The Impact of Large Changes in Asset Prices on Intra-Market Correlations in the Domestic and International Markets

Abstract

This paper considers the impact and implications of "large" changes in asset prices on the intra-market correlations in the domestic and international markets. Assuming that asset returns are normally-distributed, we show that the absolute magnitude of the correlation, conditional on a change greater than or equal to a given absolute size in one of the variables, is monotonically increasing in the magnitude of that absolute change. We present empirical tests using domestic and international-market data that support this theoretical result. These results have significant implications for hedging interest rate risk, tests of asset pricing models, Roll's R 2 concern with the explanatory power of financial asset pricing models, and the implementation of the value-at-risk concept.