Movements and Co-Movements Across European Asset Classes: Portfolio Allocation and Policy Implications

Abstract

This paper studies the impact of changes in the dynamic of correlation coefficients between asset returns on portfolio choices. Using weekly data from February 2002 to October 2011 on four different European asset classes, we obtain three main results. Firstly, we show that the 2007-2009 global demand collapse and the European sovereign debt crisis have largely affected the dynamic of correlation coefficients between European asset returns. Reductio ad absurdum, we observe that diversification can be implemented intra-class in the post-Lehman world. Secondly, in a dynamic ex-post and ex-ante mean-variance optimization (MVO) framework, we show that “stressed sovereign assets” (e.g. Greek and Italian Government Bonds) are less desirable. Thirdly, in the context of consumption-based asset pricing, we find that the resulting ex-post and ex-ante dynamic allocation reflects the investor’s insurance motive. We conclude by arguing that the resulting allocation might have strong implications for policymakers.

Keywords: time-varying correlation coefficients, mean-variance optimization, sovereign crisis, stressed assets

JEL Classification: C13, G12, G15, E44