Volatility, time varying correlation and international portfolio diversification : an empirical study of Australia and emerging markets

This paper examines the changing correlations between the equity returns of Australia and the emerging equity markets and the tests the volatility, as a factor, that may cause the correlations to change over time. Linear regression estimates of Asymmetric Dynamic Conditional Correlation Model, which allows correlations to change, have been used to test if the volatilities of individual markets or their relative volatility causes the change in correlations. The results suggest that the correlations between Australia’s equity return and emerging markets’ equity returns, represented by the respective market index returns, change over time and the variation in correlations is influenced by the volatility of the emerging market returns. In some cases, the relative volatility of the markets, the ratio of emerging market volatility to the volatility of the Australian market, is found to influence the change in correlations. The relationship between the correlations and the volatilities is stronger in some country pairs (with Brazil, Chile, India, Malaysia and Philippines) and very weak for Sri Lanka and Turkey.