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The Correlation Structure of Unexpected Returns in U.S. Equities


  • R. Brian Balyeat
  • Jayaram Muthuswamy


We examine the correlations between unexpected market moves and unexpected equity portfolio moves conditional on market performance. We derive unexpected returns from a two-stage regime switching model. The model allows for time-varying expected returns where the market portfolio alone dictates the regime switching process. Portfolios exhibit a natural hedge where correlations during extreme unexpected market downturns are generally negative. During unexpected market upswings, correlations increase. Using the unconditional analysis would lead to overhedging during market downturns and underhedging during market upswings. The adjustments to the unconditional hedging strategy conditional on extreme market movements frequently exceed ±10%. Copyright (c) 2009, The Eastern Finance Association.

Suggested Citation

  • R. Brian Balyeat & Jayaram Muthuswamy, 2009. "The Correlation Structure of Unexpected Returns in U.S. Equities," The Financial Review, Eastern Finance Association, vol. 44(2), pages 263-290, May.
  • Handle: RePEc:bla:finrev:v:44:y:2009:i:2:p:263-290

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    Cited by:

    1. Massimo Guidolin, 2013. "Markov switching models in asset pricing research," Chapters,in: Handbook of Research Methods and Applications in Empirical Finance, chapter 1, pages 3-44 Edward Elgar Publishing.

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