Abstract
This paper examines the role of non-cash flow factors over correlation jumps in financial markets. Utilizing time-varying risk aversion measure as a proxy for investor sentiment and the cross-quantilogram method applied to intraday data, we show that risk aversion captures significant predictive power over realized stock-bond correlation jumps at different quantiles and lags. The predictive relation between correlation jumps and time-varying risk aversion is found to be asymmetric, as we detect a heterogeneous dependence pattern across different quantiles and lag orders. Our findings underline the importance of non-cash flow factors over correlation jumps, highlighting the role of behavioral factors in optimal portfolio allocations and the effectiveness of diversification strategies.
Highlights
Correlations amongst asset returns in a portfolio are critical for the effectiveness of diversification strategies, during periods of market downturns, which is when diversification is needed the most [1]
1–3 depict the cross-quantilograms ρ∗τ, which detect the directional of the realized correlation jumps from time risk aversion (TVRA) bypredictability estimating the the realized stock-bond correlation jumps from time varying risk aversion (TVRA)
At the same time, when RCJ are in their median quantile (α1 = 0.5), we report a positive dependency between time-varying risk aversion measure (TVRA) and RCJ for a few lags only in the long-term period
Summary
Correlations amongst asset returns in a portfolio are critical for the effectiveness of diversification strategies, during periods of market downturns, which is when diversification is needed the most [1]. The literature offers several approaches suggesting how to explore the economic determinants of the time variation in stock-bond correlations [4], since correlations have been shown to exhibit significant variability due to market conditions in the post-war period [5]. Towards this direction, a number of empirical studies in the literature report asymmetric patterns in return correlations. This paper provides novel perspective to enlarge our understanding of the link between investor sentiment and financial market dynamics by examining how the time variation in risk preferences affects the correlation dynamics between stock and bond markets, the two dominant classes of assets in typical portfolio formations.
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