We thank David Hyland, Arnold Cowan (the Editor), and an anonymous reviewer for helpful comments.
The Correlation Structure of Unexpected Returns in U.S. Equities
Article first published online: 21 APR 2009
© 2009, The Eastern Finance Association
Volume 44, Issue 2, pages 263–290, May 2009
How to Cite
Balyeat, R. B. and Muthuswamy, J. (2009), The Correlation Structure of Unexpected Returns in U.S. Equities. Financial Review, 44: 263–290. doi: 10.1111/j.1540-6288.2009.00218.x
- Issue published online: 21 APR 2009
- Article first published online: 21 APR 2009
- large returns;
- conditional correlation;
- equity portfolios;
- portfolio performance;
- conditional beta
We examine the correlations between unexpected market moves and unexpected equity portfolio moves conditional on market performance. We derive unexpected returns from a two-stage regime switching model. The model allows for time-varying expected returns where the market portfolio alone dictates the regime switching process. Portfolios exhibit a natural hedge where correlations during extreme unexpected market downturns are generally negative. During unexpected market upswings, correlations increase. Using the unconditional analysis would lead to overhedging during market downturns and underhedging during market upswings. The adjustments to the unconditional hedging strategy conditional on extreme market movements frequently exceed ±10%.