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Diversification Meltdown or the Impact of Fat tails on Conditional Correlation?

Author

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  • Rachel Campbell
  • Catherine S. Forbes
  • Kees Koedijk
  • Paul Kofman

Abstract

A perceived increase in correlation during turbulent market conditions implies a reduction in the benefits arising from portfolio diversification. Unfortunately, it is exactly then that these benefits are most needed. To determine whether diversification truly breaks down, we investigate the robustness of a popular conditional correlation estimator against alternative distributional assumptions. Analytical results show that the apparent meltdown in the benefits from diversification could be a consequence of assuming normally distributed returns. A more realistic assumption - the bivariate Student-t distribution - suggests that constant correlation may be sustained over the full support of the multivariate return distribution

Suggested Citation

  • Rachel Campbell & Catherine S. Forbes & Kees Koedijk & Paul Kofman, 2003. "Diversification Meltdown or the Impact of Fat tails on Conditional Correlation?," Monash Econometrics and Business Statistics Working Papers 18/03, Monash University, Department of Econometrics and Business Statistics.
    • Handle: RePEc:msh:ebswps:2003-18
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    File URL: http://www.buseco.monash.edu.au/ebs/pubs/wpapers/2003/wp18-03.pdf
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    References listed on IDEAS

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    1. Butler, K. C. & Joaquin, D. C., 2002. "Are the gains from international portfolio diversification exaggerated? The influence of downside risk in bear markets," Journal of International Money and Finance, Elsevier, vol. 21(7), pages 981-1011, December.
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    Cited by:

    1. Marco Sorge, 2004. "Stress-testing financial systems: an overview of current methodologies," BIS Working Papers 165, Bank for International Settlements.
    2. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2007. "Selecting copulas for risk management," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2405-2423, August.
    3. Kole, H.J.W.G. & Koedijk, C.G. & Verbeek, M.J.C.M., 2003. "Stress Testing with Student's t Dependence," ERIM Report Series Research in Management ERS-2003-056-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    4. Albuquerque, Rui & Vega, Clara, 2006. "Asymmetric Information in the Stock Market: Economic News and Co-movement," CEPR Discussion Papers 5598, C.E.P.R. Discussion Papers.
    5. Sorge, Marco & Virolainen, Kimmo, 2006. "A comparative analysis of macro stress-testing methodologies with application to Finland," Journal of Financial Stability, Elsevier, vol. 2(2), pages 113-151, June.
    6. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2006. "Portfolio implications of systemic crises," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2347-2369, August.

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    More about this item

    Keywords

    Conditional correlation; Truncated correlation; Bivariate Student-t correlation.;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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