Diversification Meltdown or the Impact of Fat Tails on Conditional Correlation?
journal contributionposted on 07.06.2017 by Campbell, Rachel, Forbes, Catherine S., Koedijk, Kees, Kofman, Paul
Any type of content formally published in an academic journal, usually following a peer-review process.
A perceived 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. To determine whether diversification truly breaks down, we investigate the robustness of a popular conditional correlation estimator against alternative distributional assumptions. Analytical results show that the apparent meltdown in diversification could be a result of assuming normally distributed returns. A more realistic assumption - the bivariate Student-t distribution - suggests that there is little empirical support for diversification meltdown.