The Factor-Spline-GARCH Model for High- and Low-Frequency Correlations

We propose a new approach to model high- and low-frequency components of equity correlations. Our framework combines a factor asset pricing structure with other specifications capturing dynamic properties of volatilities and covariances between a single common factor and idiosyncratic returns. High-frequency correlations mean revert to slowly varying functions that characterize long-term correlation patterns. We associate such term behavior with low-frequency economic variables, including determinants of market and idiosyncratic volatilities. Flexibility in the time-varying level of mean reversion improves both the empirical fit of equity correlations in the U.S. and correlation forecasts at long horizons