Scaling Portfolio Volatility And Calculating Risk Contributions In The Presence Of Serial Cross-Correlations
Source: Cornell University
In practice daily volatility of portfolio returns is transformed to longer holding periods by multiplying by the square-root of time which assumes that returns are not serially correlated. Under this assumption this procedure of scaling can also be applied to contributions to volatility of the assets in the portfolio. Trading at exchanges located in distant time zones can lead to significant serial cross-correlations of the returns of these assets when using close prices as is usually done in practice. These serial correlations cause the square-root-of-time rule to fail. Moreover volatility contributions in this setting turn out to be misleading due to non-synchronous correlations.