Forecasting International Equity Correlations

Abstract

An important component of asset allocation decisions is the future correlation structure of equity returns. Other studies have found that correlations change through time. Examination of the changing cross-country correlations in the G-7 countries provides clues as to why they change. Equity cross-correlations are related to the coherence between business cycles in the respective countries. Correlations are higher during recessions than during growth periods. Correlations are low when two countries' business cycles are out of phase. A semicorrelation metric differentiates equity comovements in bull and bear markets and provides a method for forecasting multiperiod equity correlations. Two applications are investigated: out-of-sample global portfolio allocation and derivative instruments.

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