Dynamic correlation or tail dependence hedging for portfolio selection

In this paper we solve for the optimal portfolio allocation in a dynamic setting, where both conditional correlation and dependence between extremes are considered. We demonstrate that there are substantial economic costs for investors in disregarding either the dynamics of conditional correlation or the clustering of extreme events. The welfare loss increases dramatically with the investment horizon, during bad economic and market conditions, and for low levels of the agent’s relative risk aversion. We illustrate that both correlation hedging demands and intertemporal hedges due to increased tail dependence have distinct portfolio implications and they cannot act as substitutes to each other. There is a substantial utility loss for disregarding dependence between extreme realizations, even when dynamic conditional correlation has already been accounted for, and vice versa. Our results are robust to the sample period, the choice of the dependence structure, and both varying levels of average correlation and tail dependence coefficients