ANTICIPATING

CORRELATIONS
Robert Engle
Stern School of Business

Correlation
Correlations for Life
What is the correlation between thunder and
rain?
What is the correlation between exercise and
health?
What is the correlation between happiness
and good food?

1
Correlations for Risk
Stock returns are correlated
Stocks in one country are correlated with stocks
in another
Bond returns on one firm or country or maturity
are generally correlated with returns on others
But stock and bond returns sometimes appear
uncorrelated
The risk of a portfolio is greater if all the assets
are highly correlated. It may go down (or up)
further, if they all move together.

QUOTATIONS
It is not the biggest, the brightest or the
best that will survive, but those who adapt
the quickest. Charles Darwin
The secret of life is to be interested in
one thing profoundly and a thousand
things well. Henry Walpole
Studies of high school graduates rarely
find any correlation between recognition in
high school and recognition thereafter.

2
ANTICIPATING CORRELATIONS
Can we anticipate future correlations?

How and why do correlations change over

time?

How can we get the best estimates of

correlations for financial decision making?

CORRELATIONS WHAT ARE

THEY?
CORRELATIONS MEASURE THE
DEGREE TO WHICH TWO SERIES
MOVE TOGETHER
THEORETICAL DEFINITION:
Let r1 and r2 be mean zero random variables, then
E ( r1r2 )
1,2 = , and
E ( r12 ) E ( r22 )

E ( r1r2 ) = 1,2 E ( r12 ) E ( r22 )

3
 4 4

3 3

2 2

1 1

Y_00

Y_50
0 0

-1 -1

-2 -2

-3 -3

-4 -4
-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4
X X

4 4

3 3

2 2

1 1

Y__50
Y_90

0 0

-1 -1

-2 -2

-3 -3
-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4
X X

.15

.10
LARGE CAP STOCKS

.05
AXP

.00

-.05

-.10

-.15

.15
10 YEARS OF

.10

.05
JPM

.00

-.05

-.10

-.15

.20

.15

.10

.05
INTC

.00

-.05

-.10

-.15

.2

AXP .1
MSFT

.0

JPM
-.1

INTC -.2

.12

MSFT .08

.04
MRK

.00

MRK -.04

-.08

-.12
-.15 -.10 -.05 .00 .05 .10 .15 -.15 -.10 -.05 .00 .05 .10 .15 -.15 -.10 -.05 .00 .05 .10 .15 .20 -.2 -.1 .0 .1 .2 -.15 -.10 -.05 .00 .05 .10
AXP JPM INTC MSFT MRK

4
 DAILY CORRELATIONS

AXP JPM INTC MSFT MRK

AXP 1.000000 0.554172 0.285812 0.283375 0.224685

JPM 0.554172 1.000000 0.318260 0.310113 0.228688
INTC 0.285812 0.318260 1.000000 0.551379 0.130294
MSFT 0.283375 0.310113 0.551379 1.000000 0.186004
MRK 0.224685 0.228688 0.130294 0.186004 1.000000

T3 T5 T20
MONTH YRRET YRRET CAN$ POUND$ AUS$ YEN$ SP500

T3MONTH 1.000 0.329 0.206 0.011 0.076 0.025 0.031 -0.031

T5YRRET 0.329 1.000 0.875 -7E-04 0.136 0.007 0.005 -0.057

T20YRRET 0.206 0.875 1.000 0.007 0.103 -0.002 -0.049 -0.016

CAN$ 0.011 -7E-04 0.007 1.000 0.117 0.415 0.145 0.015

POUND$ 0.076 0.136 0.103 0.117 1.000 0.253 0.224 -0.018

AUS$ 0.025 0.007 -0.002 0.415 0.253 1.000 0.269 0.040

YEN$ 0.031 0.005 -0.049 0.145 0.224 0.269 1.000 -0.003

SP500 -0.031 -0.057 -0.016 0.015 -0.018 0.040 -0.003 1.000

5
WEEKLY EQUITY CORRELATIONS
1987-2002
US ITALY FRANCE JAPAN HONG
KONG
US 0.223 0.465 0.223 0.308
ITALY 0.537 0.237 0.269
FRANCE 0.340 0.347
JAPAN 0.229

WHY DO WE NEED
CORRELATIONS?

