From the Bloomberg "Business Class" Blog:
" working on a more accurate pricing model that incorporates The financial crisis and the meltdown in Europe have exposed the deficiencies of traditional asset- pricing models, particularly their inability to account for the effect of contagion from one market to another. The good news is that the length and the persistence of the turmoil have given researchers a trove of data to develop new predictive tools.
In our work, we developed an asset-pricing model to study these market disruptions, which incorporates random shocks to volatility that are correlated across markets"
From the paper itself:
"Crucially, our model expresses all three ways in which market shocks tend to cluster during times of crisis: time-series clustering, whereby large shocks today predict further large shocks tomorrow; cross-sectional clustering, whereby large shocks in one region pre- dict large shocks in other regions; and directional clustering, whereby shocks to aggregate volatility are associated with specific directional biases in contemporaneous country-level returns."
"We have three main findings. First, we present evidence that European equity markets exhibited significant excess correlation during the debt crisis of 2010, relative to an asset- pricing model that assumes regional market integration.....[Secondly] we find that part of this excess correlation can be attributed to the impact of mutually exciting volatility shocks in the cross-section of expected returns. We propose global and regional volatility-risk factors to quantify this impact, and show how to con- struct these volatility risk factors directly from the time series of market returns....Our third main finding concerns the contemporaneous relationship between volatility and expected returns. We are primarily interested in the role of volatility shocks in under- standing contagion, rather than in estimating volatility per se. Nonetheless, in performing a formal statistical assessment of our volatility model, we find a significant negative rela- tionship between daily volatility and expected returns on the U.S. market portfolio."
Well this one is timely. We ended class this past week saying that what we know and what we don't know about finance. One of the things I said we don't know is the benefits of diversification within a world where correlations increase dramatically in times of market turmoil. The authors do a wonderful job of looking at this "unknown" in a paper that is guaranteed to be coming to a top ranked journal soon.
I^3=Important, Interesting, Informative