An Irreversible Change of Correlations in the US Equities Market and Difficulties in Using the Information

Masahiko Egami, Yuki Shigeta and Katsutoshi Wakai

Discussion papers from Graduate School of Economics , Kyoto University

Abstract: This study statistically confirms the change of correlations across industries in the United States equities market in the financial crisis of 2007?2008. We use the regime-switching framework to identify the phenomenon and to study whether investors can use information about the structural change effectively in facing another crisis of that magnitude. To capture the irreversible structural change in the financial crisis and to separate it from the recurring boom?recession switches, we introduce two Markov chains and succeed in identifying these two different market movements. Our simulations of asset allocation demonstrate that the informed investor who knows the timing of the structural change can outperform uninformed investors from the viewpoint of mean-variance efficiency. However,our simulations also show that if the investor only assumes the possibility of the structural change and does not know its timing, then the result is not the same, which reveals the difficulty in detecting when the change actually occurs.

Keywords: stock market returns; regime-switching models; structural change; correlation risk; EM algorithm; financial crisis. (search for similar items in EconPapers)
JEL-codes: C22 G10 (search for similar items in EconPapers)
Pages: 43
Date: 2016-02
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Persistent link: https://EconPapers.repec.org/RePEc:kue:epaper:e-15-013

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