Thursday 9 June 2011

Can we spread the risk?

A primary concern for many financial-market practitioners is the strength of correlations between price changes of different assets; that is, whether prices move up or down at the same time. There are many reasons for investors to think about correlations, but perhaps the most familiar is risk management. If an investor owns strongly correlated assets then there is a high level of risk in their investments – decreases in the value of one asset are often accompanied by falls in the other assets. More generally, the strength of correlations is of interest because it can shed light on the state of the global economy. Because correlations can sometimes be explained by macroeconomic factors, looking at their levels can help to illuminate the forces driving markets.

Historically, assets from different markets tended to behave in different ways, which made it possible to achieve reasonable diversification by buying different types of asset. In our paper "Temporal Evolution of Financial Market Correlations", recently accepted by Physical Review E, however, we show that since the 2007-2008 credit crisis things are not that simple: as
sets that previously moved more or less independently now behave in a very similar manner. We demonstrate this phenomenon using principal component analysis and show that there has been a significant increase in correlations since the crisis. This has profound implications for risk management because diversification is now much more difficult. It also suggests that lots of different assets are now driven by the same economic forces. Dan and Nick

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