Dynamic Correlation or Tail Dependence Hedging for Portfolio Selection
51 Pages Posted: 15 Mar 2011
Date Written: March 15, 2011
We solve for the optimal portfolio allocation in a setting where both conditional correlation and the clustering of extreme events are considered. We demonstrate that there is a substantial welfare loss in disregarding tail dependence, even when dynamic conditional correlation has been accounted for, and vice versa. Both effects have distinct portfolio implications and cannot substitute each other. We also isolate the hedging demands due to macroeconomic and market conditions that command important economic gains. Our results are robust to the sample period, the choice of the dependence structure, and both varying levels of average correlation and tail dependence coefficients.
Keywords: correlation hedging, dynamic portfolio allocation, Monte Carlo simulation, tail dependence
JEL Classification: C15, C16, C51, G11
Suggested Citation: Suggested Citation