Asset Allocation Models and Market Volatility

Posted: 29 Jun 2001

See all articles by Eric Jacquier

Eric Jacquier

Boston University School of Management; HEC Montreal - Department of Finance

Alan J. Marcus

Boston College - Department of Finance

Abstract

Asset allocation and risk management models all assume at least short-term stability of the covariance structure of asset returns, but actual covariance and correlation relationships fluctuate dramatically. Moreover, correlations tend to increase in volatile periods, which reduces the power of diversification when it might most be desired. We propose a framework to both explain these phenomena and to predict changes in correlation structure. We model correlations between assets as resulting from the common dependence of returns on a marketwide factor. Through this link, an increase in market volatility increases the relative importance of systematic risk compared with the unsystematic component of returns. The increase in the importance of systematic risk results, in turn, in an increase in asset correlations. We report that a large portion of the variation in correlation structures can be attributed to variation in market volatility. Moreover, market volatility contains enough predictability to construct useful forecasts of covariance.

Suggested Citation

Jacquier, Eric and Marcus, Alan J., Asset Allocation Models and Market Volatility. Financial Analysts Journal, Vol. 57, No. 2, March/April 2001. Available at SSRN: https://ssrn.com/abstract=266675

Eric Jacquier (Contact Author)

Boston University School of Management ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, QC H3T 2A7
Canada

Alan J. Marcus

Boston College - Department of Finance ( email )

Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)

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