Correlation risk

Investors hold portfolios of assets with different risk-reward profiles for diversification benefits. Conditional oil the volatility of assets, diversification benefits call vary over time depending on the correlation structure among asset returns. The correlation of returns between assets has varied Substantially over time. To insure against future low diversification states, investors might demand securities that offer higher payouts in these states. If this is the case, then investors would pay a premium for securities that perform well in regimes in which the correlation is high. We empirically test this hypothesis and find that correlation carries a significantly negative price of risk, after controlling for asset volatility and other risk factors. (C) 2008 Elsevier B.V. All rights reserved.