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ENDOGENOUS CROSS CORRELATIONS

Published online by Cambridge University Press:  05 July 2007

STEPHEN E. SATCHELL  and
STEFFI J.-H. YANG
STEPHEN E. SATCHELL
Affiliation:
University of Cambridge and Trinity College, Cambridge
STEFFI J.-H. YANG
Affiliation:
Wolfson College, Cambridge
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Abstract

This paper studies the relationship between rational herding and cross correlations in security returns. It demonstrates analytically and numerically that herding, as a temporary, fragile convergence of investment behavior, can endogenously induce asset dependency. Furthermore, there exists a self-reinforcing process, in which market extreme events amplify the herd effect, which further exacerbates asset dependency. Considering the Taiwan and U.K. equity markets, we find that the simulated markets in the presence of herding have results closer to the real patterns of asset dependency than a static model with isolated, noninteracting individuals. Our findings cast doubts on the current view that transparent financial regulation is always desirable. Moreover, this paper finds statistical evidence of asymmetric correlation patterns in both the top 50 stocks in the U.K. and Taiwan equity markets. This suggests that portfolio diversification as a means of managing portfolio risk is unlikely to be effective in periods of extreme losses in these markets.

Keywords

HerdingReturn CorrelationsMarket Conditions
Type
ARTICLES
Information
Macroeconomic Dynamics , Volume 11 , Supplement S1: Interacting Agents and Market Behavior , November 2007 , pp. 124 - 153
Copyright
© 2007 Cambridge University Press

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