Malinvestment and Crisis-Emergent Asset Comovement: The Problem of Latent Correlation

28 Pages Posted: 3 Jun 2020

See all articles by Messaoud Chibane

Messaoud Chibane

Neoma Business School

Amadeus Gabriel

La Rochelle Business School - Excelia Group

Gabriel Giménez Roche

NEOMA Business School

Date Written: May 5, 2020

Abstract

The common fall of asset prices during crises and recessions implies that asset correlation is strong during these events, while not necessarily showing up during the boom phase of the business cycle. Using insights from the malinvestment cycle theory, we show that this shift in correlation is not just triggered by a crash-related shock. It is also the result of risk build-up induced by money-boosted malinvestment taking place during the boom. We provide a model where the probability of a crash increases with bank credit expansion during the growth phase, which hints at a “latent” build-up of asset correlation. Credit expansion feeds asset prices, but also widens a gap between future-oriented cash inflows and present-oriented cash outflows. As new credit widens this gap, asset valuation becomes more funding-based rather than cash flow-based. Therefore, default risk, and hence the probability of a crash, increases with credit expansion. A change in credit expansion cuts the asset price rise short and reveals the malinvestments in the economy. This process implies a “latent” build-up of asset correlation during the boom phase that becomes “effective” with the crash. Practitioners and policy-makers would thus benefit from adopting the insights of the malinvestment cycle theory to complement their ad hoc empirical findings and estimations.

Keywords: correlation shift, credit, disaster event, latent correlation, malinvestment

JEL Classification: E14, E51, G01, G11, G21

Suggested Citation

Chibane, Messaoud and Gabriel, Amadeus and Giménez Roche, Gabriel, Malinvestment and Crisis-Emergent Asset Comovement: The Problem of Latent Correlation (May 5, 2020). Available at SSRN: https://ssrn.com/abstract=3593751 or http://dx.doi.org/10.2139/ssrn.3593751

Messaoud Chibane

Neoma Business School ( email )

1 Rue du Maréchal Juin
Mont Saint Aignan Cedex, 76825
France

Amadeus Gabriel

La Rochelle Business School - Excelia Group ( email )

102 rie de Coureilles
Les Minimes
La Rochelle, 17024
France

Gabriel Giménez Roche (Contact Author)

NEOMA Business School ( email )

1 Rue du Maréchal Juin
Mont-Saint-Aignan, Normandie 76825
France

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