Diversification Meltdown or Just Fat Tails?
Rachel A.J. Pownall
Tilburg University - Department of Finance; Maastricht University - Limburg Institute of Financial Economics (LIFE)
Catherine S. Forbes
Monash University - Department of Econometrics & Business Statistics
Kees C. G. Koedijk
Tilburg University - Department of Finance
The University of Melbourne
EFA 2006 Zurich Meetings
An increase in correlation during turbulent market conditions implies a reduction in the benefits arising from portfolio diversification. Unfortunately, it is exactly then that these benefits are most needed. We investigate the robustness of recent empirical results that indicate correlation breakdown by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the empirical meltdown in diversification could be a result of assuming conditional normally distributed returns. When assuming a popular alternative distribution model - the bivariate Student-t distribution - we find significantly less support for diversification meltdown.
Number of Pages in PDF File: 38
Keywords: Exceedance correlation, Truncated correlation, Bivariate Student-t correlation
JEL Classification: G11, G14working papers series
Date posted: June 14, 2006
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