Modeling the Dependence of Conditional Correlations on Market Volatility

Journal of Business and Economic Statistics, 34/2, 254-268, 2016

38 Pages Posted: 9 May 2017

See all articles by Luc Bauwens

Luc Bauwens

Université catholique de Louvain

Edoardo Otranto

University of Messina; Universita di Cagliari - Centre for North South Economic Research (CRENOS)

Date Written: March 19, 2015

Abstract

Several models have been developed to capture the dynamics of the conditional correlations between time series of financial returns and several studies have shown that the market volatility is a major determinant of the correlations. We extend some models to include explicitly the dependence of the correlations on the market volatility. The models differ by the way – linear or nonlinear, direct or indirect – in which the volatility influences the correlations. Using a wide set of models with two measures of market volatility on two data sets, we find that for some models, the empirical results support to some extent the statistical significance and the economic significance of the volatility effect on the correlations, but the presence of the volatility effect does not improve the forecasting performance of the extended models.

Appendix is available at: https://ssrn.com/abstract=2965503

Keywords: Dynamic conditional correlations, Markov switching, Minimum variance portfolio, Model confidence set, Forecasting

JEL Classification: C22, C51, C53, C58

Suggested Citation

Bauwens, Luc and Otranto, Edoardo, Modeling the Dependence of Conditional Correlations on Market Volatility (March 19, 2015). Journal of Business and Economic Statistics, 34/2, 254-268, 2016, Available at SSRN: https://ssrn.com/abstract=2965487

Luc Bauwens (Contact Author)

Université catholique de Louvain ( email )

CORE
34 Voie du Roman Pays
B-1348 Louvain-la-Neuve, b-1348
Belgium
32 10 474321 (Phone)
32 10 474301 (Fax)

Edoardo Otranto

University of Messina ( email )

Piazza Pugliatti, 1
Messina, 98122
Italy

Universita di Cagliari - Centre for North South Economic Research (CRENOS) ( email )

V. S. Ignazio 78
Cagliari, 09124
Italy

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