The Misleading Value of Measured Correlation
Wilmott, Volume 2012, Issue 62, pages 64-73, November 2012
10 Pages Posted: 15 Feb 2017
Date Written: 2012
Within the framework of the financial industry, when representing relationships between assets, correlation is typically used. However, academics have long since questioned this method due to the plethora of issues that plague it. Indeed, it is thought that cointegration is a natural replacement in some of the cases as it is able to represent the physical reality of these assets better. However, despite this general academic consensus, financial practitioners refuse to accept cointegration as a better tool, or even the lesser of two evils. This technical report attempts to explain this bias, specifically focusing on the various consequences of model selection considering the new and challenging regulatory environment and suggests a practical replacement hybrid alternative to both cointegration and correlation.
Keywords: correlation; cointegration; mean reversion; cointelation
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