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Anticipating Correlations: A New Paradigm for Risk Management (The Econometric and Tinbergen Institutes Lectures)
By Robert Engle
Publisher: Princeton University Press
Number Of Pages: 176
Publication Date: 2009-02-08
ISBN-10 / ASIN: 0691116415
ISBN-13 / EAN: 9780691116419
Product Description:
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.
Summary: only goes up to 2007; nothing about 2008
Rating: 4
In a relatively short text, Engle explains ideas for quantifying risks in financial modelling. He takes you rapidly beyond elementary discussions. The modelling involves extensive multivariate analysis, and estimations of the covariance matrix of these variables. The empirical performance of some modelling is described, vis a vis various national stock markets and currencies.
The GARCH model is explained and used in various chapters.
The book came out in 2009, but appears to have be written only up to late 2007. The introduction refers to the "turbulent economic world of 2007". Which was only a prelude to the crashes of 2008 and the presumed Great Recession that we are currently in. While it seems early to speak of an update to this book, that update, to include 2008-9, would be useful.
Contents
Introduction vii
1 Correlation Economics 1
1.1 Introduction 1
1.2 How Big Are Correlations? 3
1.3 The Economics of Correlations 6
1.4 An Economic Model of Correlations 9
1.5 Additional Influences on Correlations 13
2 Correlations in Theory 15
2.1 Conditional Correlations 15
2.2 Copulas 17
2.3 Dependence Measures 21
2.4 On the Value of Accurate Correlations 25
3 Models for Correlation 29
3.1 The Moving Average and the Exponential Smoother 30
3.2 Vector GARCH 32
3.3 Matrix Formulations and Results for Vector GARCH 33
3.4 Constant Conditional Correlation 37
3.5 Orthogonal GARCH 37
3.6 Dynamic Conditional Correlation 39
3.7 Alternative Approaches and Expanded Data Sets 41
4 Dynamic Conditional Correlation 43
4.1 DE-GARCHING 43
4.2 Estimating the Quasi-Correlations 45
4.3 Rescaling in DCC 48
4.4 Estimation of the DCC Model 55
5 DCC Performance 59
5.1 Monte Carlo Performance of DCC 59
5.2 Empirical Performance 61
6 The MacGyver Method 74
vi Contents
7 Generalized DCC Models 80
7.1 Theoretical Specification 80
7.2 Estimating Correlations for Global Stock and Bond Returns 83
8 FACTOR DCC 88
8.1 Formulation of Factor Versions of DCC 88
8.2 Estimation of Factor Models 93
9 Anticipating Correlations 103
9.1 Forecasting 103
9.2 Long-Run Forecasting 108
9.3 Hedging Performance In-Sample 111
9.4 Out-of-Sample Hedging 112
9.5 Forecasting Risk in the Summer of 2007 117
10 Credit Risk and Correlations 122
11 Econometric Analysis of the DCC Model 130
11.1 Variance Targeting 130
11.2 Correlation Targeting 131
11.3 Asymptotic Distribution of DCC 134
12 Conclusions 137
References 141
Index 151
Introduction
The Econometric Institute Lecture Series deals with topics in econometrics
that have important policy implications. The lectures cover a wide
range of topics and are not confined to any one area or subdiscipline.
Leading international scientists in the fields of econometrics in which
applications play a major role are invited to give three-day lectures on a
topic to which they have contributed significantly.
The topic of Robert Engle’s lectures deals with the dynamics of correlations
between a large number of financial assets. In the present global
financial world it is imperative both for asset management and for risk
analysis to gain a better understanding of the changing correlations
between a large number of assets and even between different financial
markets. In Robert Engle’s book several innovative models are proposed
and tested with respect to their forecasting performance in the turbulent
economic world of 2007.
As editors of the series we are indebted to the Erasmus University
Trust Fund, the Erasmus Research Institute of Management, and the
Tinbergen Institute for continued support for the series.
Philip Hans Franses and Herman K. van Dijk
Econometric Institute
Erasmus School of Economics
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