European Journal of Operational Research 271 (2018) 676–696

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European Journal of Operational Research

journal homepage: www.elsevier.com/locate/ejor

Innovative Applications of O.R.

Long-run wavelet-based correlation for financial time series

Thomas Conlon a,∗, John Cotter a, Ramazan Gençay b
a
Smurfit Graduate Business School, University College Dublin, Ireland
b
Simon Fraser University, Burnaby, British Columbia, Canada

a r t i c l e i n f o a b s t r a c t

Article history: The asset allocation decision often relies upon correlation estimates arising from short-run data. Short-
Received 24 May 2017 run correlation estimates may, however, be distorted by frictions. In this paper, we introduce a long-run
Accepted 15 May 2018
wavelet-based correlation estimator, distinguishing between long-run common behavior and short-run
Available online 19 May 2018
singular events. Using generated data, we demonstrate a reduction in bias and error of up to 84.2% and
Keywords: 38.9%, respectively, relative to a traditional subsampled approach. Exploiting the wavelet decomposition
Decision analysis into short- and long-run components, we develop a model to help understand the sources of any het-
Long-run erogeneity in correlation. The implication is that short-run correlation may be downward biased by fric-
Correlation tions, the latter manifesting as serial- and cross-serial correlation in the raw time series. In an empirical
Wavelet application to G7 international equity markets, we present evidence of increasing correlations at longer-
Portfolio allocation run horizons. The significance for the asset allocation decision are examined using a minimum-variance
framework, highlighting distinct optimal allocation weights at short- and long-run horizons.
© 2018 Elsevier B.V. All rights reserved.

1. Introduction In this paper, we offer a number of contributions. The first

The allocation of capital between risky assets is amongst the
most crucial decisions faced by an investor. Central to the portfolio
formation decision are estimates of asset correlations. Low correla-
tions between risky assets may provide diversification benefits, al-
lowing investors to take advantage of off-setting returns in a port-
folio context. Conclusions drawn from correlations calculated using
short-run data may provide limited insight regarding long-run di-
versification opportunities.1 In this paper, we develop a method-
ology to estimate long-run correlations between time series and
present a model to help understand any apparent heterogeneity
in the term-structure of correlation. The relevance for the port-
folio allocation decision is then considered by contrasting long-
and short-run correlations between equity markets of G7 countries
and exploring the optimal portfolio weighting implications for a
minimum-variance investor.
∗
Corresponding author.
E-mail addresses: conlon.thomas@ucd.ie (T. Conlon), john.cotter@ucd.ie (J. Cot-
ter), rgencay@sfu.ca (R. Gençay).
1
Little consensus exists regarding a definition of long-run in the context of in-
vestment. Harrison and Zhang (1999) study horizons of up to two years in examin-
ing the long horizon risk and return relation. Long-run horizons of up to five years
are often considered in the literature, especially in the long-run risk and asset pric-
ing literature (Beeler & Campbell, 2012; Boudoukh, Richardson, & Whitelaw, 2007;
Kamara, Korajczyk, Lou, & Sadka, 2016). In this paper, we consider long-run hori-
zons of up to two years using daily data and up to five years using monthly data.
relates to methodology. Estimation of the co-movement between
financial assets is beset by difficulties such as asynchronous
trading, market jumps and delays in information processing.
Employing a multi-horizon non-parametric filter, the wavelet
transformation, we develop a long-run correlation estimator,
distinguishing between short-run singular events and long-run
common behavior.2 The wavelet transformation is based upon a
decomposition of time series into spectral components. In contrast
to earlier wavelet-based studies such as Hasbrouck (2018), Ortu,
Tamoni, and Tebaldi (2013), In and Kim (2006) and Gençay, Sel-
cuk, and Whitcher (2005), our focus is on residual long-run fluc-
tuations rather than short-run frequency bands. The wavelet trans-
formation is particularly appropriate for the study of financial time
series, helping to isolate long-run comovement in the presence of
frictions. The approach outlined provides numerous advantages rel-
ative to related filtering techniques. First, there is no requirement
for periodicity in time series, distinguishing the approach from
Fourier analysis, often employed to highlight spectral properties of
financial time series. Second, relative to filters such as the Baxter
and King (1999) and Hodrick and Prescott (1997), where the fo-
cus is on univariate estimation of cycles in time series, our method
2
The wavelet transformation has been extensively applied to understand time-
frequency characteristics of time series in diverse areas such as medical diagno-
sis (Ivanov et al., 1999), climate oscillations (Moy et al., 2002), image compres-
sion (Lewis & Knowles, 1992) and oceanography (Percival, 1995; Percival & Mofjeld,
1997).

