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

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Author Info

  • 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

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File URL: http://www.buseco.monash.edu.au/ebs/pubs/wpapers/2003/wp18-03.pdf
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Bibliographic Info

Paper provided by Monash University, Department of Econometrics and Business Statistics in its series Monash Econometrics and Business Statistics Working Papers with number 18/03.

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Length: 33 pages
Date of creation: Nov 2003
Date of revision:
Handle: RePEc:msh:ebswps:2003-18

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Keywords: Conditional correlation; Truncated correlation; Bivariate Student-t correlation.;

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Cited by:
  1. 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.
  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. Marco Sorge, 2004. "Stress-testing financial systems: an overview of current methodologies," BIS Working Papers 165, Bank for International Settlements.
  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. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2006. "Portfolio implications of systemic crises," Journal of Banking & Finance, Elsevier, vol. 30(8), pages 2347-2369, August.
  6. 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.

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