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Increasing correlations or just fat tails?

Rachel A.J. Campbell, Catherine Forbes, Kees G. Koedijk and Paul Kofman
Authors registered in the RePEc Author Service: Rachel A J Pownall (Campbell) ()

Journal of Empirical Finance, 2008, vol. 15, issue 2, 287-309

Abstract: Increasing correlation during turbulent market conditions implies a reduction in portfolio diversification benefits. We investigate the robustness of recent empirical results that indicate a breakdown in the correlation structure by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the increase in conditional correlation could be a result of assuming conditional normality for the return distribution. When assuming a popular alternative distribution - the bivariate Student-tr - we find significantly less support for an increase in conditional correlation and conclude that this is due to the presence of fat tails when assuming normality in the return distribution.

Date: 2008
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Journal of Empirical Finance is currently edited by R. T. Baillie, F. C. Palm, Th. J. Vermaelen and C. C. P. Wolff

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