Abstract
The instability of historical risk factor correlations renders their use in estimating portfolio risk extremely questionable. In periods of market stress correlations of risk factors have a tendency to quickly go well beyond estimated values. For instance, in times of severe market stress, one would expect with certainty to see the correlation of yield levels and credit spreads to go to -1, even though historical estimates will miss this region of correlation. This event might lead to realized portfolio risk profile substantially different than what was initially estimated. The purpose of this paper is to explore the effects of correlations on fixed income portfolio risks. To achieve this, we propose a methodology to estimate portfolio risks in both normal and stressed times using confidence weighted forecast correlations.
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