whereas the lowest correlations are observed with the implied volatilities of gold and the Euro/dollar exchange rate. Hedge ratios indicate that VIX is the least useful implied volatility index to hedge against oil implied volatility. Finally, we show that investors can benefit substantially by adjusting their portfolios based on the dynamic weights and hedge ratios obtained from the dynamic conditional correlation models, although a trade-off exists between the level of risk reduction and portfolio profitability.