Pitfalls in tests for changes in correlations

Brian H. Boyer, Michael S. Gibson and Mico Loretan
Additional contact information
Michael S. Gibson: https://www.federalreserve.gov/econres/michael-s-gibson.htm

No 597, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Correlations are crucial for pricing and hedging derivatives whose payoff depends on more than one asset. Typically, correlations computed separately for ordinary and stressful market conditions differ considerably, a pattern widely termed \"correlation breakdown.\" As a result, risk managers worry that their hedges will be useless when they are most needed, namely during \"stressful\" market situations. ; We show that such worries may not be justified since \"correlation breakdowns\" can easily be generated by data whose distribution is stationary and, in particular, whose correlation coefficient is constant. We make this point analytically, by way of several numerical examples, and via an empirical illustration. ; But, risk managers should not necessarily relax. Although \"correlation breakdown\" can be an artifact of poor data analysis, other evidence suggests that correlations do in fact change over time, though not in a way that is correlated with \"stressful\" market conditions.

Keywords: Bank management; Risk; Derivative securities (search for similar items in EconPapers)
Date: 1997
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (88)

Downloads: (external link)
http://www.federalreserve.gov/pubs/ifdp/1997/597/default.htm (text/html)
http://www.federalreserve.gov/pubs/ifdp/1997/597/ifdp597.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:597

Access Statistics for this paper

More papers in International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.) Contact information at EDIRC.
Bibliographic data for series maintained by Ryan Wolfslayer ; Keisha Fournillier ().