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Multiple break detection in the correlation structure of random variables

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  • Galeano, Pedro
  • Wied, Dominik

Abstract

Correlations between random variables play an important role in applications, e.g. in financial analysis. More precisely, accurate estimates of the correlation between financial returns are crucial in portfolio management. In particular, in periods of financial crisis, extreme movements in asset prices are found to be more highly correlated than small movements. It is precisely under these conditions that investors are extremely concerned about changes on correlations. A binary segmentation procedure to detect the number and position of multiple change points in the correlation structure of random variables is proposed. The procedure assumes that expectations and variances are constant and that there are sudden shifts in the correlations. It is shown analytically that the proposed algorithm asymptotically gives the correct number of change points and the change points are consistently estimated. It is also shown by simulation studies and by an empirical application that the algorithm yields reasonable results.

Suggested Citation

  • Galeano, Pedro & Wied, Dominik, 2014. "Multiple break detection in the correlation structure of random variables," Computational Statistics & Data Analysis, Elsevier, vol. 76(C), pages 262-282.
    • Handle: RePEc:eee:csdana:v:76:y:2014:i:c:p:262-282
    DOI: 10.1016/j.csda.2013.02.031
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    References listed on IDEAS

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