6. Correlation Tightening

Financial theory and practice place great emphasis on volatility, in its absolute sense and in relative terms as the ratio between asset-specific and market-wide volatility. But correlation appears to be the true driver of the risk-return relationship. “In falling markets, the only thing that rises is correlation,” Correlation tightening poses a unique threat to risk-return relationships and to portfolios built upon them. Meta-analysis of emerging market data reveals that the risk associated with this asset class subsists almost entirely in its vulnerability to the tightening of its correlation with developed markets during times of crisis. Although some sources dispute this characterization, correlation risk is priced into risky securities and quite likely explains the low-volatility anomaly. Correlation risk also appears to be closely related to liquidity risk and to theories of contagion.