Correlation Breakdown and the Influence of Correlations on VaR

Abstract

The correlations among assets returns is one of the key components in the construction of a diversified portfolio. It has been observed though that in time of great distress, when a drop in financial markets occurs, correlations tend to increase. As a consequence, the diversification effect is diminished when it is most needed for protecting investors from large losses. In the present work, we provide a method to characterise and measure the breakdown of correlations. We show to which extent the diversification benefit is expected to be reduced and how worst case correlations can augment standard VaR calculations. Finally, we provide a pragmatic way to identify and correct high impact model misspecifications in existing VaR models.

Keywords: Financial crisis, VaR, Correlation breakdown, Stock return asymmetries, Portfolio diversification, Financial markets

JEL Classification: C02, C46, C52, C58