6
WHY DO WE NEED
CORRELATIONS?
CALCULATE PORTFOLIO RISK

FORM OPTIMAL PORTFOLIOS

PRICE, HEDGE, AND TRADE

DERIVATIVES

DIVERSIFICATION
Diversified portfolios have lower variance
and risk because some assets go one
direction while others go the opposite.
There are many thousands of possible
stocks, bonds and other assets to invest
in. Can we reduce the risk to zero?
Clearly not. Assets are not uncorrelated.

7
PORTFOLIO RISK
Portfolio risk depends upon the
volatilities and correlations of all the
components.
For weights w and covariance matrix
Omega

P2 = w ' w

FINDING THE OPTIMAL

PORTFOLIO
Minimize portfolio variance subject to a
required return. The Markowitz Problem
With covariance matrix and expected
excess returns above a riskless rate of
min w ' w
s . t . w ' 0

1
w=
' 1 0

8
ARE CORRELATIONS TIME VARYING?

YES
WHY?
Because the business practice of the
companies changes
Because shocks to the economy affect all
businesses
Because shocks to one part of the economy
will affect only some businesses

CONDITIONAL CORRELATIONS
DEFINE BOTH COVARIANCES AND
VARIANCES CONDITIONAL ON
CURRENT INFORMATION
Et 1 ( r1,t r2,t )
1,2,t =
Et 1 ( r1,2t ) Et 1 ( r22,t )

9
ESTIMATION
HISTORICAL CORRELATIONS
Use a rolling window of N observations for both
covariances and variances. We will use 100 days.
DYNAMIC CONDITIONAL CORRELATION or
DCC
Estimates conditional correlations by first adjusting
for differing variances and then updating correlations
as new information is received.

100 day historical correlations

between AXP and GE
.9

.8
.7

.6
.5
.4

.3
.2

.1
.0
94 95 96 97 98 99 00 01 02 03 04

C 100_AX P_G E

10
GENERAL ELECTRIC PROFITS

CHANGING EXTERNAL EVENTS

CONSIDER FORD AND HONDA IN 2000

CORRELATIONS MAY HAVE CHANGED

BECAUSE OF CHANGING ENERGY
PRICES.

11
 10.0

5.0
4.0
3.0
2.5
2.0
1.5

1.0

0.5
1990 1992 1994 1996 1998 2000 2002 2004

FNBEFORE HNBEFORE

EXTEND GARCH CONFIDENCE

50.0
INTERVALS
30.0
20.0
15.0
10.0

5.0
3.0
2.0
1.5
1.0

0.5
1990 1992 1994 1996 1998 2000 2002 2004

FNB E FO R E FND O W N
HNB E FO R E HNUP
FNUP HND O W N

12
50.0
30.0
20.0
15.0
10.0

5.0
3.0
2.0
1.5
1.0

0.5
1990 1992 1994 1996 1998 2000 2002 2004

F NB E F O R E F ND O W N F NA F T E R
HNB E F O R E HNUP HNA F T E R
F NUP HND O W N

IMPLICATIONS
On Jan 1 2000 the market prices of Ford and
Honda reflected the best analysis of the
financial markets
What would happen to energy prices?
What would happen to the economy?
What choices would management make?
Five years later, Ford stock was down and
Honda was up.
The market rewarded the company that was
prepared for higher energy prices.

13
 HISTORICAL CORRELATIONS
.6
.5
.4
.3
.2
.1

.0
-.1
-.2
-.3
1990 1992 1994 1996 1998 2000 2002 2004 2006

C 1 00 _ F O R D R _ H O N D AR

USE SOME KIND OF MODEL

ONE FACTOR MODEL
MANY FACTOR MODEL
MULTIVARIATE GARCH

DYNAMIC CONDITIONAL
CORRELATION

14
MULTIVARIATE
MODELS

Dynamic Conditional Correlation

DCC is a new type of multivariate

GARCH model that is particularly
convenient for big systems. See
Engle(2002) or Engle(2005).

