How correlations change

By Felix Salmon
April 20, 2012
Paul Murphy has a good overview of RORO today: the risk-on, risk-off phenomenon whereby all assets are increasingly correlated.

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Paul Murphy has a good overview of RORO today: the risk-on, risk-off phenomenon whereby all assets are increasingly correlated. HSBC has even come up with a RORO Index, which, you won’t be surprised to hear, is going up and to the right:

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HSBC’s correlation matrices are prettier. In 2005, the world of investable assets was lovely and turquoise, full of low-correlation asset classes. Today, not so much.

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What really fascinates me about these correlation matrices, however, is the rankings. Look down the left-hand side, and you’ll see the big risk-on asset classes at the top, and the big risk-off asset classes at the bottom. Here’s how the lists changed between 2005 and today:

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There are strong similarities along the general lines you’d expect: stocks are at the top, bonds are at the bottom. But the differences are fascinating — none more than the fact that the dollar has moved from being at the top of the list in 2005 to being at the bottom of the list in 2012. Right now, the dollar is the ultimate safe asset; it’s not always thought of that way.

And while there were was a cluster of currencies at the bottom of the list in 2005 — the Swiss franc, the yen, the pound — they’ve now moved up into the middle of the list, in a world where pretty much every currency in the world has zero interest rates. The carry trade, at least between developed-world hard currencies, ain’t what it used to be.

Meanwhile, the VIX, which was right at the bottom of the list in 2005, is there no longer. It’s still used to hedge against downside volatility. But over the past seven years it has become much more of a traded asset class in its own right, and so while it used to have really strong negative correlation with, say, the Nasdaq, it doesn’t any more.

All of which is to say that correlation itself is not a simple risk-on, risk-off thing. In general, correlations rise as the RORO index goes up. But specific correlations can change in unpredictable ways. Sterling and natural gas might be among the few relatively uncorrelated asset classes today. But there’s no reason to believe they’ll stay that way tomorrow.

Comments
5 comments so far

I would say that this has a lot to do with the spread of statistical arbitrage trading.
Also, comparing those correlations calculated using some simple Pearson coefficient might be a complete fallacy. There could have been entirely same inherent correlations with just a bit noisier sampling representation (due to less amount of automated or just lower frequency trading), which is not that easy to filter out and simple correlation measures fail to do that.

Posted by M11 | Report as abusive

(In my 2nd point I was referring to the overall amount of correlation among assets, not the ranking)

Posted by M11 | Report as abusive

Of all the asset classes on the chart, I believe gold has been the best performer over the period, yet it is neither risk-on nor risk-off, but middle of the pack on both lists. Same is largely true of all the “real world” stuff and commod-currencies.

It’s the financial stuff that is at the extremes, and where the changes in rankings take place – the $ being the most striking example.

So, what’s the lesson for us from those 5 tumultuous years? How about – financial engineering is a dangerous thing to get mixed-up in?

Posted by MrRFox | Report as abusive

What exactly is meant by “correlation” in this case?

Posted by BrPH | Report as abusive

This video (made in 2011, and with fewer assets) shows the dynamics; the risk-off phenomenon is particularly clear during crisis, when the whole matrix turns red.

http://www.youtube.com/watch?v=LBO2bYH_K eA

Posted by Th.M | Report as abusive
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