Saturday, July 25, 2015

Anticipating Correlations - Engle

These are my notes on Robert Engle's book 'Anticipating Correlations - a new paradigm for risk management'. Engle is a celebrated Nobel Laureate for his contributions to the development of GARCH model of volatility.

Ch1: Correlation Economics 

The movement in the prices of assets are not independent. If they were it would have been possible to construct a portfolio with negligible volatility. Estimating the correlations for big cross-section is a Herculean task, especially when it is recognized that these correlations var over time. Hence, a forward looking correlation estimation is needed for optimal risk-management, portfolio selection and hedging. The main method developed is dynamic conditional correlations (DCC).

There are high correlations between industry sector stocks but lower otherwise. The correlation between different asset classes is lower. For equity of different countries the data should be non-synced (e.g. by taking average over more than one days) before taking correlations.

Changes in asset prices and correlations reflect changing forecasts of future payments. The effect of a news affects all asset prices to a greater or lesser extent, depending on their correlations. The most important reason why these correlations change over time is because the firms change their line of business. A second important factor is the characteristic of the news change (e.g. change in magnitude of the news). 

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