Correlation Risk

31 Pages Posted: 7 Nov 2007 Last revised: 3 Nov 2008

See all articles by C. N. V. Krishnan

C. N. V. Krishnan

Case Western Reserve University - Department of Banking & Finance

Ralitsa Petkova

Case Western Reserve University - Department of Banking & Finance

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

Date Written: September 9, 2008

Abstract

Investors hold portfolios of assets with different risk-reward profiles for diversification benefits. Conditional on the volatility of assets, diversification benefits can vary over time depending on the correlation structure among asset returns. The correlation of returns between assets has varied substantially over time. To insure against future "low diversification" states, investors might demand securities that offer higher payouts in these states. If this is the case, then investors would pay a premium for securities that perform well in regimes in which the correlation is high. We empirically test this hypothesis and find that correlation carries a significantly negative price of risk, after controlling for asset volatility and other risk factors.

Keywords: Asset Pricing, Correlation, Time-varying Correlation, Price of Correlation Risk

JEL Classification: G12

Suggested Citation

Krishnan, C. N. V. and Petkova, Ralitsa and Ritchken, Peter H., Correlation Risk (September 9, 2008). Available at SSRN: https://ssrn.com/abstract=1027479 or http://dx.doi.org/10.2139/ssrn.1027479

C. N. V. Krishnan (Contact Author)

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
PBL 363
Cleveland, OH 44106-7235
United States
216-368-2116 (Phone)

HOME PAGE: http://weatherhead.case.edu/faculty/c-n-v-krishnan

Ralitsa Petkova

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)

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