The Correlation Structure of Unexpected Returns in U.S. Equities

Abstract

This paper examines the correlations between unexpected market moves and unexpected equity portfolio moves conditional upon market performance. Unexpected returns are derived from a two stage regime switching model. The model allows for time-varying expected returns where the market portfolio alone dictates the regime switching process. Unexpected negative market movements are not accompanied by increasing correlations. Portfolios exhibit a natural hedge where correlations during extreme unexpected market downturns are generally negative. Additionally, during unexpected market upswings, correlations increase. Using the results from unconditional analysis would lead to overhedging during market downturns and underhedging during market upswings.

Keywords: Large returns, conditional correlation, equity portfolios, diversification, portfolio performance, heteroskedasticity

JEL Classification: G11, G12