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Evaluating "correlation breakdowns" during periods of market volatility

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  • Mico Loretan
  • William B. English

Abstract

Financial market observers have noted that during periods of high market volatility, correlations between asset prices can differ substantially from those seen in quieter markets. For example, correlations among yield spreads were substantially higher during the fall of 1998 than in earlier or later periods. Such differences in correlations have been attributed either to structural breaks in the underlying distribution of returns or to "contagion" across markets that occurs only during periods of market turbulence. However, we argue that the differences may reflect nothing more than time-varying sampling volatility. As noted by Boyer, Gibson and Loretan (1999), increases in the volatility of returns are generally accompanied by an increase in sampling correlations even when the true correlations are constant. We show that this result is not just of theoretical interest: When we consider quarterly measures of volatility and correlation for three pairs of asset returns, we find that the theoretical relationship can explain much of the movement in correlations over time. We then examine the implications of this link between measures of volatility and correlation for risk management, bank supervision, and monetary policy making.

Suggested Citation

  • Mico Loretan & William B. English, 2000. "Evaluating "correlation breakdowns" during periods of market volatility," International Finance Discussion Papers 658, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:658
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    References listed on IDEAS

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    1. Eichengreen, Barry & Rose, Andrew K & Wyplosz, Charles, 1996. "Contagious Currency Crises," CEPR Discussion Papers 1453, C.E.P.R. Discussion Papers.
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    3. Kristin J. Forbes & Roberto Rigobon, 2002. "No Contagion, Only Interdependence: Measuring Stock Market Comovements," Journal of Finance, American Finance Association, vol. 57(5), pages 2223-2261, October.
    4. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
    5. Bruno Solnik & Fran├žois Longin, 1998. "Correlation Structure of International Equity Markets During Extremely Volatile Periods," Working Papers hal-00599996, HAL.
    6. Fran├žois, LONGIN & Bruno, SOLNIK, 1998. "Correlation Structure of International Equity Markets During Extremely Volatile Periods," Les Cahiers de Recherche 646, HEC Paris.
    7. Spanos,Aris, 1986. "Statistical Foundations of Econometric Modelling," Cambridge Books, Cambridge University Press, number 9780521269124, May.
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    Keywords

    Stock market ; Risk management;

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