Seminars 2003 — Abstracts

Friday 9th May (session 1)

Speaker: Catherine Forbes, from Monash University.

Title: Diversification meltdown or impact of fat tails on conditional correlation?

Abstract: A perceived increase in correlation during turbulent market conditions implies a reduction in the benefits arising from portfolio diversification. Unfortunately, it is exactly during such market conditions that these benefits are most needed. To determine whether diversification truly breaks down under extreme market conditions, we investigate the robustness of a popular conditional correlation estimator against alternative distributional assumptions. Empirical results show that the apparent meltdown in the benefits from diversification is a result of the assumption of bivariate normality. Hence, a more attractive tool for portfolio management would be the adoption of the bivariate Student-t distribution, whereby the assumption of constant correlation may be sustained over the full support of the multivariate return distribution.