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Correlation Risk and Optimal Portfolio Choice

Authors

  • ANDREA BURASCHI,

  • PAOLO PORCHIA,

  • FABIO TROJANI

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    • Andrea Buraschi is at the Tanaka Business School, Imperial College London. Paolo Porchia is at the University of St Gallen. Fabio Trojani is at the University of Lugano and the Swiss Finance Institute. We thank Francesco Audrino, Mikhail Chernov, Anna Cieslak, Bernard Dumas, Christian Gouriéroux, Denis Gromb, Peter Gruber, Robert Kosowski, Abraham Lioui, Frederik Lundtofte, Antonio Mele, Erwan Morellec, Riccardo Rebonato, Michael Rockinger, Pascal St. Amour, Claudio Tebaldi, Nizar Touzi, Raman Uppal, Louis Viceira, and seminar participants at the AFA 2008 meeting, the EFA 2006 meeting, the Gerzensee Summer Asset-Pricing Symposium, CREST, HEC Lausanne, the Inquire Europe Conference, the NCCR FINRISK research day, and the annual SFI meeting for valuable suggestions. We also thank the Editor (Campbell Harvey), an Associate Editor, and an anonymous referee for many helpful comments that improved the paper. Paolo Porchia and Fabio Trojani gratefully acknowledge the financial support of the Swiss National Science Foundation (NCCR FINRISK and grants 101312-103781/1 and 100012-105745/1). The usual disclaimer applies.


ABSTRACT

We develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the degree of correlation across industries, countries, or asset classes is stochastic. Optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. We find that the hedging demand is typically larger than in univariate models, and it includes an economically significant covariance hedging component, which tends to increase with the persistence of variance–covariance shocks, the strength of leverage effects, the dimension of the investment opportunity set, and the presence of portfolio constraints.

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