Diversification Meltdown or Just Fat Tails?

38 Pages Posted: 14 Jun 2006

See all articles by Rachel A.J. Pownall

Rachel A.J. Pownall

Tilburg University - Department of Finance; Maastricht University - Department of Finance

Catherine S. Forbes

Monash University - Department of Econometrics & Business Statistics

Kees C. G. Koedijk

Tilburg University - Department of Finance

Paul Kofman

The University of Melbourne

Date Written: June 2006

Abstract

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

Pownall, Rachel Ann Jane and Forbes, Catherine S. and Koedijk, Kees G. and Kofman, Paul, Diversification Meltdown or Just Fat Tails? (June 2006). EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=908881 or http://dx.doi.org/10.2139/ssrn.908881

Rachel Ann Jane Pownall (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Catherine S. Forbes

Monash University - Department of Econometrics & Business Statistics ( email )

Wellington Road
Clayton, Victoria 3168
Australia
+61 3 990 52471 (Phone)

Kees G. Koedijk

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

Paul Kofman

The University of Melbourne ( email )

Faculty of Economics and Commerce
Department of Finance
Parkville, Victoria 3010
Australia
61 3 8344 3794 (Phone)

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