Asymmetric correlations in equity returns: a fundamental-based explanation

Abstract

Many studies have shown that the correlation of stock portfolio returns is higher during market downturns, while very few of them offer an explanation for the causes of such an asymmetry. This article examines potential fundamental causes for the phenomenon. We find that such an asymmetry is caused by the following sources during market downturns: increasing common fundamental risk, higher correlation of individual fundamental risk and more sensitive loadings of these risk factors. We also find that these fundamental factors can only partially explain the asymmetric correlation. Possible mechanisms for these sources to drive the asymmetry are also discussed in the article.

Notes

¹ The return used in the correlation calculation is net return, i.e. initial return minus risk-free interest rate.

² Refer to Section IV for a more detailed discussion.

³ In addition to industry portfolios, Ang and Chen (2002) also examined size, value and momentum portfolios. We found that the results of these portfolios are similar in our test, so this article only focuses on the industry portfolios.

⁴ To facilitate the comparison between the results of Ang and Chen (2002) and ours, we match the data period used in their paper too.

⁵ For example, dot com bubble burst in 2001 adversely affected the industries other than just IT industry. Financial crisis in 2008 started from financial industry but subsequent negative shocks certainly affected other related industries as well. This claim, however, is based on observation and intuition. No tests have been found in the literature to prove this formally.