https://doi.org/10.1016/j.ejor.2018.05.028
0377-2217/© 2018 Elsevier B.V. All rights reserved.
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696
provides for multivariate time series characterization. Finally, sep-
arating short-run singular events from long-run common behav-
ior, we focus on intertemporal characteristics linked to the trading
horizon of investors, rather than characterizing financial markets
in a narrow spectrum. We confirm the superiority of our wavelet
long-run correlation measure using generated data and show that
it provides estimates with better statistical properties relative to
traditional approaches commonly employed for financial time se-
ries.
A second methodological contribution relates to discerning the
source of any heterogeneity in comovement over short- and long-
run horizons. To this end, we decompose our long-run correla-
tion estimator into components relating to short-horizon charac-
teristics. While the tendency for differential correlation estimates
between returns of financial assets as the measurement interval
changes has long been documented, Epps (1979),3 this paper pro-
vides the first attempt to isolate the sources of any term-structure
in correlation. Exploiting our time series filter, we accurately model
long-run correlation solely as a function of short-run data while
accounting for commonly-reported characteristics of financial as-
sets such as serial- and cross-serial correlation. The latter may be
a consequence of non-synchronous trading hours or lead–lag ef-
fects between financial assets, heavily documented in the litera-
ture (Cohen & Frazzini, 2008; Hong, Torous, & Valkanov, 2007). The
implication is that short-run correlation estimates are downward
biased in the presence of frictions. In a similar fashion, short-run
estimation biases in volatility and systematic risk exposures have
also been partially attributed to non-synchronous trading (Cohen,
Hawawini, Maier, Schwartz, & Whitcomb, 1983a; Kamara et al.,
2016; Lo & Mac Kinlay, 1990). Using generated data with charac-
teristics congruent to those observed in financial time markets, we
also highlight how biased estimates of correlations emerge in the
presence of frictions. Interpreting our findings, risk-reduction ben-
efits perceived by investors due to low correlations may be over-
stated using short horizon data.
Our third contribution is empirical. In order to illustrate the
wavelet-based long-run correlation measure, we consider a set of
international equity indices from G7 countries. Diversification into
international markets is often considered in the literature as a nat-
ural risk reduction extension of the classic Markowitz portfolio
selection theory (Grubel, 1968; Levy & Sarnat, 1970; Markowitz,
1952). The diversification benefits of international diversification
have largely been established using data with monthly horizon.4
We provide conclusive evidence that correlations between devel-
oped G7 markets increase at longer-run horizons. For example, the
average correlation between markets is shown to increase from
0.578 at the commonly-examined monthly horizon to 0.755 at a
64 month horizon, a 31% increase. Moving from a one day hori-
zon to the longest horizons we observe a substantial 84% increase
in correlation, highlighting a potential reduction in diversification
opportunities amongst G7 countries in the long-run. Consistent re-
sults are documented for G7 exchange traded funds, which have
synchronous trading hours, and using an alternative wavelet ba-
sis. Moreover, using a minimum-variance allocation framework,
we demonstrate distinct optimal portfolio allocation weights at
short- and long-horizons. Finally, employing the decomposition
into short-run components previously described, we accurately
model long-run correlation using only short-run data. The intuition
from these findings is that an investor using short-horizon data,
3
For this reason, the phenomena of decreasing correlation between assets at high
frequency is sometimes known as the Epps effect.
4
Goetzmann, Li, and Rouwenhorst (2005), Longin and Solnik (2001), De Santis
and Gerard (1997), Heston and Rouwenhorst (1994) and Grubel (1968) all con-
sider data with monthly horizon, while Christoffersen, Errunza, Jacobs, and Langlois
(2012) and Bekaert, Hodrick, and Zhang (2009) study weekly data.
677
such as the monthly data often considered in the literature, may
overestimate gains from diversification.
The contributions outlined relate to the literature in a number
of ways. First, our paper pertains to but can be distinguished from
recent contributions to the long-run investment literature, where
focus has primarily been on univariate time series (Barberis, 20 0 0;
Pástor & Stambaugh, 2012). In contrast, our focus on developing
a long-run estimator of correlation relates to the determination
of opportunities for risk reduction in a portfolio context. Further-
more, this paper can be thought of in the same light as literature
which examines the implications for systematic risk at different in-
tervals (Cohen et al., 1983a; 1983b; Gençay et al., 2005; Perron,
Chun, & Vodounou, 2013). The model of long-run correlation de-
veloped here links biased short-run correlation estimates to fric-
tions, in keeping with previous work attributing horizon-related
heterogeneity in volatility and systematic risk to information trans-
mission delays and non-contemporaneous trading (Cohen, Hawaw-
ini, Maier, Schwartz, & Whitcomb, 1983b; Martens & Poon, 2001;
Schotman & Zalewska, 2006).
Common with studies such as Hasbrouck (2018), Ortu et al.
(2013), In and Kim (2006) and Gençay et al. (2005), the approach
developed here also consists of decomposing time series into spec-
tral components using wavelet analysis, but our focus is on resid-
ual long-run contributions rather than the short-run frequency
bands considered in these and other studies. Wavelet analysis has
been comprehensively utilized across a range of problems in both
economics (Faÿ, Moulines, Roueff, & Taqqu, 2009; Gençay & Sig-
nori, 2015; Hong & Kao, 2004) and finance to understand horizon
dependent characteristics. In particular, wavelet-based techniques
have been broadly applied to understand the time-frequency prop-
erties of financial time series (Gençay et al., 2005; In & Kim, 2006;
Ortu et al., 2013; Reboredo, Rivera-Castro, & Ugolini, 2017; Rua
& Nunes, 2009). Hasbrouck (2018) suggests that wavelet long-run
variance is purged of short-run variation, perhaps serving as a bet-
ter estimate of long-term variance. The approach detailed in this
paper can be thought of in a similar light, with long-run cor-
relation estimates helping to expunge short-run frictions associ-
ated with financial data. Our paper also relates to, but can be
distinguished from, Rua and Nunes (2009), where the continuous
wavelet transformation is employed to understand the highly lo-
calized comovement between international markets in particular
frequency bands. In contrast, the methodology developed here is
directly linked with realizable investment horizons. A related ap-
plication of wavelet analysis to financial time series is de-noising
through separation of low- and high-frequency fluctuations (Haven,
Liu, Ma, & Shen, 2009; Haven, Liu, & Shen, 2012; Sun & Meinl,
2012). Finally, while many papers have adopted the wavelet trans-
formation in understanding financial characteristics, this is also the
first paper to assess, using generated data, the appropriate wavelet
basis to examine financial time series and to adopt weakly-biased
coefficients in estimating financial time series correlation (Cornish,
Bretherton, & Percival, 2006).
The riskiness of a financial portfolio is linked to the risk of the
underlying assets and the correlation between constituents (Kolm,
Tütüncü, & Fabozzi, 2014).5 The long-run correlations detailed here
help to overcome the challenge of short-run data frictions. Fur-
thermore, our finding of differential correlation between financial
time-series for short- and long-run horizons is linked to the exten-
sive literature outlining horizon effects on financial characteristics.
In addition to the sensitivity of measured betas to underlying fric-
tions previously described, optimal futures hedge ratios (In & Kim,
2006), risk (Bandi & Perron, 2008; Conlon, Cotter, & Gençay, 2016),
5
Applications of correlation to operational research more generally include the
fields of supply chain management (Raghunathan, 2003), wind farm optimization
(Le Cadre, Papavasiliou, & Smeers, 2015) and queueing networks (Kim, 2011).
678 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696
asset allocation (Bianchi & Guidolin, 2014) and predictability
(Boudoukh et al., 2007) have each been shown to be dependent
upon the horizon investigated. While many such papers have in-
dicated empirical characteristics relating to horizon, we provide a
fundamental underpinning by detailing a model linking long-run
correlation to short-term characteristics.
The finding of increasing correlation between international eq-
uity markets builds upon the extended literature examining the
benefits of international diversification, but where the focus was
predominantly on weekly or monthly data. Broadening this analy-
sis to long-run horizons, we highlight a diminishing potential for
diversification in the long-run and an associated alteration in opti-
mal weights associated with a simple asset allocation framework.
Asness, Israelov, and Liew (2011), in contrast, suggest that interna-
tional investors experience less severe downside risk over holding
periods of up to ten years. Their results point towards the inad-
equacy of measuring the benefits of international diversification
using short-term correlations tarnished by simultaneous market
crashes. Finally, our results pertain to recent literature indicating
that moderate levels of co-dependence witnessed between interna-
tional equity markets may be deceptive, particularly when consid-
ered from a downside risk perspective (Christoffersen et al., 2012;
You & Daigler, 2010).
The remainder of this paper is organized as follows. In the
next section, we develop the methodology required to estimate
long-run correlation and describe how it may be decomposed into
short-run contributions. Section 3 employs a simulation study to
demonstrate the benefits of our empirical methodology in estimat-
ing correlation. Our empirical analysis is described in Section 4,
while Section 5 provides a summary and conclusion.
2. Methodology
2.1. Wavelet decomposition
The partitioning of economic and financial time series into
short- and long-term contributions has garnered considerable in-
terest in the literature (Hansen & Scheinkman, 2009; Hodrick &
Prescott, 1997; Perron et al., 2013). Low-frequency (long-run) fea-
tures of a time series may overcome short-term noise or shocks,
and help reveal underlying economic relationships between vari-
ables. When considering pairs of financial time series, measure-
ment of their short-run dependency may be biased by frictions
in the trading process. In particular, international equity markets
have non-synchronous trading hours and may be impacted by spe-
cific frictions such as price transmission delays. Aggregation over
longer horizons may help to mitigate against such biases, a prob-
lem we address here using a non-parametric multi-horizon filter,
based upon wavelet analysis.
The challenge of estimating synchronized returns from unsyn-
chronized market closing prices has previously been considered
using multivariate and state space approaches (Burns, Engle, &
Mezrich, 1998; Grigoryeva, Ortega, & Peresetsky, 2018). In particu-
lar, a vector autoregression (VAR) or Kalman filter (KF) can be used
to estimate synchronized returns, using a lagged parametric struc-
ture to impute expected returns for a closed market using infor-
mation from markets for which more recent returns exist. A num-
ber of crucial differences between such methods and the wavelet-
based approach proposed here are highlighted.
First, both the VAR and KF filter approaches require estima-
tion of the set of parameters associated with the model us-
ing, for example, maximum likelihood estimation. In contrast, the
wavelet-based approach described here is based upon predeter-
mined weights for data averaging and data differencing. In other
words, no estimation of such weights is involved and therefore
there are no estimation errors associated with the subsequent
wavelet coefficients. The predetermined weights are based upon
an objective function which minimizes misalignments in time
due to such averaging (so-called phase distortions), Daubechies
(1992). The comparative absence of estimation error associated
with wavelets may result in more robust correlation estimates rel-
ative to the VAR and KL approaches even without non-parametric
time series features, a point we consider further through a simula-
tion approach.
Second, the wavelet transformation has time-scale (or time-
frequency) localization properties, important in the presence of
non-parametric features such as jumps and regimes, commonly ob-
served in financial time series. The decomposition of a time se-
ries into separate time-scale components helps in distinguishing
jumps from continuous price changes. In the approach to long-run
correlation described below, we focus on the long-run common
behavior between time series, discarding the larger, quickly decay-
ing wavelet coefficients associated with jumps. In signal process-
ing terms, this is analogous to optimally splitting the time series
into signal and noise, with correlation estimated using signal. In
contrast, parameter estimation for traditional time series methods
such as VAR or KF may be impeded by the presence of jumps.
Third, a stylized fact pertaining to financial time series is the
existence of distinct periods of high and low volatility. The local-
ization properties of the wavelet transformation allow for a simul-
taneous decomposition of high and low volatility periods into dis-
crete scales. In the context of the long-run correlation approach
developed below, focus is on low-frequency or long horizon char-
acteristics but without a requirement for regime dependent pa-
rameter estimation, instead applying the predetermined weighting
structure referred to above. While VAR and KF can be combined
with, for example, non-linear regime switching models, this comes
at the expense of additional parameter estimation uncertainty.
In this section, we outline the wavelet approach to time series
partitioning. Specifically, we describe the maximum overlap dis-
crete wavelet transformation (MODWT), a mathematical tool that
projects a time series onto a series of orthogonal basis functions
(wavelets) resulting in a set of wavelet coefficients or filtered time
series associated with distinct frequencies (time horizons).6 While
a wide variety of wavelet basis functions are available, higher-order
sophisticated wavelet filters provide a number of benefits (Lindsay,
Percival, & Rothrock, 1996). The order of a filter is determined by
the number of vanishing moments, also associated with increas-
ing filter length and improved approximation to an ideal high pass
filter. Moreover, higher-order sophisticated wavelets display less
leakage between frequencies, a problem particularly prevalent for
the straightforward Haar wavelet. The wavelet basis derived from
filters of a particular order are also orthogonal to polynomials of
lower order. For the simplest Haar wavelet, this means that a lin-
ear trend in the data will offset the wavelet coefficients by a con-
stant related to the magnitude of the slope. Higher order wavelet
basis vectors are orthogonal to such a trend, with the implication
that our measurement of wavelet long-run correlation is not biased
by the presence of localized linear trends. Finally, the phase shift,
or shift in position of time series features is related to the degree
of symmetry in a wavelet. The Daubechies least-asymmetric fam-
ily, selected for the subsequent analysis, has smaller shifts and less
distortion in the location of features relative to the Haar wavelet.
2.2. The maximum overlap discrete wavelet transformation (MODWT)
A wavelet is a small wave which grows and decays in a limited
time period. The wavelet transformation decomposes a time series
6
An alternative is the continuous wavelet transformation, often adopted to iso-
late dynamic time-frequency characteristics of financial time series (Bredin, Conlon,
& Potì, 2015; Reboredo et al., 2017).
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696 679

into sets of coefficients relating to a scale or horizon, where the In practise, a so-called pyramid algorithm is adopted using three
elements of each set are associated with a particular location. In objects: data to be filtered, the wavelet filter {hl } and the scaling
this study we apply the MODWT, an undecimated version of the filter {gl }. The first pyramid algorithm step involves applying each
wavelet transformation which can be shown to accurately decom- filter to the original time series {rt } to obtain the following wavelet
pose the aggregate variance and covariance of a time series into and scaling coefficients:
contributions associated with a particular scale.7 L−1 L−1
 
Let {hl } = (h0 , h1 , . . . , hL−1 ) in RL be a finite length wavelet (or w1,t = hl rt−l mod T , v1,t = gl rt−l mod T , (8)
high-pass) filter of length L. Given a sequence to be filtered {rt }, l=0 l=0
the convolution of {hl } and {rt } is
for t = 1, 2, . . . , T , where l mod T is commonly used to represent

l= ∞ the calculation of coefficients at the time series boundary (Conlon
h ∗ rt = hl rt−l ∀ t, (1) et al., 2016; Gençay, Selcuk, & Whitcher, 2001; Percival & Walden,
l=−∞ 20 0 0). This application of a high- and low-pass filter results in two
where hl = 0 ∀ l < 0 and l ≤ L. A wavelet filter {hl } of length L sets of T wavelet coefficients associated with the time series. The
has the following properties, second step of the pyramid algorithm applies the filtering opera-
tions to the scaling coefficients obtained from the first step,
L−1
 L−1
 ∞

1 L−1 L−1
hl = 0 , h2l = , hl hl+2n = 0 ∀ integers n = 0.  
2 w2,t = hl v1,t−l mod T , v2,t = gl v1,t−l mod T , (9)
l=0 l=0 l=−∞
l=0 l=0
(2)
for t = 1, 2, . . . , T . At this stage, the original time series has been
These properties ensure (i) the wavelet filter sums to zero and decomposed into three constituents: w = [w1 , w2 , v2 ]. A similar
identifies changes in the data, (ii) the wavelet filter has norm 1/2, process to the second step is then followed up to J times, resulting
resulting in variance preservation between the data and the de- in Eq. (6).
composition, and (iii) orthonormality of the set of functions de-
rived from {hl }, facilitating multiresolution analysis of a finite en- 2.3. MODWT ANOVA
ergy signal. The wavelet filter {hl } is complemented by the wavelet
scaling filter {gl }, viewed as a local averaging operator and has An analysis of variance can be performed via the MODWT such
properties: that the aggregate variance of the original time series is perfectly
L−1
 L−1
 ∞
 captured by the variance of the MODWT coefficients (see Percival &
1
gl = 1 , g2l = , gl gl+2n = 0, Mofjeld, 1997 for a thorough proof). Let vector R be a vector with
2 elements {rt }, and wj and vJ be vectors representing the MODWT
l=0 l=0 l=−∞
∞
 decomposition of R. Let
gl hl+2n = 0 ∀ integers n = 0. (3)

