It is widely observed by markets participants that during periods of high market volatility, correlations between asset prices can differ substantially from those seen in period of low market volatility. For example, correlations between US Equities represented by S&P 500 and energy commodities as crude oil, gasoline, natural gas; were substantially lower prior the bull market started in 2003. Such differences in correlations among asset classes could highly affect portfolio returns and reduce the benefits of diversification, the time mostly desired by investors.
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The change in correlations had been attributed either to structural breaks in the underlying distribution of returns or to “contagion” across markets that occurs only during periods of market turbulence. This will be examined in order the above mentioned practitioner’s observations hold, and whether are statistically significant.
The reasons for this research are mainly based on the empirical observations of market participants. With this as a starting point I would like to examine whether these observations stand and whether are statistically significant. Moreover, another reason for this research is that I am interested in asset management and I would like to deepen my knowledge regarding issues that are being faced by professional asset managers; and the implications in their investment decision making procedure. Furthermore, during the recent financial crisis, starting on January 2008 there was noticed by investors that the so called decoupling between European and Asian emerging stock markets is not that robust as they were thinking. The rational that the growth rate of European, Asian and South American emerging markets have broadened and deepened to the point that they no longer depend on the United States economy for growth, leaving them insulated from a severe slowdown there. Faith in the concept has generated strong outperformance for stocks outside the United States. However, in January 2008, as fears of recession mounted in the United States, stocks declined heavily. Contrary to what the supporters of the decoupling theory would have expected, the losses were greater outside the United States, with the worst experienced in emerging markets.
Loretan and English (2000), extend previous empirical studies, allowing for robustly estimated, time-varying coeÂ¬Æ’cients. However, there are no existing studies of aggregated credit spreads, stocks and stock market volatility in which the conditional covariance structure is considered. Therefore their Â¬Ândings oÂ¬â‚¬er some of the Â¬Ârst insights regarding the variance and correlation structure of this data set. They found evidence of strongly varying conditional variances and correlations, with dependencies increasing after the outbreak of the Â¬Ânancial crisis.
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