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Implied correlation from VaR

  • Cotter, John
  • Longin, Francois

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.

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File URL: http://mpra.ub.uni-muenchen.de/3506/1/MPRA_paper_3506.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 3506.

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Date of creation: 2006
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Handle: RePEc:pra:mprapa:3506
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  1. 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.
  2. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
  3. Campa, J.M. & Chang, P.H.K., 1995. "The Forecasting Ability of Correlations Implied in Foreign Exchange Options," Papers 95-26, Columbia - Graduate School of Business.
  4. Ramchand, Latha & Susmel, Raul, 1998. "Volatility and cross correlation across major stock markets," Journal of Empirical Finance, Elsevier, vol. 5(4), pages 397-416, October.
  5. Longin, Francois M., 2000. "From value at risk to stress testing: The extreme value approach," Journal of Banking & Finance, Elsevier, vol. 24(7), pages 1097-1130, July.
  6. François Longin, 2001. "Extreme Correlation of International Equity Markets," Journal of Finance, American Finance Association, vol. 56(2), pages 649-676, 04.
  7. G. Andrew Karoly & Rene Stulz, . "Why do Markets Move Together? An Investigation of U.S.-Japan Stock Return Comovements," Research in Financial Economics 9603, Ohio State University.
  8. Lin, Wen-Ling & Engle, Robert F & Ito, Takatoshi, 1994. "Do Bulls and Bears Move across Borders? International Transmission of Stock Returns and Volatility," Review of Financial Studies, Society for Financial Studies, vol. 7(3), pages 507-38.
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