T
l=−∞ R2 = rt2 (10)
Similar to the wavelet filter, the scaling filter has unit energy and t=1
is orthogonal to even shifts. The first property ensures the scaling be the square of the Euclidean norm of R. The MODWT is energy
filter averages consecutive blocks of data, as opposed to differenc- preserving, in the sense that
ing them. The scaling filter and wavelet filter are related by the
quadrature mirror relationship 
J
R2 = wj 2 + vj 2 . (11)
gl = (−1 ) l+1
hL−1−l for l = 0, 1, . . . , L − 1. (4) j=1

Convolving a time series r having observations T with the
MODWT results in a vector of MODWT coefficients w, which can
be represented using matrix operations via,
w = Wr.
W is a (J + 1 )T × T matrix defining the MODWT and J ≤ log2 T is
the maximum decomposition level or scale of the MODWT. The ar-
ray of MODWT coefficients consists of (J + 1 ) vectors via
 T
w = w1 , w2 , . . . , wJ , vJ , (6)
When J = 1, this is given by R2 = w1 2 + v1 2 . In this paper,
our focus differs from the extant literature considering frequency-
band contributions to financial time series (see, for example, In &
(5) Kim, 2006; Ortu et al., 2013; Gençay et al., 2005). Instead of con-
sidering short-run frequency-band variance wj 2 , we concentrate
on the long-run residual contribution vj 2 .
If the sample mean of the time series R is given by R̄ =
T
t=1 rt /T , then the sample variance may be expressed as
1  2 1
T

where wj is a length T vector of wavelet coefficients associated

σR2 = rt − R̄ = R2 − R̄2 (12)
T T
t=1
with changes on a scale or horizon of length λ j = 2 j+1 and vJ is a
length T vector associated with averages on a scale of length 2J+1 . 
1 
J

J
The matrix W used to determine the wavelet coefficients com- = wj 2 + vJ 2 − R̄2 = σw2 j + σv2J , (13)
prises J + 1 submatrices, each of which has dimension T × T, and T
j=1 j=1
may be expressed as
 T where
W = W1 , W2 , . . . , WJ , VJ . (7)
1
J
1
where W j and VJ are defined in terms of the wavelet filter {hl } and σw2 j = wj 2 and σv2J = vJ 2 − R̄2 . (14)
T T
scaling filter {gl }, respectively. j=1

σw2 j is the jth scale sample wavelet variance and σv2J is the sam-
7
It is common throughout the literature to distinguish the MODWT from the ple scaling or long-run variance. The long-run scaling variance at
related discrete wavelet transform (DWT) by the use of a tilde ( ∼ ) over the corre- horizons greater than τ J is then given by
sponding notation. As the DWT is not invoked throughout the present discussion,
we omit the tilde throughout as there is limited scope for confusion. σm,J
2
= V ar (vm,J ) − R̄2m , (15)
680 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696
where vm,J are the wavelet scaling coefficients for time series m
at long-run horizons greater than τJ = 2J+1 . Similarly, the wavelet
long-run scaling covariance, σmn,J
2 , between time series of two dis-
tinct assets m and n at horizons greater than τ J are defined by
γmn,J = Cov(vm,J , vn,J ) − R̄m R̄n ,
where vm,J and vn,J are the wavelet scaling coefficients for assets m
and n at scale J.
Financial time series are usually sampled over a finite interval
at discrete times, giving rise to the crucial issue of wavelet coeffi-
cients affected by the boundary. To enable computation of wavelet
coefficients at the boundary, the MODWT treats the series as if it
were reflected about its last observation. Unbiased estimates of the
wavelet variance and covariance can then be constructed by only
considering coefficients unaffected by the boundary. The unbiased
estimator restricts the number of possible horizons which can be
examined, as the length of the wavelet must be less than the num-
ber of unbiased coefficients.
To overcome this problem, a weakly biased estimator has been
proposed where the number of wavelet coefficients is increased by
the inclusion of coefficients which are not heavily influenced by
the boundary coefficients (Cornish et al., 2006). A limited num-
j and L
j = (L − 2 )(1 − 2 −j
ber of observations within a half autocorrelation width contribute
almost exclusively to each coefficient. The maximum horizon is
restricted such that some of the coefficients are weakly affected
by boundary coefficients. The restrictions are imposed using the
length of the Haar wavelet, effectively choosing the maximum
scale based upon the unbiased Haar estimator. This allows us to
extend the wavelet ANOVA to longer horizons and, as shown using
generated data, provides improved estimation benefits relative to
unbiased coefficients. While previous studies have focused on un-
biased estimation, this extension to weakly biased coefficients per-
mits analysis at longer horizons than the related extant literature.
2.4. Long-run correlation
Previous focus in the literature has been on correlation mea-
sured using wavelet coefficients, revealing the dependence struc-
ture within specific frequency bands associated with time series
(Gençay et al., 2005; In & Kim, 2006; Ortu et al., 2013). One of
the obstacles to this approach lies in the practical implementa-
tion of frequency band analysis for investors. In contrast, our fo-
cus on wavelet scaling correlation reveals the long-run correlation
between time series after short-run effects, often associated with
 
  Cov νm, j , νn, j
ρ νm, j , νn, j =    
V ar νm, j V ar νn, j
 1 j L j −2 L j −1
 
2
Cov(rm , rn ) +
k=0 l=k+1
= 
 1 j L j −2 L j −1
 
2
σ ( rm ) + 2
2 g j,k g j,l ρ (rm )σ (rm )
k −l
k=0 l=k+1
frictions, have been removed. We later demonstrate, using a simu-
lation approach, that wavelet scaling correlation provides for more
accurate estimation of synchronized dependence than simple ag-
gregated (for example weekly or monthly) returns or using syn-
chronized returns formed using the Kalman filter or a vector au-
toregression.
While the wavelet long-run covariance decomposes the covari-
ation on a scale-by-scale basis, the empirical results in this study
will focus predominantly on the wavelet scaling correlation, corre-
sponding to long-run horizons (greater than τJ = 2J+1 ) defined as
γmn,J
ρmn,J = . (17)
σm,J σn,J
This consists of the long-run estimates of covariance and variance
(standard deviation) in the denominator and numerator, respec-
(16) tively. The result is a measure which captures the level of long-run
correlation between two time series, characterizing the long-run
dependence between two financial assets, vital in the context of
long-term asset allocation.
Confidence intervals for the wavelet long-run correlation rely
upon large-sample theory (Gençay et al., 2001). For the esti-
√ correlation coefficient ρˆmn,J , based upon a sample of size
mated
N, N − 3[h(ρˆ ) − h(ρ̄ )] has an approximately normal distribution,
−1
where ρ̄ is the population correlation. h(ρ ) = tanh (ρ ) is the
Fisher Z transformation, producing a sample correlation coefficient
which is approximately normal. An approximate 1 − α confidence
interval for ρ mn, J is given by
⎡ ⎧ ⎫ ⎧ ⎫⎤
⎨  −1
( 1 − α2 )
⎬ ⎨  −1
( 1 − α2 )
⎬
⎣tanh h[ρˆ (J )] −  , tanh h[ρˆ (J )] +  ⎦ (18)
⎩ ˆ Nj − 3
⎭ ⎩ ˆ ⎭
Nj − 3
 
where Nˆ j = N j − L
is the number of discrete
wavelet transform coefficients associated with scale J.
2.5. A model of long-run correlation
A variety of previous studies have demonstrated increased long-
run comovement between financial time series. Moreover, ear-
lier studies employed wavelets to examine the horizon dependent
properties of cross-market correlations between assets, but pro-
vided little intuition regarding the underlying drivers (In & Kim,
2006; Ortu et al., 2013; Rua & Nunes, 2009). Next, we demonstrate
how long-run correlation may be expressed as a function of just
the original unfiltered returns plus a correction to account for se-
rial and cross-serial correlation between markets. This provides a
fundamental insight regarding the origin of horizon dependent cor-
relation. To this end the following proposition details the relation-
ship between long- and short-run correlation.
Proposition 1. Wavelet long-run correlation between two stationary,
additive time series can be written as a function of the short-run co-
variance between the time series, the short-run variance of each time
series plus a series of correction terms capturing the short-run se-
rial and cross-serial covariance between the time series. The MODWT
wavelet long-run correlation between time series rm and rn at scale j
can be decomposed as:
 
g j,k g j,l ρ k−l (rm , rn ) + ρ −(k−l ) (rm , rn ) σ (rm )σ (rn ).
  (19)
 1 j L j −2 L j −1
 
2
2
σ ( rn ) + 2
2 g j,k g j,l ρ (rn )σ (rn )
k −l 2
k=0 l=k+1
Proof: See Appendix A
This proposition relates the wavelet long-run correlation to
short-run correlation estimated using the original untransformed
data plus a correction for serial and cross-serial correlation and
holds for any admissible wavelet type. Many sources of serial
and cross-serial correlations in financial time series have been
proposed, and include trading frictions, nonsynchronous trading,
trading liquidity, time-varying risk premia and analyst coverage
(Chordia, Sarkar, & Subrahmanyam, 2011; Lo & Mac Kinlay, 1990).
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696 681