15
DYNAMIC CONDITIONAL
CORRELATION OR DCC
1. Estimate volatilities for each asset and
compute the standardized residuals or
volatility adjusted returns.
2. Estimate the time varying covariances
between these using a maximum likelihood
criterion and one of several models for the
correlations.
3. Form the correlation matrix and covariance
matrix. They are guaranteed to be positive
definite.

HOW IT WORKS
When two assets move in the same direction,
the correlation is increased slightly.
This effect may be stronger in down markets
(asymmetry in correlations).
When they move in the opposite direction it is
decreased.
The correlations often are assumed to only
temporarily deviate from a long run mean
UPDATING IS THE CENTRAL FEATURE

16
CORRELATIONS UPDATE LIKE
GARCH
Approximately,
t = + 1,t 1 2,t 1 + t 1

=
1

DCC Correlations AXP and GE

.9

.8

.7

.6

.5

.4

.3

.2

.1
.0
95 96 97 98 99 00 01 02 03 04

C 9_AXP _G E

17
 .9
.8

.7

.6
.5

.4

.3
.2

.1

.0
95 96 97 98 99 00 01 02 03 04

C100_AXP_GE C4_AXP_GE C9_AXP_GE

FACTOR MODELS
One or more factors influence all assets
Some assets are more affected by a
particular factor than others
Sometimes the factors have little volatility
and therefore have little influence

18
ONE FACTOR ARCH
One factor model such as CAPM
There is one market factor with fixed betas and
constant variance idiosyncratic errors
independent of the factor. The market has
some type of ARCH with variance m ,t.
2

ri ,t = i rm ,t + e i ,t
i ,i ,t = i2 m2 ,t + i

If the market has asymmetric volatility, then

individual stocks will too.

MARKET VOLATILITY
.030

.025

.020

.015

.010

.005

.000
94 95 96 97 98 99 00 01 02 03 04

C o n d it io n a l S t a n d a r d D e via t io n

19
CALCULATE DYNAMIC
CORRELATIONS
1 2 m2 ,t
t =
(
1
2 2
m ,t + 12 )( 22 m2 ,t + 22 )

When market volatility is high then correlations

are high. The market/economy in general
influences both stocks positively.

AXP AND GE AGAIN

.9

.8

.7

.6

.5

.4

.3

.2

.1
94 95 96 97 98 99 00 01 02 03 04

C 4_AXP _G E

20
CORRELATION OF EXTREMES
How correlated are extreme returns?
Bankruptcy is an extreme event and
corresponds to an extremely large
negative stock return over a period of
time.
Are bankruptcies correlated?

CREDIT RISK APPLICATION

This one factor model is the basis of a new
credit risk model that I have been developing
with a graduate student and hedge fund quant.
How correlated are loan defaults?
When the aggregate market is very low, the
probability of default is greater for all
companies. When it is high, the probability of
default is low for all companies. Hence defaults
are correlated and the distribution of market
returns tells how much.

21
ASYMMETRY IN MARKET RETURNS

Aggregate market returns have negative

skewness, particularly for long horizon
returns. Elsewhere I have shown that this
is due to asymmetric volatility.
Negative skewness in market returns
means that large declines can happen
with the associated credit events.

EXAMINING THE ONE

FACTOR MODEL OF
CORRELATIONS

22
HOW WELL DOES THIS WORK?
Examine 18 large cap stocks in the US.
Calculate correlations either historically or with
Dynamic Conditional Correlation (DCC)
Relate these correlations to the volatility of
S&P500.
Does High market volatility mean high
correlation?

