RiskMetrics - Correlations change over time


Correlations change over time

Correlations are dynamic


Correlations are constantly changing, and in turbulent times they may even dramatically reverse from positive to negative.

Example: stocks vs. bonds


For example, while we generally observe positive correlations between stocks and bonds, this relationship is not stable. Note in particular how the normally positive correlation between stocks and government bonds suddenly turned negative in October 1997, when there was a high stock market volatility. We attribute this reversal of correlation to the flight to safety phenomenon, where investors exit stock en masse in favor of bonds.

Diversification benefit

Changes in correlations can have profound impact on market risk. Interestingly in the case above, an investor holding both the S&P 500 and US 10 Year notes would have experienced a higher diversification benefit as correlations reversed during the October '97 crisis (portfolio risk reduction when it counts: while stocks fell, government bonds appreciated). On the other hand, your portfolio risk would have increased if you held the S&P 500 but had a short position in US 10 year notes.

Keep models updated

The dynamic nature of correlations (and volatilities) shows that it's important to update risk models constantly to reflect current market conditions.

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