Cross-serial correlations are also related to the speed of adjustment A higher value of δ (k) represents a slower response to inno-
hypothesis, whereby some assets adjust more slowly than others vations in the world market. Market M2 differs in a number of
to economy-wide information (Chordia et al., 2011). This proposi- respects from market M1. Taking the simplest case with no delay
tion will later allow us to demonstrate how long-run correlations in market response due to market frictions, T = 0, the returns for
between international equity markets may be modeled using only market M2 simply reduce to:
short-run data, gaining some insight into the sources of hetero-
geneity in correlation across horizons. Relative to the extant litera- RtM2 = α2 + β2 RW
t−1,3 + β2 Rt,1 + β2 Rt,2 + ε
W W M2
(22)
ture documenting increasing long horizon correlation, the decom- Market M2 is closed during trading period 3 and price informa-
position into short-run characteristics provides a fundamental un- tion from this period is incorporated during the first trading ses-
derpinning to the sources of correlation heterogeneity by horizon. sion of the following trading day, represented in Eq. (22) through
the β2 RWt−1,3 term. This setup results in daily returns of M2 incor-
3. Wavelet long-run correlation – a simulation study
porating price information from both days t − 1 and t. This model
is analogous to the trading structure found between US and Eu-
To demonstrate how biased estimation of correlation may
ropean equity markets. On a given day, trading begins on Euro-
emerge and illustrate the advantages of estimating long-run corre-
pean markets, followed by a period during which US and Euro-
lation using the wavelet scaling framework outlined, we generate
pean markets are open, concluded by a period when only the US
time series with characteristics congruent to those of international
is open. Information common to both markets is incorporated into
equity markets, examined empirically later in the study.8 At a basic
US markets during the final trading period, but European equity
level, information common to international markets is embedded
markets only incorporate this information into prices when trading
at different times as a result of varied market trading hours. In-
recommences the following morning. Such non-synchronous trad-
ternational equity indices also experience jumps, which would not
ing has been shown previously to result in biased estimation of
be expected from a typical Gaussian distribution (Pukthuanthong
cross-correlation between markets, a consequence of induced serial
& Roll, 2014). Finally, equity markets have been shown to be sub-
cross-correlation (Martens & Poon, 2001; Schotman & Zalewska,
ject to delays in information processing, resulting in lead–lag ef-
2006). Increasing the horizon over which returns are aggregated
fects between indices and individual assets (see, for example, Ahn,
has the effect of reducing the proportion of non-synchronous trad-
Boudoukh, Richardson, & Whitelaw, 2002; Cohen & Frazzini, 2008;
ing hours between the two markets, resulting in diminished corre-
Hong et al., 2007). Each of these attributes are incorporated in
lation estimation bias.
the simulation, inducing biased estimation of the true synchronous
Allowing for market frictions results in a further delay in in-
correlation.
formation transmission from the world market impacting returns
The simulation is founded on the relationship between returns
of market M2. Considering a first order delay, T = 1 and setting
for two markets, each having systematic exposure to a single com-
δ (1 ) = δ and δ (0 ) = 1 − δ, Eq. (21) reduces to:
mon factor (the ‘world market’), with resultant intermarket cross-
correlation.9 Daily logarithmic returns for the first market are de- RtM2 = α2 + δβ RW
t−1,2 + β2 Rt−1,3 + β2 Rt,1 + (1 − δ )β2 Rt,2 + ε .
W W W M2
fined by:
(23)
RtM1 = α1 + β1 RW
t,1 + β1 Rt,2 + β1 Rt,3 + ε
W W M1
, (20)
In this case, returns for market M2 on day t are additionally a func-
where RtM1 is the aggregate daily market return on day t. This is a tion of period RW with a commensurate decrease in the depen-
t−1,2
function of the exposure, β 1 , to the world market over three time
dence on RWt,2 . A value of γ = 0.05, as examined in the following
cohorts RW comprising the trading day, plus a zero-mean, tempo-
t,i simulation, results in 5% of the returns from the second trading
rally uncorrelated idiosyncratic noise, ε M1 . The world market is a cohort of day t − 1 being incorporated on day t. Note that such a
zero-mean, independent and identically distributed factor. For mar- model can be easily extended to include higher order delay terms,
ket M1, all returns are perfectly time synchronised with the world but we limit our analysis to first order market delay.
market and the market is assumed frictionless, implying no delays Using generated data, we contrast the ability of wavelets and
in information transmission.10 Market M2 is defined as: subsampling to measure the true synchronized long-run correla-
 tion between markets. World market returns (RW ) are simulated

T
RtM2 = α2 + β2 δ (k ) RW
t −1−int ( k ),3−k mod 3 using a jump-diffusion process, following Merton (1976),
3
k=0
 dSn

2 = αn dt + σn dzn + Jn dQ (λ ) (24)
+ RW
t −int ( k+
+ε M1
. (21) Sn
3 ),3− (k+ j ) mod 3
j

j=1 where α n is the diffusion process, zn is a standard Brownian mo-

Exposure to the world market is represented by β 2 , while δ (k) cap-
tures a delayed response of market M2 to the world market and
can be chosen to be constant or permitted to vary over time. This
structure is similar to the model proposed by Ahn et al. (2002) for
portfolios subject to partial adjustment. Under this formulation,
market wide information is slowly incorporated into certain assets,
a consequence of delayed information transmission, noise trading
or alternative mechanisms.
8 the long-horizon correlation and the impact of boundary coeffi-
The characteristics simulated are not exhaustive but, instead, attempt to capture
some of the features relevant to generating biased estimates of cross-correlation.
9
A similar approach was applied by Lo and Mac Kinlay (1990) to examine
whether non-synchronous trading leads to serial correlation in portfolios.
10
The last assumption could be easily relaxed to incorporate market frictions in
both markets. The impact would be to further bias correlation measurement. For
brevity, market one is assumed not to be subject to any frictions.
tion, Q is a Poisson process with intensity λ, Jn is the random,
normally distributed jump amplitude associated with the Poisson
event. Markets M1 and M2 are both assumed to have a beta coef-
ficient or systematic risk exposure of 0.8 with the world market.11
In this study, we compare the effectiveness of wavelet scaling cor-
relation to subsampled or aggregated correlation using both bias
and mean square error. In each case, we are comparing the mea-
sured correlation to the actual synchronized correlation at a par-
ticular horizon. MODWT scaling coefficients are used to measure
cients is examined. To this end, both unbiased correlation, where
11
A variety of values for the systematic risk coefficient were tested resulting in no
qualitative impact on results. The wavelet scaling estimator was found to provide
superior estimation of synchronized correlation in all cases.
682 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

Fig. 1. Simulation contrasting long-run correlation for different wavelet families. Long-run correlation estimated using various families are contrasted with subsampled corre-
lation. Long time series of length 10,0 0 0 are examined. Bias is defined as E[ρˆ ] − ρ , while error is defined using the mean square error E[(ρˆ − ρ )2 ]. Scaling coefficients
associated with the maximum overlap discrete wavelet transform are used in the calculation of wavelet correlation. The model generating returns for two individual markets
was simulated 50,0 0 0 times for long time-series with asynchronous trading, jumps and delay frictions. The world market is specified to have volatility of 20%, each market
has a beta of 0.8 and jumps are specified to have frequency 0.01 and volatility of 200%. Subsampled data corresponds to original data sampled at differing horizons, Haar is
the Haar wavelet, LA8 is the least asymmetric wavelet of length 8, C6 is the Coiflet wavelet of length 6 and D8 is the Daubechies wavelet of length 8. Correlation is estimated
at 4, 8, 16, 32, 64, 128, 256 and 512 day horizons.

Table 1
Description of wavelet families employed in the study.

Wavelet Description

Haar The Haar wavelet is a symmetric filter of length L = 2. The Haar Wavelet is the only symmetric compactly supported orthonormal wavelet
(Daubechies, 1992). One drawback to the Haar Wavelet is that it is a poor approximation to an ideal band-pass filter (Gençay et al., 2001).
D8 The Daubechies wavelet of length L = 8. The Daubechies wavelet family provide improved frequency-domain characteristics relative to the
Haar Wavelet (Gençay et al., 2001). The Daubechies wavelets are asymmetric compactly supported orthonormal wavelets, with an
arbitrary number of vanishing moments (Daubechies, 1992).
LA8 The Daubechies least asymmetric wavelet (Symlet) of length L = 8. A modification of the Daubechies family of wavelets resulting in
increased filter symmetry (Daubechies, 1992). The Daubechies least asymmetric wavelets are near symmetric compactly supported
orthonormal wavelets, with an arbitrary number of vanishing moments.
C6 The Coiflet wavelet of length L = 6. The Coiflet family are near symmetric compactly supported orthonormal wavelets, with an arbitrary
number of vanishing moments (Percival & Walden, 20 0 0).

all boundary coefficients are removed, and weakly biased correla-
tion, described in Section 2.3, where included coefficients are dic-
tated by the equivalent width of the wavelet filter, are examined.
Through the application of generated data, we discern the im-
pact of non-overlapping trading hours and other frictions rele-
vant to international markets on correlation estimation. The sim-
ulation is based on the relationship between time series repre-
senting two markets, each having systematic exposure to a sin-
gle common factor (the ‘World market’), resulting in market cross-
correlation. Biased estimation of correlation is then induced. First,
non-overlapping trading hours between the markets are intro-
duced, resulting in common information being impounded non-
synchronously. This is analogous to the limited overlaps in trading
hours witnessed in world markets. Second, delays in market infor-
mation processing are represented by allowing market returns to
be a function of previous returns of the world market. Finally, the
impact of jumps and regimes are examined.
A synopsis of results using generated data is now detailed, with
full details provided in Appendix B. First, given the array of differ-
ent wavelet families available, we contrast their performance with
that of subsampling12 in Fig. 1. Four distinct types of wavelet are
examined, the Haar, the Daubechies wavelet of length 8 (D8), the
Coiflet wavelet of length 6 (C6) and the Daubechies least asym-
metric wavelet of length 8 (LA8). A description of each of the
wavelet families is provided in Table 1. Second, we contrast the
performance of the wavelet long-run correlation estimator to alter-
native methods including a constant conditional correlation (CCC-
GARCH)13 estimate employing returns synchronized using a vector
autoregressive model (VAR), following Burns et al. (1998), and the
Kalman filter (KL), respectively. See Appendix B for an outline of
how each alternative methodology is developed.
Fig. 1 contrasts the level of estimation bias and error for differ-
ent wavelet families relative to traditional subsampled time series
at various horizons.14 At monthly horizons, typically examined in
the literature on international asset allocation, both the LA8 and
D8 wavelets provide correlation estimates with bias which is 16%
(26%) of subsampled data for long (short) time series. For horizons
of 512 days (approximately 2 years), long-run correlation bias is
about 78% of that obtained using subsampled data. Estimation er-
ror using wavelets is also shown to be consistently lower than that
using subsampled data across all horizons. Contrasting the vari-
ous higher order wavelets examined, marginal differences in per-
formance are found, in particular between D8 and LA8.
The LA8 wavelet is selected for the estimation of long-run cor-
relation in the following empirical application due to the perfor-
mance outlined and benefits in alignment between filtered time
series. In Fig. 2, long-run correlation using the LA8 wavelet is
compared with constant correlation estimates using VAR and KF
models, respectively. The performance enhancements from the
long-run correlation estimator in the presence of parametric fea-
tures are isolated by contrasting data with and without volatility
regimes and jumps. Moreover, various lags of the VAR and KF are

12
Subsampled return intervals are created by summing over high frequency log-
arithmic returns and calculating long horizon or low-frequency returns. For exam-
ple, daily price data may be subsampled every Friday or on the last day of every
month to create weekly and monthly data, respectively. Concerns surrounding this
approach include a lack of motivation concerning subsample timing and the impact
of a reduced sample size.
13
This CCC estimate reduces to an constant unconditional correlation in the
framework developed here. In each case detailed, the estimated correlation is con-
stant across all horizons.
14
Bias is defined as E[ρˆ ] − ρ , where E denotes an expectation, while error is de-
termined using the mean square error E[(ρˆ − ρ )2 ].
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696
Fig. 2. Simulation contrasting wavelet long-run correlation with alternative approaches. Wavelet long-run correlation estimates are compared using generated data with constant correlation estimates resulting from vector autore-
gression (VAR) and Kalman filtered (KF) data. In each case the accuracy of the wavelet estimate is detailed as a proportion of the alternative method (Relative bias or error < 1 implies outperformance by wavelet long-run
correlation). Long time series of length 10,0 0 0 are examined. Bias is defined as E[ρˆ ] − ρ , while error is defined using the mean square error E[(ρˆ − ρ )2 ]. Scaling coefficients associated with the maximum overlap discrete wavelet
transform are used in the calculation of wavelet correlation. The model generating returns for two individual markets was simulated 50,0 0 0 times for long time-series with asynchronous trading, jumps and delay frictions. The
world market is specified to have volatility of 20% and each market has a beta of 0.8. VAR(1), VAR(3) and VAR(5) correspond to a vector autoregression with lags of 1, 3 and 5, respectively. KF(1), KF(3) and KF(5) refer to a Kalman
filter approach with 1, 3 and 5 lags, respectively. Jump int. refers to the frequency of jumps. The asymmetric wavelet of length 8 (LA8) is used throughout. Correlation is estimated at 4, 8, 16, 32, 64, 128, 256 and 512 day horizons.

