EPPS EFFECT STILL EXISTENT: DIFFERING UNCONDITIONAL CORRELATION BEHAVIORS FOR INTER-SECTOR STOCK PAIRS
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Abstract
For diversification purposes, investors may well distribute their investment budgets to different assets. Degree of co-movement between these assets is one of the critical determinants of portfolio performances. An investment strategy that favors putting the assets -of which the prices are driven by the same underlying factors- into to the same basket will be vulnerable to negative shocks. As the number of assets in an investment bundle grows, variance risk gradually fades whereas the covariance risk still lasts. In that regard, correlation numbers become significant. Measured correlation figures on the other hand differ as the adopted methodology for correlation calculation varies. As the time series of interest are constructed with narrower intervals for a given period, correlation numbers decrease almost all the time. This is called as Epps Effect in the literature and non-synchronicity and lead-lag relationships were shown to be main causes behind the scene. This study displays how correlation numbers continue rising as the measurement intervals gets larger for stock pairs of the same sector even though this is not the case when pairs are formed with the stocks of different sectors. Although trading practices and market dynamics changed tremendously, and algorithms took over considerable share in trading volumes, this study sheds light on the on-going existence of Epps Effect in an emerging market exchange in spite of the recent technological improvements in various layers of investment cycle.