Testing and Valuing Dynamic Correlations for Asset Allocation

48 Pages Posted: 15 Sep 2008

See all articles by Robert F. Engle

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Ric Colacito

University of North Carolina Kenan-Flagler Business School; NBER

Date Written: October 17, 2005

Abstract

We evaluate alternative models of variances and correlations with an economic loss function. We construct portfolios to minimize predicted variance subject to a required return. It is shown that the realized volatility is smallest for the correctly specified covariance matrix for any vector of expected returns. A test of relative performance of two covariance matrices is based on Diebold and Mariano (1995). The method is applied to stocks and bonds and then to highly correlated assets. On average dynamically correct correlations are worth around 60 basis points in annualized terms but on some days they may be worth hundreds.

Keywords: GARCH, DCC, Forecast Evaluation

Suggested Citation

Engle, Robert F. and Colacito, Riccardo, Testing and Valuing Dynamic Correlations for Asset Allocation (October 17, 2005). Journal of Business and Economic Statistics, Vol. 24, N. 2,, pp. 238-253, April 2006. Available at SSRN: https://ssrn.com/abstract=1267010

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

Riccardo Colacito (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

HOME PAGE: http://drric.web.unc.edu/

NBER ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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