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Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities

Author

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  • Zintle Twala

    (Department of Economics, University of Pretoria, Pretoria, South Africa)

  • Riza Demirer

    (Department of Economics & Finance, Southern Illinois University Edwardsville, Edwardsville, USA)

  • Rangan Gupta

    (Department of Economics, University of Pretoria, Pretoria, South Africa)

Abstract

Time-varying correlations have broad implications in asset pricing, portfolio management and hedging. Numerous studies in the literature have found that the change in correlations is mainly related to the size of market movements, hence volatility. However, recent research finds that correlations varying over time do not necessarily imply that correlations depend on the size of markets movements, but that the effect of market movements is amplified in times of high financial distress, characterised by low liquidity. This paper seeks to investigate the effect of liquidity on time-varying correlations among different asset classes, namely stocks, corporate bonds and commodities. Applying regression analysis with structural breaks to correlations estimated via a rolling-window approach, we show that liquidity indeed has a significant effect on the time-variation in asset correlations, particularly in the case of how bond returns comove with other asset classes. We observe that higher liquidity risk is associated with lower correlation of bond returns with stocks as well as commodities. Our findings suggest that measures of liquidity risk can improve models of correlations and potentially help improve the effectiveness of risk management strategies during periods of turbulence.

Suggested Citation

  • Zintle Twala & Riza Demirer & Rangan Gupta, 2018. "Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities," Working Papers 201808, University of Pretoria, Department of Economics.
    • Handle: RePEc:pre:wpaper:201808
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    1. Badshah, Ihsan & Demirer, Riza & Suleman, Muhammad Tahir, 2019. "The effect of economic policy uncertainty on stock-commodity correlations and its implications on optimal hedging," Energy Economics, Elsevier, vol. 84(C).
    2. Urom, Christian & Anochiwa, Lasbrey & Yuni, Denis & Idume, Gabriel, 2019. "Asymmetric linkages among precious metals, global equity and bond yields: The role of volatility and business cycle factors," The Journal of Economic Asymmetries, Elsevier, vol. 20(C).

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    More about this item

    Keywords

    Conditional correlation; Asset Classes; Liquidity and Volatility;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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