Increasing correlations or just fat tails?
Increasing correlation during turbulent market conditions implies a reduction in portfolio diversification benefits. We investigate the robustness of recent empirical results that indicate a breakdown in the correlation structure by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the increase in conditional correlation could be a result of assuming conditional normality for the return distribution. When assuming a popular alternative distribution – the bivariate Student-tr – we find significantly less support for an increase in conditional correlation and conclude that this is due to the presence of fat tails when assuming normality in the return distribution.
|Keywords||Bivariate Student-tr, correlation, exceedance correlation, truncated correlation|
|JEL||G11, Portfolio Choice; Investment Decisions (jel), G14, Information and Market Efficiency; Event Studies (jel)|
|Persistent URL||dx.doi.org/10.1016/j.jempfin.2007.01.001, hdl.handle.net/1765/13885|
Campbell-Pownall, R.A.J, Forbes, C.S, Koedijk, C.G, & Kofman, P. (2008). Increasing correlations or just fat tails?. Journal of Empirical Finance, 15(2), 287–309. doi:10.1016/j.jempfin.2007.01.001