Contemporary and long‐run correlations: A covariance component model and studies on the S&P 500 cash and futures markets

In this article, a multivariate component model for conditional asset return covariance is developed as an extension to the univariate volatility component model of Engle & Lee (1999). The conditional covariance now is decomposed into a long‐run (trend) component and a short‐run (transitory) component. Through the decomposition, relationships like the long‐run correlation and volatility copersistence can be studied solely upon examining the long‐run trend of the conditional covariance. The decomposition also has important implications in studying portfolio hedging problems such as the multi‐period minimum‐variance hedging for long‐term portfolio management. The empirical study in this article focuses on estimating the covariance component structure between the S&P 500 cash and futures markets and their contemporary and long‐run correlation relationship and the volatility copersistence relationship. © John Wiley & Sons, Inc. Jrl Fut Mark 19: 877–894, 1999