Time variation in the correlation structure of exchange rates: High-frequency analyses

The correlation structure of asset returns is a crucial parameter in risk management as well as in theoretical finance, In practice, however, the true correlation structure between the returns of assets can easily become obscured by time variation in the observed correlation structure and in the liquidity of the assets, We employed a time-stamped high-frequency data set of exchange rates, namely, the US$-deutsche mark and the US$-yen exchange rates, to calibrate the observed time variation in the correlation structure between their returns. We also documented time variation in the liquidity structure of these rates. We then attempted to link the observed correlations with the liquidity lia an application of an illiquid trading model first developed by Scholes and Williams (1976). We show that the observed correlation structure is strongly biased by the liquidity and that it is possible to effect at least a partial rectification of the otherwise downward-biased observed correlation. The rectified sample correlation is, therefore, more appropriate for input into models used for forecasting, option pricing, and other risk management applications. (C) 2001 John Wiley & Sons, Inc.