We examine the correlations between unexpected market moves and unexpected equity portfolio moves conditional on market performance. We derive unexpected returns from a two-stage regime switching model. The model allows for time-varying expected returns where the market portfolio alone dictates the regime switching process. Portfolios exhibit a natural hedge where correlations during extreme unexpected market downturns are generally negative. During unexpected market upswings, correlations increase. Using the unconditional analysis would lead to overhedging during market downturns and underhedging during market upswings. The adjustments to the unconditional hedging strategy conditional on extreme market movements frequently exceed ±10%. Copyright (c) 2009, The Eastern Finance Association.
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Article provided by Eastern Finance Association in its journal Financial Review.