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Are Correlations Constant? Empirical and Theoretical Results on Popular Correlation Models in Finance

60 Pages Posted: 30 Jun 2016 Last revised: 15 Jul 2017

Zeno Adams

University of St. Gallen

Roland Füss

University of St. Gallen - School of Finance

Thorsten W. Glück

European Business School (EBS) Wiesbaden, Germany - Department of Finance, Accounting and Real Estate

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Date Written: July 13, 2017

Abstract

Multivariate GARCH models have been designed as an extension of their univariate counterparts. Such a view is appealing from a modeling perspective but imposes correlation dynamics that are similar to time-varying volatility. In this paper, we argue that correlations are quite different in nature. We demonstrate that the highly unstable and erratic behavior that is typically observed for the correlation among financial assets is to a large extent a statistical artefact. We provide evidence that spurious correlation dynamics occur in response to financial events that are sufficiently large to cause a structural break in the time-series of correlations. A measure for the autocovariance structure of conditional correlations allows us to formally demonstrate that the volatility and the persistence of daily correlations are not primarily driven by financial news but by the level of the underlying true correlation. Our results indicate that a rolling-window sample correlation is often a better choice for empirical applications in finance.

Keywords: Change-point tests, correlation breaks, dynamic conditional correlation (DCC), multivariate GARCH models, spurious conditional correlation

JEL Classification: C12, C52, G01, G11

Suggested Citation

Adams, Zeno and Füss, Roland and Glück, Thorsten W., Are Correlations Constant? Empirical and Theoretical Results on Popular Correlation Models in Finance (July 13, 2017). Journal of Banking and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2802590

Zeno Adams (Contact Author)

University of St. Gallen ( email )

Bodanstrasse 6
St. Gallen, 9000
Switzerland

Roland Füss

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland
+41 (0)71 224 70 42 (Phone)
+41 (0)71 224 70 88 (Fax)

HOME PAGE: http://www.sbf.unisg.ch/en/Lehrstuehle/Lehrstuhl_Fuess.aspx

Thorsten Glück

European Business School (EBS) Wiesbaden, Germany - Department of Finance, Accounting and Real Estate ( email )

Gustav-Stresemann-Ring 3
Wiesbaden, Wiesbaden 65189
Germany
+49 611 7102 1232 (Phone)
+49 611 7102 10 1232 (Fax)

HOME PAGE: http://www.ebs.edu

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