Correlation in currency markets a risk-adjusted perspective

This paper examines the nature of correlation in the major currency markets from 1980-96, after adjusting for risk. Currency correlations are found to have an autoregressive structure, similar to that for variance. However, evidence for a link between volatility and correlation, asymmetry in correlation and cross-market effects in volatility is unconvincing on a risk-adjusted basis. The study finds that complex multivariate specifications designed to capture such effects are of dubious value. More parsimonious specifications generally perform best, provided that they capture volatility clustering. The implications for asset allocation and hedging decisions are also examined.