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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Keywords Bivariate Student-tr, correlation, exceedance correlation, truncated correlation
JEL Portfolio Choice; Investment Decisions (jel G11), Information and Market Efficiency; Event Studies (jel G14)
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Series ERIM Top-Core Articles
Journal Journal of Empirical Finance
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