The Dynamics of Asset Interdependence in the Great Recession

Correlation among financial assets during the 2007–2008 financial crisis is a topic of interest among practitioners and academics, as the increase in correlation among previously considered uncorrelated classes during the crisis has negative implications for portfolio diversification. Previous research considered the rise in correlation throughout the crisis to be a result of liquidity. This paper aims to reexamine those results and test for evidence that a rise in correlation can be found by examining daily data from the Federal Reserve Economic Data database and Yahoo Finance. Correlation coefficients conditional on heteroskedasticity for stock and real estate returns are compared with each other, as well as with bill, note, and bond yields. By examining cross-asset correlations during the two years prior, during, and after the 2007–2008 financial crisis, the rise in cross-asset correlation during the crisis period can be attributed to a rise in volatility in financial markets at that time, and not due to a rise in the underlying linkage between asset classes. This rise in volatility can be linked to the lack of liquidity from the 2007–2008 financial crisis and supports a broader theoretical relationship between low liquidity, high volatility, and elevated measured correlations. These findings suggest that policy interventions aimed at restoring market liquidity during crises can help stabilize not only volatility but also investor confidence in diversification strategies. Perceived breakdowns in diversification may only be reflecting temporary volatility distortions, rather than structural failures in asset class separation.