Title: Structural change in asset correlations and macroeconomic fundamentals
Authors: Malvina Marchese - City University of London (United Kingdom) [presenting]
Ioannis Kyriakou - Cass Business School (United Kingdom)
michael tamvakis - bayes business school (United Kingdom)
Francesca Di Iorio - University of Naples Federico II (Italy)
Abstract: The relation between parameter instability in asset returns correlations and macro-economic fundamentals is revisited using a new correlation component model, the Regime Switching DCC-MIDAS (RSDCC-MIDAS), that distinguishes regime switches in the short and long-run correlations. Breaks in the secular component are associated with low-frequency macro-economic fundamentals via a Smooth Transition MIDAS regression, while the short-run correlations are characterized by abrupt breaks due to market constraints. After a discussion of estimation and inference, and simulation-based evaluations, the model is applied to the prediction of energy future returns. Results from an extensive forecasting exercise reveal the benefits of the specification in terms of forecasting performance at medium and long horizons. In addition, the inclusion of breaks in the short-run component increases the model out-of sample performance over periods of pronounced market instability, such as the Covid-19 crisis period.