Abstract
The time-variation in asset correlations have broad implications in asset pricing, portfolio management and hedging. Numerous studies in the literature have found that the change in correlations is mainly related to the magnitude of market movements, hence volatility. However, recent research finds that the size of markets fluctuations is not necessarily the primary driver for the time-variation in correlations, but that the effect of market movements is amplified in times of high financial distress, characterised by low liquidity. This paper seeks to investigate the effect of liquidity on time-varying correlations among different asset classes, namely stocks, corporate bonds and commodities. Our findings show that liquidity indeed has a significant effect on the time-variation in asset correlations, particularly in the case of how bond returns comove with other asset classes. We observe that higher liquidity risk is associated with lower correlation of bond returns with stocks as well as commodities. Our findings suggest that measures of liquidity risk can improve models of correlations; and potentially help improve the effectiveness of risk management strategies during periods of financial distress.
Highlights
Correlations are critical in portfolio allocation decisions and assessing risks associated with investment positions
Our findings suggest that liquidity has a significant effect on the time-variation in asset correlations, in the case of how bond returns co-move with other asset classes
While higher volatility is generally found to be associated with increased correlations, consistent with earlier research, we argue that the negative effect of liquidity on correlations is driven by shifts in risk aversion that drives investors to shift funds out of relatively riskier asset classes during periods of market stress
Summary
Correlations are critical in portfolio allocation decisions and assessing risks associated with investment positions. While higher volatility is generally found to be associated with increased correlations, consistent with earlier research, we argue that the negative effect of liquidity on correlations is driven by shifts in risk aversion that drives investors to shift funds out of relatively riskier asset classes during periods of market stress. This argument is further supported by the analysis of sub-periods based on the structural breaks in the time series.
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