Correlation Forecasts, Tail Risks, and Something About a Rug

When we estimate risk, we’re not re-telling the past. We’re forecasting.


THOUGH IT RECEIVED A LOT OF POSITIVE FEEDBACK FROM investors, our research on the failure of diversification skirted an important question: Can we forecast correlations? The answer: sort of. As we discussed in the previous chapter, the left-tail events that drive correlation shifts in the markets are basically impossible to predict. Perhaps all we can do is build the airplane to withstand the turbulence whenever it occurs. Nonetheless, if volatility is persistent, and if we can forecast portfolio volatility, which is in part driven by correlations among the underlying assets, shouldn’t we observe some ...

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