Increasing correlations or just fat tails?

R.A.J. Campbell, C.S. Forbes, K.G. Koedijk, P. Kofman

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Increasing correlation during turbulent market conditions implies a reduction in portfolio diversification benefits. We investigate the robustness of recent empirical results that indicate a breakdown in the correlation structure by deriving theoretical truncated and exceedance correlations using alternative distributional assumptions. Analytical results show that the increase in conditional correlation could be a result of assuming conditional normality for the return distribution. When assuming a popular alternative distribution - the bivariate Student-tr - we find significantly less support for an increase in conditional correlation and conclude that this is due to the presence of fat tails when assuming normality in the return distribution. © 2007 Elsevier B.V. All rights reserved.
Original languageEnglish
Pages (from-to)287-309
JournalJournal of Empirical Finance
Issue number2
Publication statusPublished - Mar 2008
Externally publishedYes

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