No. 2/2011
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CORRELATIONS IN EXTREME SITUATIONS
– AN EMPIRICALANALYSIS IN THE GERMAN
FINANCIAL MARKET WITH THE SPECIAL FOCUS
ON THE IRRATIONALITY OF MARKETS
Svend Reuse
Gabler Wiesbaden 2011. 283 p., 76 fig. and 37 tab. ISBN 978-3-8349-2724-8.
The classical Markowitz approach of portfolio theory is more than 50 years old.
Even though it is often used in practice, the financial crisis in 2007/2008 led to
hard criticism of the approach, especially due to the efficiency of correlations.
The topic of the presented book, which has been a dissertation at Masaryk
University, is highly topical and answers central questions according the usage of
portfolio theory. It is published in one of the best German publishing houses:
Gabler Research.
The work is structured in six chapters. The formulation of the central theses
builds chapter 1. Chapter 2 sums up the status quo of portfolio theory and asset
allocation with special respect to aspects of behavioral finance. This chapter
shows a high academic level and sums up all relevant aspects of the topic.
Chapter 3 deals with a survey conducted in 1,000 German banks. The return rate
of 11.3% can be stated as good and representative. Banks of all banking groups
answered a questionnaire. The topic of the questionnaire deals with the status quo
of asset allocation in German banks, the used models of allocation and it analyses
the bearing of correlations in extreme situations with the focus on irrational
behavior. Resulting from the findings of the survey, market data based
irrationality indices for a 10 year history are evaluated. The survey convinces by
its representativeness, the quality of answers and the new findings which are
generated for the first time in this form. The survey is done at a high scientific
level.
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24
Chapter 4 deals with the main problem of the book, the bearing and modulation
of correlations. The two used computer programs are programmed especially for
this purpose. They offer a high level of professionalism; they can be used in
practice without any change. Further, the done analysis shows that correlations
remain stable especially in times of extreme situations. This result is higher-thanaverage
and proves in theory and practice that the basic ideas of Markowitz are
still valid. After that, the definitions of KaC (Korrelation-at-Chance) and KaR
(Korrelation-at-Risk) show that correlation risk is separable. Based onto the
indices of chapter 3, a tactical optimization approach is modeled that outperforms
the Markowitz approach. This model implements the historical extreme
correlations. Only by varying the correlations based on the impacts of the
irrationality indices, the developed model leads to a better performance with
lower risk in 16 year backtesting. In this context, the general efficiency of the
Markowitz approach is shown as well. This model can be used in practice, it is
interesting e.g. for investment fund managers.
Chapter 5 deals with the modulation of a correlation certificate. A correlation
option is modeled. The backtesting of this option shows shown that correlation
risk can be hedged. The new findings consist of the definition of a correlation
strike and the integration of the investor’s individual portfolio into the
modulation. This option would lead to interest in the Czech or German financial
market.
Chapter 6 sums up all findings of the book. Finally, all four theses of the work
can be verified. First, the classical Markowitz approach is still an efficient model
as correlations remain stable during a crisis. Second, it is shown by the
irrationality indices that phases of irrationality can be identified early. Third, the
tactical oriented model shows that the combination of behavioral finance and
extreme correlations leads to an absolute and a relative outperformance compared
to the classical asset allocation. Fourth and last, the developed correlation
certificate makes clear that diversification risk can be hedged and an investor is
able to eliminate short term correlation risk by using the certificate.
The book convinces the reader by its high scientific level: 513 cited sources,
1,214 footnotes, a perfect structured annex and figures and tables of high quality
support this. The work combines classical portfolio theory and behavioral
finance. It offers some new results in this research area, primary done by the
survey, the tactical optimization approach and the correlation option.
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“Correlations in extreme Situations” is very interesting for those who deal with
asset allocation in practice. But even for further scientific research it is
recommendable without any restrictions as it is a good basis for the integration of
classical portfolio theory and behavioral finance. The work is worth to be
distributed widely in the Czech Republic and in Germany.
Reviewed by:
Eric Frère
Hochschule für Oekonomie und Management (FOM)
Dean for international studies
Professorship for Finance and Entrepreneurship