State-Dependent Dependencies: A Continuous-Time Dynamics for Correlations

43 Pages Posted: 1 Apr 2010 Last revised: 8 Oct 2015

See all articles by Christoph Becker

Christoph Becker

University of Applied Sciences Darmstadt

Wolfgang M. Schmidt

Frankfurt School of Finance & Management

Date Written: February 15, 2010

Abstract

We propose a new asset price model in continuous time where correlations and volatilities are functions of the current state of the market. The state of the market is based on a window of past asset realisations, the length of this window being a measure for the memory of the market. The approach is motivated by empirical findings from regression analyses in discrete time. A maximum likelihood approach is developed to estimate the parameters of the model from discrete asset realisations. We analyze data from the S&P 500 and the German DAX index from 1990-2010 and find strong empirical evidence that correlations increase in bear markets. For international markets we show existence of financial contagion and measure the severity of financial contagion dependent on market conditions. We explore consequences of market-state dependent volatilities and correlation in financial risk management and option pricing theory. We investigate the variance as a measure of portfolio risk and compare the variance from a model with constant correlation with the variance of a model with state dependent correlation.

Suggested Citation

Becker, Christoph and Schmidt, Wolfgang M., State-Dependent Dependencies: A Continuous-Time Dynamics for Correlations (February 15, 2010). Available at SSRN: https://ssrn.com/abstract=1553115 or http://dx.doi.org/10.2139/ssrn.1553115

Christoph Becker (Contact Author)

University of Applied Sciences Darmstadt ( email )

Schöfferstrasse 3
Darmstadt, 64295
Germany

Wolfgang M. Schmidt

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
149
Abstract Views
1,148
Rank
354,722
PlumX Metrics