Correlation risk and optimal portfolio choice

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Buraschi, Andrea ; Porchia, Paolo ; Trojani, Fabio (2010)

We develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the degree of correlation across industries, countries, or asset classes is stochastic. Optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. We find that the hedging demand is typically larger than in univariate models, and it includes an economically significant covariance hedging component, which tends to increase with the persistence of variance-covariance shocks, the strength of leverage effects, the dimension of the investment opportunity set, and the presence of portfolio constraints.
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