Does Expectation of Correlation Breakdown in Financial Market Fulfill Itself?

This paper develops a model appeared in the literature whose focus was the way rational risk averse investors anticipate the correlation breakdowns of asset returns in periods of excess demand. That model analysed the dynamics of the “expected” returns of the risky asset, and their consistency with empirical evidence. However, the same model did not provide any evidence on actual correlation generated by the dynamics of returns. A model to link asset returns to excess demand is required to analyse the implied correlation between the securities traded. In this work we estimate such a model. Results confirm that the expected and ex-post correlation tend to move closely. In other words a self-fulfilling prophecy about correlation breakdown can take place, even when rational agents dominate the financial market.