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Korean Journal of Financial Studies 2016;45(4):865-894.
Published online September 30, 2016.
The Effect of Common Factors on Correlation Matrix of Stock Returns and Portfolio Diversification
Cheoljun Eom, Jong Won Park
공통요인이 주식수익률간 상관행렬과 분산투자에 미치는 영향
엄철준, 박종원
Abstract
In this paper, we examine the effect of common factors on correlation matrix of stock returns and portfolio diversification and risk reduction. Contrary to the traditional method which uses the property of common factors to estimate the correlation matrix, we use the adjusted correlation matrices which are excluded the properties of common factors from the original correlation matrix. Selected common factors are the market risk premium, SMB, HML, Momentum, Long-run reversal, Short-run reversal, and Liquidity factors. Major empirical results for the Korean Stock Market are as follows: First, the market factor has the most powerful effect on the correlation matrix of stock returns. And in the large stock group the market factor, SMB, and HML have a relatively high influence, but in the small stock group the size factor (SMB) makes a distinct difference between the two correlation matrices. Second, the results of portfolio optimization show that the effect of common factors on correlation matrix makes a significant influence on the portfolio diversification and risk reduction. Especially, the difference of diversification and risk reduction between the original portfolio optimization results and the adjusted portfolio optimization results is very large in case of using the adjusted correlation matrix with the market factor compared to those of other common factors. And in the small stock group the difference of diversification and risk reduction is large in case of using the adjusted correlation matrix with the size factor compared to the large stock group. Third, the performance of diversification and risk reduction is very high in case of using the adjusted correlation matrix with the market factor compared to those of original correlation matrix. These results mean that the practical problem of portfolio optimization function in real field (the results with concentrated diversification portfolios instead of the well-diversified portfolio which is expected in the portfolio theory) is caused by the effect of market factor on the correlation matrix and the adjusted correlation matrix which is excluded the property of common factor can be useful for constructing the optimal portfolio in real field.
Key Words: 공통요인,분산투자,상관관계행렬,시장요인,위험축소,Common Factor,Correlation Matrix,Market Factor,Portfolio Diversification,Risk Reduction


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