Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities

  • Zintle Twala Department of Economics, University of Pretoria, Pretoria, South Africa
  • Riza Demirer Department of Economics & Finance, Southern Illinois University Edwardsville, Edwardsville, USA
  • Rangan Gupta Department of Economics, University of Pretoria, Pretoria, South Africa
DOI: https://doi.org/10.22610/jebs.v10i2(J).2221
Keywords: Conditional correlation, Asset Classes, Liquidity and Volatility

Abstract

The time-variation in asset correlations have broad implications in asset pricing, portfolio management and hedging. Numerous studies in the literature have found that the change in correlations is mainly related to the magnitude of market movements, hence volatility. However, recent research finds that the size of markets fluctuations is not necessarily the primary driver for the time-variation in correlations, but that the effect of market movements is amplified in times of high financial distress, characterised by low liquidity. This paper seeks to investigate the effect of liquidity on time-varying correlations among different asset classes, namely stocks, corporate bonds and commodities. Our findings show that liquidity indeed has a significant effect on the time-variation in asset correlations, particularly in the case of how bond returns comove with other asset classes. We observe that higher liquidity risk is associated with lower correlation of bond returns with stocks as well as commodities. Our findings suggest that measures of liquidity risk can improve models of correlations; and potentially help improve the effectiveness of risk management strategies during periods of financial distress. 

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Published
2018-05-19
How to Cite
Twala, Z., Demirer, R., & Gupta, R. (2018). Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities. Journal of Economics and Behavioral Studies, 10(2(J), 120-132. https://doi.org/10.22610/jebs.v10i2(J).2221
Issue
Vol 10 No 2(J) (2018)
Section
Research Paper

Copyright (c) 2018 Zintle Twala, Riza Demirer, Rangan Gupta

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