Best of the Battle Plan: New Research on Volatility and Correlation
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Today I’d like to share with you the abstract of a study done on correlation. Last year saw the creation of the S&P 500 Implied Correlation Index (the symbol is JCJ). The S&P 500 implied correlation index (JCJ) measures the expected correlation between the stocks in the S&P 500 until January 2011.
As you can see from the following study, it’s been found that “there is a systemic tendency for the implied correlation index to increase when the market index returns decrease and/or the market volatility increases.
Basically what this study is saying is that during market declines, diversification does little to lessen risk.
For those of you in my Chairman’s Club, you already know this. As you remember, one of our researchers David Weilmuenster actually showed this in one of our meetings back in late 2008. The professors in this study using the new Implied Correlation Index have found the same.
I’ll address this topic with you more over time as it’s important and it obviously has a major impact on how you construct your portfolio, especially in times of market declines and higher volatility as everyone saw in 2008 and is again seeing now.
Implied correlation index: A new measure of diversification
Vasiliki D. Skintzi *, Apostolos-Paul N. Refenes
Athens University of Economics and Business, Athens, Greece
email: Vasiliki D. Skintzi (firstname.lastname@example.org)
*Correspondence to Vasiliki D. Skintzi, Financial Engineering Research Centre, Department of Management Science & Technology, Athens University of Economics and Business, 47A Evelpidon & 33 Lefkados 113 62 Athens, Greece
Most approaches in forecasting future correlation depend on the use of historical information as their basic information set. Recently, there have been some attempts to use the notion of implied correlation as a more accurate measure of future correlation. This study proposes an innovative methodology for backing-out implied correlation measures from index options. This new measure called implied correlation index reflects the market view of the future level of the diversification in the market portfolio represented by the index. The methodology is applied to the Dow Jones Industrial Average index, and the statistical properties and the dynamics of the proposed implied correlation measure are examined. The evidence of this study indicates that the implied correlation index fluctuates substantially over time and displays strong dynamic dependence. Moreover, there is a systematic tendency for the implied correlation index to increase when the market index returns decrease and/or the market volatility increases, indicating limited diversification when it is needed most. Finally, the forecast performance of the implied correlation index is assessed. Although the implied correlation index is a biased forecast of realized correlation, it has a high explanatory power, and it is orthogonal to the information set compared to a historical forecast. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:171-197, 2005.
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Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.