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A method of estimating changes in correlation between assets and its application to hedge fund investment

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One of the difficult problems in asset allocation is accounting for changes in the correlation between assets and asset classes. This problem is particularly evident among hedge funds, where many strategies that appear uncorrelated with the stock market for long periods of time suddenly become highly correlated with the market during periods of substantial market decline. The standard market-model for securities assumes constant correlation. This paper outlines a simple econometric method for determining whether assets exhibit time-varying correlation, and for estimating the rate of change. This method is tested using monthly returns for a number of hedge fund indexes to predict changes in the correlation of these indexes with the S&P500 stock index.Journal of Asset Management (2001) 1, 217–230; doi:10.1057/palgrave.jam.2240016
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Document Type: Research Article

Affiliations: 1: 1Graduate School of Management, Clark University, 950 Main St., Worcester, MA, 01610, USA., Tel: +508 793 7596, Fax: +508 793 8822, Email: [email protected] 2: 2Research Director of the Center for International Securities and Derivatives Markets at the University of Massachusetts, and Research Director for TRS Associates 3: 3Professor of Finance at the School of Management at the University of Massachusetts in Amherst, Massachusetts

Publication date: 2001-01-01

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