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.

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