Correlation Risk and Optimal Portfolio Choice

58 Pages Posted: 14 Jun 2006 Last revised: 16 Feb 2009

Andrea Buraschi

The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)

Paolo Porchia

IE Business School

Fabio Trojani

University of Geneva; Swiss Finance Institute

Date Written: May 26, 2006

Abstract

We develop a new framework for intertemporal portfolio choice when the covariance matrix of returns is stochastic. An important contribution of this framework is that it allows to derive optimal portfolio implications for economies in which the degree of correlation across different industries, countries, and asset classes is time-varying and stochastic. In this setting, markets are incomplete and optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. The model gives rise to simple optimal portfolio solutions that are available in closed-form. We use these solutions to investigate, in several concrete applications, the properties of the optimal portfolios. We find that the hedging demand is typically four to five times larger than in univariate models and it includes an economically significant correlation hedging component, which tends to increase with the persistence of variance covariance shocks, the strength of leverage effects and the dimension of the investment opportunity set. These findings persist also in the discrete-time portfolio problem with short-selling or VaR constraints.

Keywords: Dynamic Porfolio Choice, Stochastic Correlation, Intertemporal Hedging

JEL Classification: G11, G13

Suggested Citation

Buraschi, Andrea and Porchia, Paolo and Trojani, Fabio, Correlation Risk and Optimal Portfolio Choice (May 26, 2006). AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=908664 or http://dx.doi.org/10.2139/ssrn.908664

Andrea Buraschi

The University of Chicago ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
7738347123 (Phone)

HOME PAGE: http://www.andreaburaschi.com/

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.andreaburaschi.com/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Paolo Porchia (Contact Author)

IE Business School ( email )

Serrano 99
Madrid, 28006
Spain
+34917821706 (Phone)
+34 91 745 47 62 (Fax)

HOME PAGE: http://paolo-porchia.profesores.ie.edu/

Fabio Trojani

University of Geneva ( email )

Geneva
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

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