Changing Correlation and Equity Portfolio Diversification Failure for Linear Factor Models during Market Declines*

Abstract

The paper considers a linear factor model (LFM) to study the behaviour of the correlation coefficient between various stock returns during a downturn. Changing correlation is related to the tail distribution of the driving factors, which is the market for Sharpe's one‐factor model. General classes of distribution functions are considered and asymptotic conditions found on the tails of the distribution, which determine whether diversification will succeed or fail during a market...