683
684 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696
considered (in Fig. 2(iii, iv), (vii, viii), (xi, xii), (xv, xvi), respec-
tively).
Focussing first on correlation estimates using VAR synchronized
data, we find that wavelet long-run correlation provides supe-
rior estimates in the presence of jumps and regimes for horizons
greater than 8 days (figures (i, ii) and (v, vi)). Moreover, for more
frequent jumps the wavelet long-run correlation estimator has im-
proved bias and error relative to the VAR estimated correlations.
The sensitivity of the VAR approach to different lags are also ex-
amined for jumps intensity 0.03 (figures (iii, iv)) and for 3 regimes
(figures (vii, viii)). In the presence of jumps we find a relative per-
formance improvement for 3 VAR lags, but a subsequent disim-
provement for 5 lags. In all cases, however, wavelets are found
to provide performance benefits. In the later study of allocation
weights, focus will be on the VAR(3) model.
Next we contrast the performance of the wavelet long-run esti-
mator to a synchronization method based upon the Kalman filter.
Considering the case without regimes or jumps first, the wavelet-
based correlation technique provides estimates with bias and error
much lower than KF. The inclusion of jumps and regimes results
in a relative improvement in performance for the wavelet long-run
correlation. The presence of longer KF lags is found to have only
limited impact on relative performance in the presence of jumps
and regimes (figures (xi, xii) and (xv, xvi).
While the performance of the wavelet based approach is con-
sistently better than VAR and KF alternatives at horizons 8 and
longer, some underperformance is evident at the shortest horizons
considered especially relative to the VAR(1) approach. This under-
performance is attributed to the choice of simulation parameters,
chosen to mirror that observed between European and US markets.
Specifically, the wavelet averaging process is disadvantaged by sig-
nificant non-synchronous trading ( 13 day) at the shortest horizons.
At long horizons this non-trading overlap is proportionally small,
resulting in consistent wavelet outperformance. Thus, the long-run
outperformance is due to better wavelet estimates, rather than de-
clining performance for the parametric approaches.
4. Empirical analysis
4.1. Data
We highlight the application of the wavelet long-run correla-
tion estimator using international market time series. Equity mar-
ket indices are commonly employed to examine benefits of diversi-
fying into international markets. The data considered here consists
of daily prices for G7 international equity indices15 from January 1,
1980 through December 31, 2015, a total of 9394 days. Data are ob-
tained from DataStream, a division of Thompson Reuters. For each
country, the index chosen represents a broad coverage of large-
and mid-cap equities, with data available over the entire sample
period. To remove the impact of exchange rate fluctuations from
the analysis, each local index is converted to a common currency,
US dollars.16 Monthly data is most widely considered when mea-
suring the benefits of international diversification. In this study,
we will examine a range of differing horizons and provide an ex-
position of why alternative horizons might indicate a variation in
comovement between assets. To this end, both daily and monthly
base data are examined, with the latter considered as the bench-
mark for determination of long-run heterogeneity in correlation.
15
The specific indices under consideration are as follows: Canada – S&P/TSX Com-
posite Index, France – DataStream value-weighted total return index, Germany Dax
30 Index, Italy – DataStream value-weighted total return index, Japan – MSCI total
return index, United Kingdom – FTSE 100, United States – S&P 500.
16
US dollar conversion uses WM/Reuters benchmark closing spot rates simultane-
ously fixed at 4 p.m. London time.
To reinforce our empirical analysis, we also consider exchange
traded funds (ETF) which track G7 equity indices. An exchange
traded fund (ETF) is a market listed fund which invests in a bas-
ket of securities (Alexander & Barbosa, 2008). We focus on ETFs
which replicate major international stock indices, but which can be
transacted during the U.S. trading day. Relative to the diverse trad-
ing hours of international equity indices, the end-of-day price for
each of the ETFs under consideration is recorded at 4:30 p.m. each
day. The implication is that common price-relevant information
should be impounded within these markets synchronously, rather
than awaiting the next trading day, as is often the case for inter-
national equity indices where trading is across time-zones.17 For
the US we use the SPDR S&P 500 ETF, which tracks the S&P 500
index. The other 6 markets are representing by iShares MSCI ETFs.
These ETF track the MSCI index which itself represents the perfor-
mance of large- and mid-cap equities within each country. Daily
data on each market is available from January 1997 through De-
cember 2015, a total of 4957 days. These ETF securities are selected
as they can be bought and sold on US exchanges during common
trading hours, providing a contrast to the non-synchronous trading
hours of world equity indices.
4.2. Empirical study
Imperfect correlations between financial assets implies the po-
tential to reduce, but not eliminate, portfolio risk. In this em-
pirical study, we use the methodology described to determine
whether long-run correlations between G7 equity markets differ
from short-run. We first investigate baseline correlation results for
each market. To this end, long-run correlations are calculated us-
ing Eq. (17). Based upon the simulation study previously outlined,
the Daubechies wavelet of length 8 is selected to decompose re-
turns into the range of horizons considers. In each case, a weakly
biased estimator is employed, which results in the inclusion of co-
efficients not heavily influenced by boundary coefficients (Cornish
et al., 2006). We support our initial findings using exchange traded
funds to verify that results are not purely a consequence of asyn-
chronous trading. Employing our model of long-run correlation, we
next determine whether long-run correlations can be replicated by
accounting for characteristics observable at short-run horizons. Fi-
nally, we demonstrate the robustness of our empirical characteri-
zation to an alternative wavelet basis, the Haar wavelet.
Baseline results for G7 equity markets over the period
1980–2015 are given in Table 2. Examining first the average corre-
lation between the 7 markets, there are a number of notable find-
ings. First, moving from short- to long-run intervals, we reveal a
significant increase in correlation. Starting at a daily level, the av-
erage correlation is 0.41, increasing by 41% to 0.578 at the monthly
interval favored in academic studies. This then increases further, to
0.694 at a 512 day (or two year) horizon and on to 0.755 at the
longest 64 month horizon examined. This constitutes an 84% in-
crease between the shortest 1 day horizon examined, or a 31% in-
crease between a monthly horizon, and the longest 64 month hori-
zon detailed. The aforementioned finding of increasing long-run
inter-market correlation is evident whether we begin with daily or
monthly base data.
Results are also found to be independent of the specific mar-
ket examined. Breaking out the average correlations amongst the
G7 countries, a consistent increase in long-run correlations is evi-
dent. The increase in average correlation from a monthly horizon
to a 64 month horizon ranges from 23.6% for the U.S. to 32.7% for
17
See Appendix B for a detailed review of the impact of non-synchronous opening
hours and market frictions on the measurement of correlation.
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696 685

Table 2
Unconditional long-run correlations for G7 equity indices (1980–2015). Notes: The average correlation between G7 international equity indices is estimated at
different time horizons using data sampled at data (panel (i)) and monthly intervals (panel (ii)) from 1980 to 2015. Average correlations are across all markets are
detailed in column 1. In the following columns, average correlation between each market and the other six markets is presented. The Daubechies least asymmetric
MODWT scaling filter of length 8 is used to decompose returns data into the range of horizons considered, and long-run correlations estimated at each horizon.
Daily and monthly correlations found using the original untransformed data are also shown. 95% confidence intervals for correlations are shown in brackets. The
equality of correlation matrices with daily data and monthly data is tested using the Jennrich test. and  indicate rejection of the null hypothesis of equality at a
1% level between correlation matrices at each horizon and daily and monthly horizons, respectively.

