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On the Link between Volatilities, Regime Switching Probabilities and Correlation Dynamics

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  • Jean-David Fermanian
  • Hassan Malongo

Abstract

When markets are stressed, volatilities and correlations tend to increase jointly, and volatilities often react quicker than correlations. Based on this intuition, we extend the Dynamic Conditional Correlation model (Engle, 2002) in order to check whether the individual volatilities and/or the probabilities that some assets belong to a high/low volatility regime influence their correlation dynamics. We evaluate potential asymmetrical leverage effects too. We apply our methodology to MSCI Developed Markets indexes that cover twenty-three countries. The new models provide better in-sample fits and forecasts of the portfolio return distributions. Therefore, they are valuable frameworks for portfolio allocation and financial risk management.

Suggested Citation

  • Jean-David Fermanian & Hassan Malongo, 2018. "On the Link between Volatilities, Regime Switching Probabilities and Correlation Dynamics," Annals of Economics and Statistics, GENES, issue 131, pages 1-24.
  • Handle: RePEc:adr:anecst:y:2018:i:131:p:1-24
    DOI: 10.15609/annaeconstat2009.131.0001
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    File URL: https://www.jstor.org/stable/10.15609/annaeconstat2009.131.0001
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    More about this item

    Keywords

    Dynamic Correlations; Multivariate GARCH Models; Regime-Switching; Volatility Regimes.;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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