Beyond Correlation: Extreme Co-movements Between Financial Assets
by Roy Mashal of Columbia University, and
October 14, 2002
Abstract: This paper investigates the potential for extreme co-movements between financial assets by directly testing the underlying dependence structure. In particular, a t-dependence structure, derived from the Student t-distribution, is used as a proxy to test for this extremal behavior. Using likelihood ratio-based methods, we show that the presence of extreme co-movements is statistically significant in three asset markets (equities, currencies, and commodities), as well as across international (G5) equity markets. In addition, this likelihood ratio test indicates that the "correlation-based" Gaussian dependence structure is not supported on the basis of observed asset co-movements. The economic significance and consequences of these results are illustrated via several examples.
Keywords: asset returns, extreme co-movements, copulas, dependence modeling, hypothesis testing, pseudo-likelihood, portfolio models, risk management.