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How past market movements affect correlation and volatility

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  • Becker, Christoph
  • Schmidt, Wolfgang M.

Abstract

The influence of past stock price movements on correlations and volatilities is essential for understanding diversification and contagion in financial markets. We develop a model that makes the influence of past returns, aggregated into driving factors for correlations and volatilities, explicit. Employing information about recent market movements leads to a more realistic model for the behavior of stock returns in a downturn than conventional models. Our approach offers a fresh perspective on the behavior of stock markets, and provides an alternative to the concept of exceedance correlation. For a US investor we find that international diversification in China or the UK remains beneficial in a crisis.

Suggested Citation

  • Becker, Christoph & Schmidt, Wolfgang M., 2015. "How past market movements affect correlation and volatility," Journal of International Money and Finance, Elsevier, vol. 50(C), pages 78-107.
    • Handle: RePEc:eee:jimfin:v:50:y:2015:i:c:p:78-107
    DOI: 10.1016/j.jimonfin.2014.09.003
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    More about this item

    Keywords

    Correlation; Volatility; Financial contagion; Diversification; Exceedance correlation; GARCH models;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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