(i) Daily data

Horizon (days) All markets France Germany Italy Canada Japan UK US

Daily 0.410 0.521 0.513 0.436 0.423 0.127 0.500 0.349

[0.394, 0.426] [0.507, 0.535] [0.498, 0.527] [0.420, 0.452] [0.407, 0.439] [0.108, 0.147] [0.485, 0.514] [0.331, 0.366]
4 0.476 ,  0.568 ,  0.568 ,  0.471 ,  0.482 ,  0.227 ,  0.553 ,  0.460 , 
[0.454, 0.497] [0.549, 0.586] [0.549, 0.586] [0.449, 0.492] [0.461, 0.504] [0.200, 0.254] [0.534, 0.572] [0.437, 0.481]
8 0.0.506 ,  0.581 ,  0.587 ,  0.489 ,  0.515 ,  0.280 ,  0.573 ,  0.515 , 
[0.485, 0.526] [0.563, 0.599] [0.569, 0.605] [0.467, 0.51] [0.494, 0.535] [0.253, 0.306] [0.554, 0.592] [0.494, 0.535]
16 0.523 ,  0.604 ,  0.598 ,  0.494 ,  0.530 ,  0.312 ,  0.582 ,  0.545 , 
[0.503, 0.543] [0.586, 0.622] [0.58, 0.616] [0.472, 0.514] [0.509, 0.550] [0.286, 0.337] [0.563, 0.600] [0.525, 0.564]
32 0.544 ,  0.616 ,  0.606 0.517 ,  0.549 ,  0.353 ,  0.594 ,  0.575 , 
[0.524, 0.564] [0.598, 0.633] [0.588, 0.624] [0.496, 0.537] [0.529, 0.568] [0.328, 0.378] [0.576, 0.612] [0.556, 0.593]
64 0.593 ,  0.649 0.63 ,  0.565 ,  0.604 0.431 0.652 ,  0.621 , 
[0.575, 0.611] [0.633, 0.665] [0.612, 0.646] [0.546, 0.584] [0.586, 0.621] [0.408, 0.454] [0.635, 0.668] [0.604, 0.638]
128 0.621 ,  0.667 ,  0.652 ,  0.605 ,  0.645 ,  0.446 0.682 ,  0.648 , 
[0.603, 0.638] [0.651, 0.682] [0.636, 0.668] [0.587, 0.623] [0.629, 0.661] [0.423, 0.469] [0.667, 0.697] [0.632, 0.664]
256 0.675 ,  0.725 ,  0.694 ,  0.666 ,  0.682 ,  0.530 ,  0.724 ,  0.708 , 
[0.660, 0.69] [0.711, 0.738] [0.679, 0.708] [0.650, 0.681] [0.666, 0.697] [0.509, 0.550] [0.710, 0.737] [0.693, 0.721]
512 0.694 ,  0.741 ,  0.728 ,  0.670 ,  0.682 ,  0.566 ,  0.748 ,  0.725 , 
[0.679, 0.709] [0.728, 0.753] [0.714, 0.741] [0.654, 0.686] [0.666, 0.697] [0.546, 0.586] [0.735, 0.760] [0.711, 0.738]
(ii) Monthly data
Monthly 0.578 0.638 0.618 0.537 0.590 0.429 0.631 0.602
[0.513, 0.636] [0.580, 0.690] [0.557, 0.672] [0.467, 0.600] [0.526, 0.647] [0.349, 0.503] [0.571, 0.684] [0.54, 0.657]
4 0.616 ,  0.665 ,  0.645 ,  0.582 ,  0.630 ,  0.476 ,  0.671 ,  0.642 , 
[0.528, 0.691] [0.585, 0.733] [0.562, 0.716] [0.487, 0.663] [0.544, 0.703] [0.366, 0.573] [0.591, 0.738] [0.559, 0.713]
8 0.652 ,  0.698 ,  0.662 ,  0.638 ,  0.674 ,  0.499 ,  0.703 ,  0.688 , 
[0.57, 0.721] [0.624, 0.759] [0.582, 0.730] [0.552, 0.711] [0.595, 0.740] [0.391, 0.593] [0.630, 0.764] [0.612, 0.752]
16 0.678 ,  0.724 ,  0.707 ,  0.660 ,  0.674 ,  0.538 ,  0.727 ,  0.714 , 
[0.600, 0.743] [0.655, 0.782] [0.635, 0.767] [0.577, 0.729] [0.594, 0.741] [0.435, 0.627] [0.659, 0.784] [0.642, 0.773]
32 0.725 ,  0.788 ,  0.765 ,  0.691 ,  0.695 ,  0.595 ,  0.784 ,  0.759 , 
[0.656, 0.783] [0.731, 0.834] [0.705, 0.815] [0.614, 0.755] [0.618, 0.759] [0.500, 0.676] [0.726, 0.830] [0.697, 0.810]
64 0.755 ,  0.813 ,  0.820 ,  0.725 ,  0.733 ,  0.618 ,  0.831 ,  0.744 , 
[0.691, 0.807] [0.761, 0.854] [0.771, 0.859] [0.652, 0.784] [0.664, 0.790] [0.525, 0.696] [0.784, 0.869] [0.678, 0.798]

Germany. A Jennrich test18 confirms that differences between cor-
relations estimated at a daily or monthly horizon and long hori-
zons estimates are statistically significant at a 1% level. These base-
line results suggest that short horizon investors have greater op-
portunities to benefit from diversification through low correlation,
relative to their long horizon counterparts. As highlighted earlier,
the heterogeneity in correlation across horizons may partially em-
anate from non-synchronous trading between markets in addition
to other frictions. We attempt to distinguish between these sources
next, by examining assets with contemporaneous trading hours.
We now test whether our findings are robust by examining
whether correlations between ETFs representing indices from the
markets previously considered are heterogeneous across horizons.
Results, outlined in Table 3, show a diminution but not elimination
of the horizon-based heterogeneity in international market corre-
lations. Across all markets, we witness a statistically significant
16.23% and 8.76% average increase in correlation between daily and
monthly horizons, respectively, and the longest 64 horizon. Consid-
ering long-term correlation across the countries, increases of be-
tween 3.3% and 8.3% between monthly and 64 month data are wit-
nessed. An exception is Japan, where a 45% increase in correlation
is found. This reduced diversification potential occurred during a
period of secular stagnation of the Japanese Economy. Some evi-
18
The test for equality of two correlation matrices proposed by Jennrich
(1970) has a test statistic distributed as χ 2 with p( p − 1 )/2 degrees of freedom,
where p is the number of variables in each correlation matrix.
dence of a tapering in correlation is witnessed from a one year
horizon onwards, with only limited increases in correlation de-
tailed beyond this horizon for ETFs. While findings are diminished
in magnitude relative to the correlation increases highlighted us-
ing equity indices, statistically significant differences in correlation
across horizons are found. If non-contemporaneous market trading
hours were the sole source of raised long-run international market
correlation, we would expect the effect to be eliminated at long
horizons using synchronized data. These findings for ETFs suggest
that frictions other than non-contemporaneous trading also con-
tribute to increasing long-horizon correlation. The following Sec-
tion considers the impact of the heterogeneous correlation esti-
mates on long-run asset allocation.
4.3. Implications for asset allocation
The finding of raised correlation between international equity
indices for long-run horizons may result in an alteration in opti-
mal allocations. In this section, we examine whether optimal as-
set allocation weights for a minimum-variance portfolio strategy
are impacted at various horizons for the set of international eq-
uity indices studied. For comparison, allocation weights are also
determined using data synchronized through the use of VAR and
the KF filter. Global minimum-variance portfolios are examined as
they bypass the requirement to estimate expected returns and as-
sociated estimation error (Carroll, Conlon, Cotter, & Salvador, 2017;
Maillet, Tokpavi, & Vaucher, 2015; Moreno & Olmeda, 2007). Fo-
cus is on portfolios constrained to take weights between zero and
686 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

Table 3
ETF unconditional long-run correlations (1997–2014). Notes: The average correlation between Exchange Traded Funds (ETF) tracking G7 equity markets is estimated at
different time horizons using data sampled at data (panel (i)) and monthly intervals (panel (ii)) from 1997 to 2015. Average correlations are across all markets are
detailed in column 1. In the following columns, average correlation between each market and the other six markets is presented. The Daubechies least asymmetric
MODWT scaling filter of length 8 is used to decompose returns data into the range of horizons considered, and long-run correlations estimated at each horizon.
Daily and monthly correlations found using the original untransformed data are also shown. 95% confidence intervals for correlations are shown in brackets. The
equality of correlation matrices with daily data and monthly data is tested using the Jennrich test. and  indicate that the null hypothesis of equality is rejected
at a 1% level between correlation matrices at each horizon and daily and monthly horizons, respectively.

(i) Daily data

Horizon (days) All markets France Germany Italy Canada Japan UK US

Daily 0.684 0.748 0.743 0.699 0.618 0.572 0.713 0.694

[0.669, 0.698] [0.736, 0.76] [0.731, 0.756] [0.684, 0.712] [0.600, 0.635] [0.553, 0.591] [0.698, 0.726] [0.679, 0.709]
4 0.700 0.769 ,  0.759 0.709 0.659 ,  0.562 0.734 ,  0.708
[0.679, 0.719] [0.752, 0.784] [0.742, 0.775] [0.689, 0.728] [0.635, 0.68] [0.534, 0.589] [0.716, 0.752] [0.687, 0.727]
8 0.720 0.792 ,  0.779 0.727 0.697 ,  0.553 0.759 ,  0.733 , 
[0.701, 0.738] [0.777, 0.806] [0.763, 0.793] [0.709, 0.745] [0.676, 0.717] [0.524, 0.580] [0.742, 0.775] [0.715, 0.751]
16 0.729 0.800 0.791 0.731 0.710 0.555 0.769 0.747
[0.710, 0.747] [0.785, 0.813] [0.776, 0.805] [0.712, 0.749] [0.69, 0.729] [0.527, 0.582] [0.753, 0.785] [0.729, 0.764]
32 0.730 0.802 0.787 0.724 0.712 0.556 0.779 0.751
[0.712, 0.748] [0.788, 0.816] [0.772, 0.802] [0.705, 0.742] [0.692, 0.731] [0.528, 0.583] [0.763, 0.794] [0.733, 0.768]
64 0.759 ,  0.826 ,  0.802 ,  0.763 ,  0.754 ,  0.583 0.810 ,  0.774 , 
[0.742, 0.775] [0.814, 0.838] [0.788, 0.816] [0.747, 0.779] [0.736, 0.771] [0.556, 0.609] [0.796, 0.823] [0.757, 0.789]
128 0.758 ,  0.828 ,  0.804 ,  0.767 ,  0.768 ,  0.552 0.815 ,  0.768
[0.741, 0.773] [0.816, 0.84] [0.79, 0.817] [0.751, 0.782] [0.751, 0.784] [0.523, 0.579] [0.801, 0.827] [0.752, 0.784]
256 0.792 ,  0.858 ,  0.836 ,  0.788 ,  0.783 ,  0.643 ,  0.838 ,  0.800 , 
[0.777, 0.806] [0.847, 0.868] [0.824, 0.848] [0.773, 0.802] [0.767, 0.798] [0.619, 0.666] [0.826, 0.849] [0.785, 0.814]
512 0.781 ,  0.858 ,  0.853 ,  0.758 ,  0.763 ,  0.635 ,  0.822 ,  0.780 , 
[0.765, 0.796] [0.847, 0.868] [0.841, 0.863] [0.741, 0.774] [0.746, 0.780] [0.610, 0.659] [0.808, 0.834] [0.764, 0.795]
(ii) Monthly data
Monthly 0.731 0.799 0.779 0.721 0.722 0.554 0.784 0.755
[0.666, 0.784] [0.75, 0.84] [0.724, 0.824] [0.655, 0.776] [0.654, 0.778] [0.458, 0.638] [0.729, 0.829] [0.694, 0.805]
4 0.764 ,  0.833 ,  0.804 ,  0.766 ,  0.761 ,  0.595 ,  0.816 ,  0.774 , 
[0.679, 0.830] [0.769, 0.88] [0.732, 0.86] [0.682, 0.831] [0.672, 0.829] [0.461, 0.702] [0.745, 0.869] [0.689, 0.838]
8 0.783 ,  0.847 ,  0.822 ,  0.784 ,  0.784 ,  0.623 ,  0.837 ,  0.784 , 
[0.703, 0.844] [0.787, 0.891] [0.753, 0.873] [0.706, 0.844] [0.701, 0.846] [0.496, 0.724] [0.773, 0.884] [0.702, 0.846]
16 0.783 ,  0.854 ,  0.839 ,  0.769 ,  0.772 ,  0.632 ,  0.830 ,  0.786 , 
[0.702, 0.845] [0.796, 0.897] [0.776, 0.886] [0.686, 0.833] [0.684, 0.838] [0.505, 0.731] [0.764, 0.880] [0.704, 0.848]
32 0.804 ,  0.879 ,  0.868 ,  0.795 ,  0.765 ,  0.677 ,  0.839 ,  0.804 , 
[0.728, 0.861] [0.828, 0.915] [0.814, 0.907] [0.717, 0.853] [0.673, 0.834] [0.560, 0.768] [0.776, 0.887] [0.727, 0.861]
64 0.795 ,  0.859 ,  0.874 ,  0.756 ,  0.746 ,  0.802 ,  0.849 ,  0.791 , 
[0.712, 0.856] [0.797, 0.903] [0.818, 0.913] [0.658, 0.829] [0.649, 0.820] [0.720, 0.862] [0.784, 0.896] [0.708, 0.852]

