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The dynamics of volatility and correlation during periods of crisis: Implications for active asset management

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  • Marcello Esposito

    (Marcello Esposito, Università ‘C. Cattaneo’, Scuola di Economia e Management)

Abstract

The 2007–2008 financial crisis will be remembered for many exceptional facts. Among them, the spectacular increase in stock market’s volatility and correlation. This has been interpreted as a sort of structural break in stock market’s dynamics and a proof of the fallacy of one of the central tenets of financial advisory services: the importance of portfolio diversification. I will show, on the contrary, that this phenomenon is not at all surprising, given the increase in market volatility, and it derives from a very simple dynamic CAPM model. I calibrate the model over the last 20 years and show that it fits very well the observed dynamic of stock markets’ volatility and correlation. Finally, I use the model to investigate if the 2007–2008 environment should have been detrimental to bottom-up managers and favorable for top-down managers, as far as ‘alpha’ creation is concerned.

Suggested Citation

  • Marcello Esposito, 2016. "The dynamics of volatility and correlation during periods of crisis: Implications for active asset management," Journal of Asset Management, Palgrave Macmillan, vol. 17(3), pages 135-140, May.
    • Handle: RePEc:pal:assmgt:v:17:y:2016:i:3:d:10.1057_jam.2016.5
    DOI: 10.1057/jam.2016.5
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    References listed on IDEAS

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    1. Bekaert, Geert & Hodrick, Robert J. & Zhang, Xiaoyan, 2012. "Aggregate Idiosyncratic Volatility," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 47(6), pages 1155-1185, December.
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    3. Sandoval, Leonidas & Franca, Italo De Paula, 2012. "Correlation of financial markets in times of crisis," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 391(1), pages 187-208.
    4. Bartram, Söhnke M. & Bodnar, Gordon M., 2009. "No place to hide: The global crisis in equity markets in 2008/2009," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1246-1292, December.
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