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The Factor-Spline-GARCH Model for High and Low Frequency Correlations

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  • Rangel José Gonzalo
  • Engle Robert F.

Abstract

We propose a new approach to model high and low frequency components of equity correlations. Our framework combines a factor asset pricing structure with other specifications capturing dynamic properties of volatilities and covariances between a single common factor and idiosyncratic returns. High frequency correlations mean revert to slowly varying functions that characterize long-term correlation patterns. We associate such term behavior with low frequency economic variables, including determinants of market and idiosyncratic volatilities. Flexibility in the time varying level of mean reversion improves the empirical fit of equity correlations in the US and correlation forecasts at long horizons.

Suggested Citation

  • Rangel José Gonzalo & Engle Robert F., 2009. "The Factor-Spline-GARCH Model for High and Low Frequency Correlations," Working Papers 2009-03, Banco de México.
    • Handle: RePEc:bdm:wpaper:2009-03
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    More about this item

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • 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
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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