Correlations during Extreme Market Conditions
from Quantitative Work Alliance for Applied Finance, Education & Wisdom (QWAFAFEW) - Boston
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Tuesday, June 17, 2008, 6:15pm - 8:15pm
"A banker is someone who lends you an umbrella when the sun is shinning, and wants it back when it starts to rain". - Attributed to Mark Twain
The same can be said of diversification. It shows up uninvited during bull markets, and disappears during crashes. We measure conditional correlations during extreme market conditions to assess the asymmetric nature of diversification. To control for the conditioning bias, we compare behavior in the tails of the empirical distribution with the multivariate normal distribution. We find that correlations increase significantly more on the downside than on the upside. Loss-averse investors not only seek diversification on the downside, they also seek high correlations (unification) on the upside. Unconditional correlations - and conventional portfolios construction approaches in general - fail to capture this obvious feature of investor preferences. We use Full-Scale Optimization to construct portfolios that are resilient to market crises and that limit diversification on the upside. Our findings have meaningful impact on the decision to diversify internationally and on optimal portfolio construction in general.
Our speaker, Sebastien Page, CFA, is senior managing director and head of the Portfolio and Risk Management Group at State Street Global Markets. Previously, Mr. Page worked at CDP Capital on asset allocation. In 2000, he won first prize in the Montreal CFA Society - August Hagedorn Contest for his research article on value at risk. In 2002, he won the Quebec Financial Industry honorable mention in the Young Professional of the Year category, and in 2003, he won the Bernstein Fabozzi/Jacobs Levy Award for Best Article in the Journal of Portfolio Management. He has also published articles in the Journal of Asset Management, the Journal of Investing, and the Canadian Investment Review. Mr. Page is a frequent speaker at various academic and practitioner conferences. He holds an MSc in finance from Sherbrooke University in Canada, and is a CFA Charterholder.
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