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Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities

Zintle Twala (), Riza Demirer () and Rangan Gupta ()
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Zintle Twala: Department of Economics, University of Pretoria, Pretoria, South Africa

No 201808, Working Papers from University of Pretoria, Department of Economics

Abstract: Time-varying correlations have broad implications in asset pricing, portfolio management and hedging. Numerous studies in the literature have found that the change in correlations is mainly related to the size of market movements, hence volatility. However, recent research finds that correlations varying over time do not necessarily imply that correlations depend on the size of markets movements, but that the effect of market movements is amplified in times of high financial distress, characterised by low liquidity. This paper seeks to investigate the effect of liquidity on time-varying correlations among different asset classes, namely stocks, corporate bonds and commodities. Applying regression analysis with structural breaks to correlations estimated via a rolling-window approach, we show that liquidity indeed has a significant effect on the time-variation in asset correlations, particularly in the case of how bond returns comove with other asset classes. We observe that higher liquidity risk is associated with lower correlation of bond returns with stocks as well as commodities. Our findings suggest that measures of liquidity risk can improve models of correlations and potentially help improve the effectiveness of risk management strategies during periods of turbulence.

Keywords: Conditional correlation; Asset Classes; Liquidity and Volatility (search for similar items in EconPapers)
JEL-codes: C22 G10 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-rmg
Date: 2018-02
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