Excessive Variation of Risk Factor Correlations and Volatilities

by Salih N. Neftci CUNY & the University of Reading, and
Hans Genberg the Graduate Institute, Geneva

July 2000

Introduction: This paper argues that excessive time variation in volatility and correlations is a critical problem in effective risk management. This goes beyond the standard mean-variance portfolio analysis.
The objective of this paper is to investigate the linkages in terms of time varying, stochastic volatilities in a sample of asset returns from three major markets and for three types of instruments. We focus on the time series properties of correlations of returns, volatilities of returns, and correlations of volatilities. These parameters play a crucial role in the recommendations of the Basle Committee concerning capital adequacy requirements against market risk. The financial market turmoil of the last few years is another reason that justifies this study. Market participants have realized that the estimated correlations and the volatilities of implied volatilities can vary excessively during turbulent periods.

Published in: Journal of Futures Markets, Vol. 22, No. 12, (December 2002), pp. 1119-1146.

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