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Changing Correlation and Equity Portfolio Diversification Failure for Linear Factor Models during Market Declines

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  • Alessio Sancetta
  • Steve E. Satchell

Abstract

The paper considers a linear factor model (LFM) to study the behaviour of the correlation coefficient between various stock returns during a downturn. Changing correlation is related to the tail distribution of the driving factors, which is the market for Sharpe's one-factor model. General classes of distribution functions are considered and asymptotic conditions found on the tails of the distribution, which determine whether diversification will succeed or fail during a market decline.

Suggested Citation

  • Alessio Sancetta & Steve E. Satchell, 2007. "Changing Correlation and Equity Portfolio Diversification Failure for Linear Factor Models during Market Declines," Applied Mathematical Finance, Taylor & Francis Journals, vol. 14(3), pages 227-242.
    • Handle: RePEc:taf:apmtfi:v:14:y:2007:i:3:p:227-242
    DOI: 10.1080/13504860600858279
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    References listed on IDEAS

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    1. J. V. Andersen & D. Sornette, 1999. "Have your cake and eat it too: increasing returns while lowering large risks!," Papers cond-mat/9907217, arXiv.org.
    2. A. Sancetta & Satchell, S.E., 2001. "Bernstein Approximations to the Copula Function and Portfolio Optimization," Cambridge Working Papers in Economics 0105, Faculty of Economics, University of Cambridge.
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    Cited by:

    1. Kwon, Oh Kang & Satchell, Stephen, 2018. "The distribution of cross sectional momentum returns," Journal of Economic Dynamics and Control, Elsevier, vol. 94(C), pages 225-241.
    2. Christoffersen, Peter & Langlois, Hugues, 2013. "The Joint Dynamics of Equity Market Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 48(5), pages 1371-1404, October.
    3. Dominik Wied & Matthias Arnold & Nicolai Bissantz & Daniel Ziggel, 2013. "Über die Anwendbarkeit eines neuen Fluktuationstests für Korrelationen auf Finanzzeitreihen," AStA Wirtschafts- und Sozialstatistisches Archiv, Springer;Deutsche Statistische Gesellschaft - German Statistical Society, vol. 6(3), pages 87-103, March.
    4. Florian Stark & Sven Otto, 2020. "Testing and Dating Structural Changes in Copula-based Dependence Measures," Papers 2011.05036, arXiv.org.
    5. Ma, Rong & Zhang, Yin & Li, Honggang, 2017. "Traders’ behavioral coupling and market phase transition," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 486(C), pages 618-627.

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