Volatility, Correlation, and the Market Trend

Abstract

The influence of past stock price movements on volatilities and correlations is essential for understanding diversification and contagion in financial markets. We develop a model that makes the influence of past returns on volatilities and correlations explicit. Employing information about recent market movements leads to a more realistic model for the behavior of stock returns in a downturn than conventional models. Our approach offers a fresh perspective on the behavior of stock markets, and provides an alternative to the concept of exceedance correlation. We provide strong evidence for the existence of contagion in financial markets that cannot be absorbed by diversification.