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Evaluating "correlation breakdowns" during periods of market volatility

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  • Mico Loretan
  • William B. English

Abstract

Financial market observers have noted that during periods of high market volatility, correlations between asset prices can differ substantially from those seen in quieter markets. For example, correlations among yield spreads were substantially higher during the fall of 1998 than in earlier or later periods. Such differences in correlations have been attributed either to structural breaks in the underlying distribution of returns or to "contagion" across markets that occurs only during periods of market turbulence. However, we argue that the differences may reflect nothing more than time-varying sampling volatility. As noted by Boyer, Gibson and Loretan (1999), increases in the volatility of returns are generally accompanied by an increase in sampling correlations even when the true correlations are constant. We show that this result is not just of theoretical interest: When we consider quarterly measures of volatility and correlation for three pairs of asset returns, we find that the theoretical relationship can explain much of the movement in correlations over time. We then examine the implications of this link between measures of volatility and correlation for risk management, bank supervision, and monetary policy making.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 658.

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Date of creation: 2000
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Handle: RePEc:fip:fedgif:658

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Keywords: Stock market ; Risk management;

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  1. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  2. Kristin Forbes & Roberto Rigobon, 1999. "No Contagion, Only Interdependence: Measuring Stock Market Co-movements," NBER Working Papers 7267, National Bureau of Economic Research, Inc.
  3. Eichengreen, Barry & Rose, Andrew K & Wyplosz, Charles, 1996. "Contagious Currency Crises," CEPR Discussion Papers 1453, C.E.P.R. Discussion Papers.
  4. Stefan Gerlach & Frank Smets, 1994. "Contagious speculative attacks," BIS Working Papers 22, Bank for International Settlements.
  5. Fran├žois, LONGIN & Bruno, SOLNIK, 1998. "Correlation Structure of International Equity Markets During Extremely Volatile Periods," Les Cahiers de Recherche 646, HEC Paris.
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