Testing and Valuing Dynamic Correlations for Asset Allocation

We evaluate alternative models of variances and correlations with an economic loss function. We construct portfolios to minimize predicted variance subject to a required return. It is shown that the realized volatility is smallest for the correctly specified covariance matrix for any vector of expected returns. A test of relative performance of two covariance matrices is based on work of Diebold and Mariano. The method is applied to stocks and bonds and then to highly correlated assets. On average, dynamically correct correlations are worth around 60 basis points in annualized terms, but on some days they may be worth hundreds.

[1]  Chris Kirby,et al.  The Economic Value of Volatility Timing , 2000 .

[2]  John R. Graham,et al.  Market Timing Ability and Volatility Implied in Investment Newsletters' Asset Allocation Recommendations , 1994 .

[3]  R. Litzenberger,et al.  SKEWNESS PREFERENCE AND THE VALUATION OF RISK ASSETS , 1976 .

[4]  Increased Correlation in Bear Markets: A Downside Risk Perspective , 2002 .

[5]  M. West,et al.  Bayesian Dynamic Factor Models and Portfolio Allocation , 2000 .

[6]  F. Longin,et al.  Extreme Correlation of International Equity Markets , 2000 .

[7]  Stephen Figlewski,et al.  International asset allocation with time varying risk: an analysis and implementation , 1994 .

[8]  R. Ibbotson,et al.  Stocks, bonds, bills, and inflation : historical returns (1926-1987) , 1989 .

[9]  T. Copeland,et al.  Market Timing: Style and Size Rotation Using the VIX , 1999 .

[10]  R. Engle,et al.  Multivariate Simultaneous Generalized ARCH , 1995, Econometric Theory.

[11]  R. Engle,et al.  Asymmetric Dynamics in the Correlations of Global Equity and Bond Returns , 2003, SSRN Electronic Journal.

[12]  K. West,et al.  Asymptotic Inference about Predictive Ability , 1996 .

[13]  Campbell R. Harvey,et al.  Forecasting International Equity Correlations , 1994 .

[14]  W. Ziemba,et al.  The Effect of Errors in Means, Variances, and Covariances on Optimal Portfolio Choice , 1993 .

[15]  Chris Kirby,et al.  The Economic Value of Volatility Timing Using 'Realized' Volatility , 2001 .

[16]  Jeffrey A. Busse.  Volatility Timing in Mutual Funds: Evidence from Daily Returns , 1999 .

[17]  A. Timmermann,et al.  Predictability of Stock Returns: Robustness and Economic Significance , 1995 .

[18]  Michael W. Brandt.  Estimating Portfolio and Consumption Choice: A Conditional Euler Equations Approach , 1999 .

[19]  T. Bollerslev,et al.  Intraday periodicity and volatility persistence in financial markets , 1997 .

[20]  F. Diebold,et al.  Comparing Predictive Accuracy , 1994, Business Cycles.

[21]  R. Stambaugh,et al.  On the Predictability of Stock Returns: An Asset-Allocation Perspective , 1995 .

[22]  R. Engle,et al.  Index-option pricing with stochastic volatility and the value of accurate variance forecasts , 1993 .

[23]  Carol Alexander,et al.  A Primer on the Orthogonal GARCH Model , 2001 .

[24]  Campbell R. Harvey,et al.  Market Timing Ability and Volatility Implied in Investment Newsletters' Asset Allocation Recommendations , 1994 .

[25]  R. Engle.  Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation , 1982 .

[26]  Michael W. Brandt,et al.  Variable Selection for Portfolio Choice , 2001 .

[27]  W. Newey,et al.  Large sample estimation and hypothesis testing , 1986 .

[28]  K. West,et al.  The Predictive Ability of Several Models of Exchange Rate Volatility , 1994 .

[29]  Josef Lakonishok,et al.  The Risk and Return from Factors , 1997, Journal of Financial and Quantitative Analysis.

[30]  T. Bollerslev,et al.  Generalized autoregressive conditional heteroskedasticity , 1986 .

[31]  R. Engle.  Dynamic Conditional Correlation : A Simple Class of Multivariate GARCH Models , 2000 .

[32]  Tim Bollerslev,et al.  Chapter 49 Arch models , 1994 .

[33]  Chi-Fu Huang,et al.  Foundations for financial economics , 1988 .

[34]  J. Wooldridge.  A Unified Approach to Robust, Regression-Based Specification Tests , 1990, Econometric Theory.

[35]  R. Engle.  Dynamic Conditional Correlation , 2002 .

[36]  R. Campbell,et al.  Increased Correlation in Bear Markets , 2002 .

[37]  E. Elton,et al.  Asset Selection with Changing Capital Structure , 1973, Journal of Financial and Quantitative Analysis.