On the link between volatilities, regime switching probabilities and correlation dynamics

When markets are stressed, volatilities and correlations tend to increase jointly, and volatilities often react quicker than correlations. Based on this intuition, we extend the Dynamic Conditional Correlation model (Engle, 2002) in order to check whether the individual volatilities and/or the probabilities that some assets belong to a high/low volatility regime influence their correlation dynamics. We evaluate potential asymmetrical leverage effects too. We apply our methodology to MSCI Developed Markets indexes that cover twenty-three countries. The new models provide better in-sample fits and forecasts of the portfolio return distributions. Therefore, they are valuable frameworks for portfolio allocation and financial risk management.