one hundred percent, replicating constraints often placed upon
traditional asset managers. The global minimum-variance portfolio
is found by searching for the weights which provide the portfolio
with lowest variance ex-ante.19
Results are outlined in Table 4. Substantial alteration in optimal
weights are observed from daily through to the longest horizons
examined, especially for the US, Japan, Canada, France and Italy.
For the US, a minimum-variance investor should allocate 36% of
their wealth at a daily horizon, rising to 70% at a 512 day hori-
zon. A corresponding decrease in optimal weights is observed for
other countries. Optimal weights associated with Japan, Italy and
France decrease from a daily horizon allocation of 0.285, 0.125 and
0.052, respectively, to a zero allocation at the longest horizons ex-
amined. Considering the allocations associated with data synchro-
nized using VAR and the KF filter, we also observe commensu-
rate changes in weights relative to daily data but do not capture
the long-horizon weighting adjustments found using wavelet long-
run correlation. These findings highlight the central importance of
horizon in the estimation of characteristics essential to the portfo-
lio allocation decision.
19
Specifically, we look for portfolio weights ωj at horizon or scale j such that
min ωj Hj ωjT ,
ωj ∈[0,1]
N
where Hj is the covariance matrix at scale j estimated using Eq. (16), and i=1
for N available assets.
4.4. Modeling long-run correlation
In Section 4.2, we detailed increased long-run correlations be-
tween international equity markets, even for contemporaneously
measured markets. The latter finding suggests that frictions other
than non-contemporaneous trading must also contribute to the
alteration in correlation found from short to long-run horizons.
Previous studies have examined the temporal characteristics of
markets with synchronized trading hours but potential lags in
information transmission due to differentials in trading liquidity
(Ahn et al., 2002; Cohen et al., 1983b; Schotman & Zalewska,
2006). Such non-contemporaneous trading has been suggested to
induce cross-serial correlation between markets, in turn downward
biasing the measurement of cross-correlation (Martens & Poon,
2001; Schotman & Zalewska, 2006). Furthermore, strong evidence
for lead–lag effects in information transmission between financial
assets exists (Cohen & Frazzini, 20 08; Hong et al., 20 07; Hou &
Moskowitz, 2004). Informed trading is transmitted from large liq-
uid stocks to smaller more illiquid stocks with a lag, inducing
cross-serial correlations between stocks (Chordia et al., 2011). The
high levels of observed serial correlation found for equity indices is
also partially a consequence of microstructure frictions and infor-
mation transmission delays from large to small stocks (Ahn et al.,
2002; Lo & Mac Kinlay, 1990).
In this section, we outline how changes in correlations from
(25)
short to long-run horizons may manifest as a result of serial- and
cross-serial correlation between markets. To this end, we model
=1 long-run correlation using only short-run (daily) data, with a
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696 687

Table 4
Minimum variance portfolio allocation weights by horizon (1980–2015). Notes: Portfolio allocation weights
for a set of G7 international equity indices are determined at each horizon. The optimal allocation weights
are determined using a global minimum variance approach, with weights constrained to be between zero
and one for each asset. The required long-run covariance matrix between assets at different wavelet hori-
zons was calculated using the Daubechies least asymmetric MODWT scaling filter of length 8. For com-
parison, allocations weights are also determined using synchronized data from a VAR(3) and KF(3) filter.
Daily and monthly horizon allocations determined using the original untransformed data are also shown.

(i) Daily data – wavelet long-run correlation

France Germany Italy Canada Japan UK US

Daily 0.052 0.021 0.066 0.125 0.285 0.094 0.358

Wavelet horizon 4 0.036 0.017 0.055 0.113 0.297 0.070 0.412
8 0.032 0.016 0.042 0.084 0.291 0.077 0.457
16 0.022 0.016 0.040 0.068 0.280 0.094 0.480
32 0.020 0.016 0.026 0.049 0.267 0.111 0.510
64 0.015 0.018 0.014 0.021 0.225 0.094 0.614
128 0.018 0.017 0.011 0.011 0.205 0.119 0.619
256 0.009 0.015 0.006 0.009 0.179 0.092 0.690
512 0.008 0.011 0.005 0.016 0.135 0.126 0.699
VAR 0.028 0.015 0.063 0.055 0.279 0.079 0.482
KF 0.021 0.012 0.056 0.077 0.284 0.062 0.489
(ii) Monthly data
Monthly 0.001 0.001 0.023 0.001 0.221 0.066 0.686
Wavelet horizon 4 0.001 0.001 0.003 0.001 0.196 0.110 0.687
8 0.001 0.001 0.0 0 0 0.0 0 0 0.166 0.135 0.697
16 0.0 0 0 0.0 0 0 0.0 0 0 0.0 0 0 0.140 0.160 0.700
32 0.0 0 0 0.0 0 0 0.0 0 0 0.104 0.070 0.156 0.670
64 0.0 0 0 0.0 0 0 0.0 0 0 0.318 0.004 0.001 0.676
VAR 0.0 0 0 0.0 0 0 0.008 0.0 0 0 0.120 0.153 0.718
KF 0.001 0.001 0.014 0.001 0.127 0.168 0.688

correction for serial and cross-serial correlation between the orig-
inal series. As outlined in Section 2.4, wavelet long-run corre-
lation can be exploited to model long-run behavior using orig-
inal (one-day) short-run returns.20 To model the long-run τ J -
horizon wavelet scaling cross-correlation using original untrans-
formed (daily) data, we measure serial correlation and all lagging
and leading cross-serial correlations between each market up to
interval τ J . Eq. (19) outlines how the various leading and lagging
serial and cross-serial correlations are weighted, conditional upon
the wavelet basis employed. We focus on the Daubechies least
asymmetric wavelet, in keeping with the earlier simulation anal-
ysis, but it is important to note that consistent results are to be
found for any general admissible wavelet type.21
Table 5 details τ J horizon long-run correlations modeled us-
ing only one-day returns. In each case, an average over all pairs
of international equity indices is shown. Long-run correlations are
modeled for a range of different long-run horizons. For example,
the 8 day horizon corresponds to the long-run wavelet correla-
tion at horizon τ3 = 23 . When no corrections for serial or cross-
serial correlations are accounted for, Eq. (19) reduces to the cross-
correlation between the original, daily, time series. This underesti-
mates the long-run correlation by 18.9%. Incorporating information
on serial and cross-serial correlation for up to 7 lags results in an
increase in the modeled correlation to 0.506, consistent with the
average measured correlation of 0.505.
Considering the model of long-run correlation at longer hori-
zons, coherent results are found. Exploring a 256 day horizon, we
demonstrate a consistent increase in modeled correlation as fur-
ther intertemporal lags are included in the model. For example,
incorporating information on serial and cross-serial correlation for
up to 3 lags results in an increase of 25.3% in average modeled
20
This analysis is not restricted to the use of daily data. Long-run correlation can
similarly be modeled as a function of monthly base data.
21
Congruent results were found for various wavelet types but are not detailed
here for brevity. Results are available from the authors upon request.
cross-correlation relative to daily. While this captures about 38.7%
of the total increase required to replicate the estimated long-run
correlation, modeled correlation is found to monotonically increase
with the inclusion of up to 127 lags.
Previous research examining the intertemporal behavior of fi-
nancial characteristics such as systematic risk has established that
short horizon measurements are biased (Cohen et al., 1983b;
Gençay et al., 2005). These findings have largely been related to
frictions in the trading process manifesting in differential price ad-
justment delays and resulting in cross-serial correlation between
securities. Moreover, the presence of serial correlation in equity
indices has been extensively documented (Ahn et al., 2002; Lo &
Mac Kinlay, 1990). This is consistent with our model, where the
low levels of short-run correlation are a consequence of serial-
and cross-serial correlations in the underlying data. The analysis
using generated data detailed demonstrates that estimation of cor-
relation is biased by inducing such characteristics. Taken together,
these findings suggest that the correlation between international
equity indices is, on average, downward biased at short horizons.
The consequence of this, from the perspective of investors, is that
perceived diversification benefits of international allocation may be
overestimated at short horizons.
4.5. Robustness
Finally, we illustrate that our empirical findings are not funda-
mentally a consequence of the specific wavelet family chosen. In
Table 6, the Haar wavelet is employed to estimate long-run corre-
lation between G7 equity indices. Consistent with previous analy-
sis, correlation is found to increase between short- and long-run
horizons. From daily and monthly horizons, respectively, an 81%
and 28.6% increase in correlation is found at the longest 64 month
horizon examined. Moreover, consistent results are found for each
of the countries under examination.
688 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

Table 5
Modeled τ -horizon long-run correlations for different intertemporal lags. Notes: Long horizon average τ -day cor-
relations between each pair of international equity indices is modeled using Eq. (19). Modeled correlation is cal-
culated using the short-horizon (daily) contemporaneous correlation between each market, combined with lagged
and leading serial and cross-serial correlation terms, also estimated using short-horizon data from 1980 to 2015.
The Daubechies least asymmetric wavelet scaling coefficients of length 8 are used to weight the input terms, as
described in Proposition 1. The number of intertemporal lags indicates the number of lagged and leading intertem-
poral variances and covariances used to impute the τ -horizon correlation. Estimated correlations are found using
wavelet long-run correlation. Correlations are modeled for each pair of international equity markets individually
and then averaged cross-sectionally.

(i) Modeled τ horizon average correlations

Horizon

No of intertemporal lags Original 4 8 16 32 64 128 256 512

0 0.410 0.410 0.410 0.410 0.410 0.410 0.410 0.410 0.410

3 0.476 0.503 0.511 0.513 0.514 0.514 0.514 0.514
7 0.506 0.522 0.526 0.527 0.528 0.528 0.528
15 0.522 0.543 0.560 0.566 0.568 0.568
31 0.540 0.585 0.619 0.631 0.634
63 0.587 0.617 0.623 0.624
127 0.614 0.654 0.683
255 0.658 0.667
511 0.678
(ii) Estimated long-run average correlations

Horizon

Return interval Original 4 8 16 32 64 128 216 512

Average correlation 0.410 0.476 0.506 0.523 0.544 0.593 0.621 0.675 0.694

Table 6
Unconditional long-run correlations with haar wavelet (1980–2015). Notes: The average correlation between G7 international equity indices is estimated at different
time horizons using data sampled at data (panel (i)) and monthly intervals (panel (ii)) from 1980 to 2015. Average correlations are across all markets are detailed
in column 1. In the following columns, average correlation between each market and the other six markets is presented. The Haar MODWT scaling filter of length
8 is used to decompose returns data into the range of horizons considered, and long-run correlations estimated at each horizon. Daily and monthly correlations
found using the original untransformed data are also shown. 95% confidence intervals for correlations are shown in brackets. The equality of correlation matrices
with daily data and monthly data is tested using the Jennrich test. and  indicate that the null hypothesis of equality is rejected at a 1% level between correlation
matrices at each horizon and daily and monthly horizons, respectively.

