Abstract
Executive SummaryEvidence from the recent financial crisis brings into question the stability of risk management correlation assumptions and the effect this has on possible extreme outcomes. In this paper, we present evidence of unstable correlations between mortgage asset returns in recent years inhibiting any practical mean variance approach to portfolio diversification and risk management. Our findings suggest that returns on residential mortgage investments exhibit unusual levels of skewness and asymmetric dependence (higher correlations in downside markets). Incorporating higher-order return distribution moments in portfolio selection and diversification decisions is important to all investors concerned with fat tail risks. Optimizing portfolios from the standpoint of loss mitigation seems easy to achieve with careful geographic diversification, but deep recession loss correlations defy the longer term trends. For this reason, higher capital reserves or new hedging instruments are required to truly mitigate downside risk.
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
