We consider Sharpe’s one factor model of asset returns and its extension to K factors in order to explain theoretically why diversification can fail. This model can be used to explain nonlinear dependence amongst the assets in a portfolio. The result is intimately related to the tail distribution of the driving factor, the market. We study these properties for general classes of distribution functions. We find asymptotic conditions on the tails of the distribution which determine whether diversification will succeed or fail in the presence of a market fall. Turning to exact analysis, we characterise the only distribution having constant correlation when the market falls, namely the exponential distribution.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
page. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.