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Implied correlation from VaR

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  • Cotter, John
  • Longin, Francois

Abstract

Most of the methods used by financial institutions to implement valueat- risk models are based on the multivariate Gaussian distribution with a constant correlation matrix. In this paper we use VaR calculation in a reverse way to imply the correlation between asset price changes. The distribution of implied correlation under normality is also studied in order to take into account any bias and sampling error. Empirical results for US and UK equity markets show that implied correlation is not constant but tends to be higher for long positions than for short positions. This result is statistically significant and can be interpreted as departure from normality. Our test provides a new way – by focusing the tail dependence - to assess the model risk associated with quantitative methods based on normality in asset management and risk management areas.

Suggested Citation

  • Cotter, John & Longin, Francois, 2006. "Implied correlation from VaR," MPRA Paper 3506, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:3506
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    References listed on IDEAS

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    Cited by:

    1. Mittnik, Stefan, 2014. "VaR-implied tail-correlation matrices," Economics Letters, Elsevier, vol. 122(1), pages 69-73.
    2. Zhou, Xinmiao & Qian, Huanhuan & Pérez-Rodríguez, Jorge. V. & González López-Valcárcel, Beatriz, 2020. "Risk dependence and cointegration between pharmaceutical stock markets: The case of China and the USA," The North American Journal of Economics and Finance, Elsevier, vol. 52(C).
    3. Liu, Jinjing, 2023. "A novel downside beta and expected stock returns," International Review of Financial Analysis, Elsevier, vol. 85(C).

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    More about this item

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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