The Correlation Structure of Unexpected Returns in U.S. Equities

Posted: 20 Feb 2009

See all articles by R. Brian Balyeat

R. Brian Balyeat

Xavier University - Department of Finance

Jayaram Muthuswamy

Kent State University

Multiple version iconThere are 2 versions of this paper

Date Written: February 16, 2009

Abstract

We examine the correlations between unexpected market moves and unexpected equity portfolio moves conditional on market performance. We derive unexpected returns from a two-stage regime switching model. The model allows for time-varying expected returns where the market portfolio alone dictates the regime switching process. Portfolios exhibit a natural hedge where correlations during extreme unexpected market downturns are generally negative. During unexpected market upswings, correlations increase. Using the unconditional analysis would lead to overhedging during market downturns and underhedging during market upswings. The adjustments to the unconditional hedging strategy conditional on extreme market movements frequently exceed /- 10%.

Keywords: G11, G12

JEL Classification: Large returns, conditional correlation, equity portfolios, diversification, portfolio

Suggested Citation

Balyeat, Ralph Brian and Muthuswamy, Jayaram, The Correlation Structure of Unexpected Returns in U.S. Equities (February 16, 2009). The Financial Review, Vol. 44, No. 2, May 2009, Available at SSRN: https://ssrn.com/abstract=1344741

Ralph Brian Balyeat (Contact Author)

Xavier University - Department of Finance ( email )

3800 Victory Parkway
Cincinnati, OH 45207
United States
513 745-3013 (Phone)
513 745-4383 (Fax)

Jayaram Muthuswamy

Kent State University ( email )

Kent, OH 44242
United States

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