Sunday, January 15, 2012

correlation and realized volatility -- won't stay constant

I read these findings sometime ago and now i feel more strongly that the asset correlation theory is rather impractical, unreliable, even misleading. It can give naive users a false sense of security, just like VaR does.

One problem i feel strongly about is that strength of correlation doesn't last.

(There are many commonalities between vol and correlation as 2 statistical power-tools.) Just as observed volatility[1] changes over time[2], observed correlation between any 2 assets seldom stays stable. Intuitively, 2 assets can be highly correlated now and uncorrelated later[3]. This is an important fact to bear in mind when using correlation numbers to predict anything long-term.

FX rates often show strong correlation with one subset of "drivers" now, and then another subset of drivers later. If you follow the correlation with one particular driver, it rises and falls.

[2] Note vol is often assumed to have a lasting character particular to a given stock. Such an assumption in turn assumes history tends to repeat itself. What's the pattern that repeats? For realized volatility of stocks/indices/currencies, there's often an observed pattern that periods of high vol follow periods of low vol. I think a small number of symbols exhibit a consistently high volatility, often for obvious reasons.

The volatility of SPX (i.e. S&P 500) is reflected in the Volatility Index (VIX). You can see how VIX rises and ebbs

[1] using daily closing prices, but how about using hourly prices or monthly closing prices? Stdev/vol may look very different

[3]but probably won't become anti-correlated. I guess 2 anti-correlated assets can show positive correlation in a credit crisis, when every security loses value relative to hard currencies or commodities.

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