Anticipating Correlations: A New Paradigm for Risk Management

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Princeton University Press, Jan 19, 2009 - Business & Economics - 176 pages
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Financial markets respond to information virtually instantaneously. Each new piece of information influences the prices of assets and their correlations with each other, and as the system rapidly changes, so too do correlation forecasts. This fast-evolving environment presents econometricians with the challenge of forecasting dynamic correlations, which are essential inputs to risk measurement, portfolio allocation, derivative pricing, and many other critical financial activities. In Anticipating Correlations, Nobel Prize-winning economist Robert Engle introduces an important new method for estimating correlations for large systems of assets: Dynamic Conditional Correlation (DCC).

Engle demonstrates the role of correlations in financial decision making, and addresses the economic underpinnings and theoretical properties of correlations and their relation to other measures of dependence. He compares DCC with other correlation estimators such as historical correlation, exponential smoothing, and multivariate GARCH, and he presents a range of important applications of DCC. Engle presents the asymmetric model and illustrates it using a multicountry equity and bond return model. He introduces the new FACTOR DCC model that blends factor models with the DCC to produce a model with the best features of both, and illustrates it using an array of U.S. large-cap equities. Engle shows how overinvestment in collateralized debt obligations, or CDOs, lies at the heart of the subprime mortgage crisis--and how the correlation models in this book could have foreseen the risks. A technical chapter of econometric results also is included.

Based on the Econometric and Tinbergen Institutes Lectures, Anticipating Correlations puts powerful new forecasting tools into the hands of researchers, financial analysts, risk managers, derivative quants, and graduate students.

 

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Contents

1 Correlation Economics
1
2 Correlations in Theory
15
3 Models for Correlation
29
4 Dynamic Conditional Correlation
43
5 DCC Performance
59
6 The MacGyver Method
74
7 Generalized DCC Models
80
8 FACTOR DCC
88
9 Anticipating Correlations
103
10 Credit Risk and Correlations
122
11 Econometric Analysis of the DCC Model
130
12 Conclusions
137
References
141
Index
151
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