Evaluating Correlation Breakdowns During Periods of Market Volatility

Abstract

Financial market observers have noted that during periods of high market volatility, correlations between asset prices can differ substantially from those seen in quieter markets. For example, correlations among yield spreads were substantially higher during the fall of 1998 than in earlier or later periods. Such differences in correlations have been attributed either to structural breaks in the underlying distribution of returns or to "contagion" across markets that occurs only during periods of market turbulence. However, we argue that the differences may reflect nothing more than time-varying sampling volatility. As noted by Boyer, Gibson, and Loretan (1999), increases in the volatility of returns are generally accompanied by an increase in sampling correlations even when the true correlations are constant. We show that this result is not just of theoretical interest: When we consider quarterly measures of volatility and correlation for three pairs of asset returns, we find that the theoretical relationship can explain much of the movement in correlations over time. We then examine the implications of this link between measures of volatility and correlation for risk management, bank supervision, and monetary policy making.

Selecting copulas for risk management

“…Second, we add to the literature on diversification breakdown (see e.g. Loretan and English, 2000;Campbell et al, 2002;Ang and Chen, 2002), as we find that the traditional correlation approach overstates diversification benefits, most notably for assets with a low or negative correlation. Third, we provide straightforward tests for the fit of copulas, that are easy to implement in comparison with Fermanian (2005) and Chen et al (2004).…”

Contagion in the Presence of Stochastic Interdependence

“…However, American banks accounted for nearly thirty percent of Philippine liabilities on the eve of the crisis. 19 By contrast, for example, in September 1997 the Malaysian government banned short selling on equity markets and imposed restrictions on forward sales of the ringgit.…”

International Equity Correlations, Integration and Contagion

“…They found mixed evidence of changing correlations through time but strong evidence that correlations increase a lot when the volatility of the U.S. market is high. Loretan and English (2000) also documented higher than average correlations during periods of higher than average volatility but cautioned against concluding that the correlation structure had changed.…”