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Forecasting International Equity Correlations

Financial Analysts Journal, November/December (1995): 32-45

Claude Erb

First National Bank of Chicago, Chicago, IL 60670, USA

Campbell R. Harvey

Duke University, Durham, NC 27706, USA

National Bureau of Economic Research, Cambridge, MA 02138, USA

Tadas Viskanta

First National Bank of Chicago, Chicago, IL 60670, USA


An important component for asset allocation decisions is the future correlation structure of equity returns. We characterize the changing cross-equity correlations in the G-7 countries. While others have found that correlations change through time, we explore the reasons why they change. We find that equity cross-correlations are related to the coherence between business cycles in the respective countries. Correlations are higher during recessions than during growth periods. Correlations are low when the two business cycles are out of phase. We also propose a semicorrelation metric which differentiates equity comovements in bull and bear markets. Finally, we present a method to forecast multiperiod equity correlations. Two applications are investigated: out-of-sample global portfolio allocation and derivative instruments.