Correlation Risk and Optimal Portfolio Choice

In this paper we solve an intertemporal portfolio problem with correlation risk, using a new approach for the simultaneous modeling of stochastic correlation and volatility. The solutions of the model are in closed form and include an optimal portfolio demand for hedging correlation risk. We calibrate the model and find that the optimal demand to hedge correlation risk is a non-negligible fraction of the myopic portfolio, which often dominates the pure volatility hedging demand. The hedging demand for correlation risk is larger in settings with high average correlations and correlation variances. Moreover, it is increasing in the number of assets available for investment as the dimension of uncertainty with regard to the correlation structure becomes proportionally more important.