Evaluation of correlation forecasting models for risk management

Reliable correlation forecasts are of paramount importance in modern risk management systems. A plethora of correlation forecasting models have been proposed in the open literature, yet their impact on the accuracy of value‐at‐risk calculations has not been explicitly investigated. In this paper, traditional and modern correlation forecasting techniques are compared using standard statistical and risk management loss functions. Three portfolios consisting of stocks, bonds and currencies are considered. We find that GARCH models can better account for the correlation's dynamic structure in the stock and bond portfolios. On the other hand, simpler specifications such as the historical mean model or simple moving average models are better suited for the currency portfolio. Copyright © 2007 John Wiley & Sons, Ltd.