Changing Correlation and Equity Portfolio Diversification Failure for Linear Factor Models during Market Declines*

The paper considers a linear factor model (LFM) to study the behaviour of the correlation coefficient between various stock returns during a downturn. Changing correlation is related to the tail distribution of the driving factors, which is the market for Sharpe's one-factor model. General classes of distribution functions are considered and asymptotic conditions found on the tails of the distribution, which determine whether diversification will succeed or fail during a market decline.