RESULTS

23
PLOT
About 30 Correlations of these large cap
stocks on left axis
Estimated with DCC not using market
data
Compare with a GARCH of the S&P500
plotted on right axis

.024

.020
S&P volatility
.016

1.2 .012

0.8 .008

.004
0.4

0.0
Correlations

-0.4
94 95 96 97 98 99 00 01 02 03 04

24
MEAN CORRELATION AND MARKET
VOLATILITY
.032 .50

.028 .45

.024 .40

.020 .35

.016 .30

.012 .25

.008 .20

.004 .15

.000 .10
94 95 96 97 98 99 00 01 02 03 04

M E AN C O R 9F V9F _S P R E T

REGRESSION
Dependent Variable: MEANCOR9F
Method: Least Squares
Date: 09/10/06 Time: 20:00
Sample: 1/04/1994 12/31/2004
Included observations: 2770

Variable Coefficient Std. Error t-Statistic

C 0.176566 0.003343 52.81508

V9_SPRET 9.600815 0.296987 32.32740

25
REGRESSION IN DIFFERENCES
Dependent Variable: D(MEANCOR9F)
Method: Least Squares
Date: 09/09/06 Time: 11:37
Sample (adjusted): 1/06/1994 12/31/2004

Included observations: 2768 after adjustments

Convergence achieved after 4 iterations

Newey-West HAC Standard Errors & Covariance (lag truncation=8)

Variable Coefficient Std. Error t-Statistic Prob.

C -2.57E-06 9.18E-05 -0.028054 0.9776

D(V9F_SPRET) 7.755417 0.612757 12.65660 0.0000
AR(1) 0.070129 0.023881 2.936653 0.0033

FINDINGS
MARKET VOLATILITY IS PART OF THE
STORY
THE CURRENT DECLINE IN MARKET
VOLATILITY HAS NOT LEAD TO THE
EXPECTED DROP IN CORRELATIONS.

26
ANTICIPATING CORRELATIONS
FORECASTING FACTOR VOLATILITIES
IS PART OF THE ANSWER
HOW CAN WE MAKE THIS WORK
BETTER?
Research Agenda!
Build DCC models on the residuals
Build Factor DCC models

27
HOW DO WE FORECAST FACTOR
VOLATILITIES?
USE GARCH MODELS OR SIMILAR
MODELS FOR SHORT RUN
FORECASTS.
USE NEW MULTI-COUNTRY RESULTS
USING THE SPLINE GARCH FOR LONG
RUN MACRO BASED FORECASTS.

SPLINE GARCH FOR LOW

FREQUENCY VOLATILITY AND ITS
MACROECONOMIC CAUSES
Engle and Rangel
Model the daily volatility of many country
equity returns
Extract a low frequency component using
the spline
Model how this component depends on
the macroeconomy

28
 S&P500
1 .2

1 .0

0 .8

0 .6

0 .4

0 .2

0 .0
60 65 70 75 80 85 90 95 00

CVOL UVOL

MULTIPLE REGRESSIONS
All Countries
emerging 0.0376
( 0.0131 )** Time Effects
transition -0.0178
( 0.0171 )
log(mc) -0.0092 0.25
( 0.0055 )*
log(gdpus) 0.0273
( 0.0068 )** 0.2
nlc -1.8E-05
( 5.4E-06 )**
grgdp -0.1603 0.15
( 0.1930 )
gcpi 0.3976
( 0.1865 )** 0.1
vol_irate 0.0020
( 0.0008 )**
vol_gforex 0.0222 0.05
( 0.0844 )
vol_grgdp 0.8635
( 0.1399 )**
0
vol_gcpi 0.9981 1990 1994 1998 2002
( 0.3356 )**

29
ANTICIPATING CORRELATIONS
To forecast correlations, we must forecast the
volatility of the factors that influence the
companies.
When volatility is forecast to be high, then
correlations will be high.
Inflation, slow growth, macroeconomic instability
forecast high market volatility.
This does not work well when companies are
changing their business. May need to update
residual correlations using factor DCC.

30