LO 7.1: Describe how equity correlations and correlation volatilities behave

LO 7.1: Describe how equity correlations and correlation volatilities behave throughout various economic states.
The recent financial crisis of 2007 provided new information on how correlation changes during different economic states. From 1972 to 2012, an empirical investigation on correlations of the 30 common stocks of the Dow Jones Industrial Average (Dow) was conducted. The correlation statistic was used to create a 30 x 30 correlation matrix for each stock in the Dow every month. This required 900 correlation calculations (30 x 30 = 900). There were 490 months in the study, so 441,000 monthly correlations were computed (900 x 490 = 441,000). However, the correlations of each stock with itself were eliminated from the study resulting in a total of 426,300 monthly correlations (441,000 30 x 490 = 426,300).
The average correlation values were compared for three states of the U.S. economy based on gross domestic product (GDP) growth rates. The state of the economy was defined as an expansionary period when GDP was greater than 3.3%, a normal economic period when GDP was between 0% and 3.3%, and a recession when there were two consecutive quarters of negative growth rates. Based on these definitions, from 1972 to 2012 there were six recessions, five expansionary periods, and five normal periods.
The average monthly correlation and correlation volatilities were then compared for each state of the economy. Correlation levels during a recession, normal period, and expansionary period were 37.0%, 32.7%, and 27.5%, respectively. Thus, as expected, correlations were highest during recessions when common stocks in equity markets tend to go down together. The low correlation levels during an expansionary period suggest common stock
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Topic 7 Cross Reference to GARP Assigned Reading – Meissner, Chapter 2
valuations are determined more on industry and company-specific information rather than macroeconomic factors.
The correlation volatilities during a recession, normal period, and expansionary period were 80.5%, 83.4%, and 71.2%, respectively. These results may seem a little surprising at first as one may expect volatilities are highest during a recession. However, there is perhaps slightly more uncertainty in a normal economy regarding the overall direction of the stock market. In other words, investors expect stocks to go down during a recession and up during an expansionary period, but they are less certain of direction during normal times, which results in higher correlation volatility.
Professor Note: The main lesson from this portion o f the study is that risk managers should be cognizant o f high correlation and correlation volatility levels during recessions and times o f extreme economic distress when calibrating risk management models.
M e a n R e v e r s i o n a n d A u t o c o r r e l a t i o n

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