Evaluating Correlation Breakdowns During Periods of Market Volatility

33 Pages Posted: 10 Jul 2000

See all articles by Mico Loretan

Mico Loretan

Swiss National Bank

William B. English

Board of Governors of the Federal Reserve System

Date Written: February 2000

Abstract

Financial market observers have noted that during periods of high market volatility, correlations between asset prices can differ substantially from those seen in quieter markets. For example, correlations among yield spreads were substantially higher during the fall of 1998 than in earlier or later periods. Such changes in correlations could reflect changes in the underlying distribution of returns or "contagion" across markets that is present only during periods of market turbulence. However, as noted by Boyer, Gibson and Loretan (1999), increases in the volatility of returns are generally accompanied by an increase in sampling correlations even when the true correlations are constant. We show that this result is not just of theoretical interest: When we consider quarterly measures of volatility and correlation for three pairs of asset returns, we find that the theoretical relationship can explain much of the movement in correlations over time. We then examine the implications of this link between measures of volatility and correlation for risk management, bank supervision, and monetary policy making.

Keywords: Risk management, Conditional Correlation

JEL Classification: G0

Suggested Citation

Loretan, Mico and English, William B., Evaluating Correlation Breakdowns During Periods of Market Volatility (February 2000). Available at SSRN: https://ssrn.com/abstract=231857 or http://dx.doi.org/10.2139/ssrn.231857

Mico Loretan (Contact Author)

Swiss National Bank ( email )

Fraumuensterstr. 8
Zuerich, 8022
Switzerland

William B. English

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-736-5645 (Phone)
202-452-3819 (Fax)

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