Volatility Dependent Dynamic Equicorrelation

Adam Clements, Ayesha Scott () and Annastiina Silvennoinen
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Ayesha Scott: QUT

No 111, NCER Working Paper Series from National Centre for Econometric Research

Abstract: This paper explores the link between equicorrelation and market volatility. The standard equicorrelation model is extended to condition the correlation process on volatility, based on the Volatility Dependent Dynamic Conditional Correlation class of model. Analysis of this relationship is presented in two empirical examples, with both a national and international context studied. The various correlation forecasting methods are compared using a portfolio allocation problem, specifically the global minimum variance portfolio and Model Confidence Set. Relative economic value is also considered. In the case of U.S. equities, overall the equicorrelation models perform well and the inclusion of volatility in the equicorrelations performs well against the standard equicorrelated model. For large portfolios a simple specification such as constant conditional correlation seems sufficient, particularly during periods of market calm. Internationally, the equicorrelated models perform poorly against the dynamic conditional corelation-based models. Reasoning is provided that the information pooling advantage equicorrelation has over dynamic conditional correlation models is eroded when forecasting correlations between indices, rather than equities. In both applications, there appears to be no statistically significant difference between the standard equicorrelation model and the Volatility Dependent class although in general a volatility dependent structure leads to lower portfolio variances.

Keywords: Volatility; multivariate GARCH; equicorrelation; portfolio allocation (search for similar items in EconPapers)
JEL-codes: C22 G11 G17 (search for similar items in EconPapers)
Date: 2016-05-11
New Economics Papers: this item is included in nep-ecm and nep-ets
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