Diversification Meltdown or Just Fat Tails?
38 Pages Posted: 14 Jun 2006
Date Written: June 2006
An increase in correlation during turbulent market conditions implies a reduction in the benefits arising from portfolio diversification. Unfortunately, it is exactly then that these benefits are most needed. We investigate the robustness of recent empirical results that indicate correlation breakdown by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the empirical meltdown in diversification could be a result of assuming conditional normally distributed returns. When assuming a popular alternative distribution model - the bivariate Student-t distribution - we find significantly less support for diversification meltdown.
Keywords: Exceedance correlation, Truncated correlation, Bivariate Student-t correlation
JEL Classification: G11, G14
Suggested Citation: Suggested Citation