(i) Daily data

Horizon (days) All markets France Germany Italy Canada Japan UK US

Daily 0.410 0.521 0.513 0.436 0.423 0.127 0.500 0.349

[0.394, 0.426] [0.507, 0.535] [0.498, 0.527] [0.420, 0.452] [0.407, 0.439] [0.108, 0.147] [0.485, 0.514] [0.331, 0.366]
4 0.476 ,  0.560 ,  0.558 ,  0.466 ,  0.474 ,  0.212 ,  0.545 ,  0.443 , 
[0.444, 0.487] [0.541, 0.579] [0.539, 0.577] [0.444, 0.487] [0.452, 0.496] [0.184, 0.239] [0.525, 0.564] [0.420, 0.465]
8 0.506 ,  0.574 ,  0.576 ,  0.480 ,  0.500 ,  0.259 ,  0.561 ,  0.489 , 
[0.47, 0.512] [0.555, 0.592] [0.557, 0.594] [0.458, 0.501] [0.478, 0.52] [0.232, 0.286] [0.541, 0.580] [0.468, 0.510]
16 0.524 ,  0.596 ,  0.590 ,  0.490 ,  0.521 ,  0.296 ,  0.575 ,  0.527 , 
[0.493, 0.534] [0.577, 0.613] [0.572, 0.608] [0.469, 0.511] [0.500, 0.541] [0.269, 0.322] [0.556, 0.594] [0.506, 0.547]
32 0.544 ,  0.609 ,  0.602 0.513 ,  0.544 ,  0.341 ,  0.593 ,  0.560 , 
[0.517, 0.557] [0.591, 0.626] [0.583, 0.619] [0.492, 0.534] [0.523, 0.563] [0.316, 0.366] [0.574, 0.610] [0.541, 0.579]
64 0.593 0.640 0.624 0.552 0.591 0.407 ,  0.638 0.604
[0.561, 0.598] [0.623, 0.656] [0.607, 0.641] [0.532, 0.571] [0.573, 0.609] [0.383, 0.430] [0.621, 0.654] [0.586, 0.622]
128 0.621 ,  0.666 ,  0.651 ,  0.601 ,  0.632 ,  0.442 0.671 ,  0.639 , 
[0.597, 0.632] [0.65, 0.681] [0.634, 0.666] [0.582, 0.618] [0.615, 0.649] [0.419, 0.465] [0.656, 0.687] [0.623, 0.656]
256 0.675 ,  0.714 ,  0.686 ,  0.650 ,  0.668 ,  0.513 ,  0.712 ,  0.691 , 
[0.646, 0.677] [0.699, 0.727] [0.67, 0.7] [0.633, 0.666] [0.652, 0.684] [0.491, 0.534] [0.698, 0.725] [0.676, 0.705]
512 0.692 ,  0.742 ,  0.730 ,  0.671 ,  0.680 ,  0.558 ,  0.744 ,  0.720 , 
[0.677, 0.707] [0.729, 0.755] [0.717, 0.743] [0.655, 0.687] [0.664, 0.695] [0.538, 0.578] [0.731, 0.757] [0.706, 0.734]
(ii) Monthly data
Monthly 0.578 0.638 0.618 0.537 0.590 0.429 0.631 0.602
[0.513, 0.636] [0.58, 0.69] [0.557, 0.672] [0.467, 0.6] [0.526, 0.647] [0.349, 0.503] [0.571, 0.684] [0.54, 0.657]
4 0.614 ,  0.665 ,  0.643 ,  0.579 ,  0.629 ,  0.473 ,  0.667 ,  0.642 , 
[0.525, 0.69] [0.585, 0.733] [0.559, 0.714] [0.484, 0.661] [0.543, 0.702] [0.362, 0.57] [0.587, 0.735] [0.558, 0.713]
8 0.644 ,  0.690 ,  0.664 ,  0.624 ,  0.661 ,  0.493 ,  0.696 ,  0.679 , 
[0.56, 0.715] [0.615, 0.754] [0.584, 0.731] [0.535, 0.699] [0.58, 0.73] [0.384, 0.588] [0.621, 0.758] [0.602, 0.744]
16 0.674 ,  0.725 ,  0.703 ,  0.653 ,  0.669 ,  0.537 ,  0.726 ,  0.707 , 
[0.595, 0.740] [0.656, 0.782] [0.630, 0.764] [0.570, 0.724] [0.589, 0.737] [0.434, 0.626] [0.657, 0.783] [0.634, 0.767]
32 0.71 ,  0.769 ,  0.749 ,  0.680 ,  0.688 ,  0.588 ,  0.770 ,  0.739 , 
[0.639, 0.772] [0.708, 0.818] [0.685, 0.802] [0.600, 0.746] [0.610, 0.753] [0.491, 0.670] [0.709, 0.819] [0.673, 0.794]
64 0.743 ,  0.802 ,  0.802 ,  0.713 ,  0.715 ,  0.616 ,  0.809 ,  0.741 , 
[0.676, 0.798] [0.747, 0.846] [0.748, 0.845] [0.638, 0.775] [0.641, 0.776] [0.523, 0.695] [0.757, 0.852] [0.673, 0.796]
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696 689

5. Conclusions Doug Breeden, Michael Brennan, Maureen O’Hara, John McConnell,

Matthew Spiegel, René Stulz, Hassan Tehranien, two anonymous
The notion of long-run asset risk has received considerably at- referees, the Editor, Emanuele Borgonovo and participants at the
tention in the literature in recent years, but there has been lit- Midwest Finance Association meeting (Chicago, 2017), FMA Euro-
tle focus on long-run multivariate asset characteristics. Despite the pean meeting (Ca’ Foscari University, Venice, Italy, 2015), INFINITI
central role of correlation in the portfolio allocation decision, few conference (Prato, Italy, 2014), FMA annual meeting (Chicago, Illi-
studies have considered whether correlation and associated diver- nois, 2013), Simon Fraser University, University College Dublin, Uni-
sification opportunities are consistent in the long-run. In this pa- versity of Liverpool and Xiamen University for helpful comments.
per, we present a methodology to determine the long-run corre-
lation between financial assets and demonstrate improved estima-
tion at long-run horizons relative to traditional approaches. Using Appendix A
the wavelet transformation, we focus on the long-run correlation
after short-run effects, often associated with frictions, have been
removed. This differentiates our methodology from previous re- Proof of Proposition. Following a procedure similar to Cohen
search focused on wavelet-based correlation in a narrow frequency et al. (1983b), we outline how long horizon wavelet cross-
band. Moreover, our method has no requirement for periodicity correlation can be expressed as a function of original (1 day) cor-
in data and, relative to alternative time series filters, provides for relation with a correction for serial and cross-serial correlation.
multivariate time series characterization. This general proof holds for any choice of admissible wavelet basis.
Using generated data with characteristics common to those MODWT wavelet scaling coefficients for a time series rm of length
found in financial markets, we illustrate the estimation benefits T at scale j are given by
available to an investor adopting the wavelet long-run measure to
estimate correlation, relative to traditional subsampling. For long L j −1

time series, the bias associated with the wavelet long-run correla- νm, j = g j,l rm,t−l mod T (26)
tion is up to 84.2% lower than for sub-sampling and error is up l=0
to 38.9% lower. We also highlight additional performance bene-
fits from higher-order sophisticated wavelets and detail efficiency where Lj is the filter width and gj, l is the wavelet scaling filter at
gains from including weakly affected coefficients. scale j.
Employing time series representing equity indices from G7 Wavelet scaling covariance between time series rm and rn at
countries, we highlight significant differences between short- and scale j can be written as,
long-run correlations. Contrasting the longest 64 month hori- L −1 L j −1

zon (approximately 5 year horizon) examined with the baseline   
j

monthly horizon so often considered in the literature, we observe Cov νm, j , νn, j = Cov g j,k rm,t−k mod T , g j,l rn,t−l mod T (27)
a 31% increase in the average cross-sectional correlation between k=0 l=0
markets. Consistent results are found for all G7 countries. Increas-
ing correlations are also found for ETFs, suggesting that empirical
L j −1 L j −1
findings are not simply a consequence of non-synchronous trading   
hours between international markets. = g j,k g j,l Cov rm,t−k mod T , rn,t−l mod T . (28)
Investigating the origins of any heterogeneity in correlation k=0 l=0
over horizons, we develop a model linking long-run correlation
to short-run financial characteristics. Complementing our empiri- Eq. (28) is a weighted cross-covariance matrix, where the wavelet
cal findings, we model long-run correlation using only short-run scaling filters gj, l and gj, k are the weighting parameters. Each term
data, with a correction for short-run serial and cross-serial correla- in Eq. (28) can be considered separately. The Lj diagonal elements
tion. In keeping with previous literature examining the intervalling of the cross-covariance matrix are each equal to the contempo-
effect on systematic risk, our model suggests that short-run mea- raneous covariance between the original data rm and rn , because
surement of correlation may be biased downwards by frictions. The of the assumption of stationarity of the time series. For k = l, this
implication of this for investors is that perceived diversification op- may be written as:
portunities resulting from short-run correlation may be overesti-  
mated.
g j,k g j,l Cov rm,t−k mod T , rn,t−l mod T = g2j,l Cov(rm , rn )
In summary, our results highlight the central importance of  j
= g2l Cov(rm , rn ), (29)
considering horizon when investigating the potential for diver-
sification. Employing data with a one-month interval, common where the jth scale wavelet scaling filter gj can be written as a
throughout the literature, results in underestimation of long-run cascade of j scaling filters g j = g ∗ g ∗ · · · ∗ g, and ∗ denotes a con-
correlation. The implications of these findings for long-run portfo- volution.
lio allocation appears a fruitful avenue for future research. The off-diagonal elements above and below the diago-
nal are considered in turn. Using the identity Cov(rm , rn ) =
Acknowledgment ρ (rm , rn )σ (rm )σ (rn ), for k = l we can then write,
 
Thomas Conlon and John Cotter would like to acknowledge the g j,k g j,l Cov rm,t−k mod T , rn,t−l mod T
financial support of Science Foundation Ireland under Grant Num-
bers 16/SPP/3347 and 08/SRC/FM1389. Thomas Conlon also grate- = g j,k g j,l ρ k−l (rm , rn )σ (rm,t−k mod T )σ (rn,t−l mod T ) (30)
fully acknowledges financial support from the Irish Canadian Uni-
versity Foundation and the Irish Research Council under Grant = g j,k g j,l ρ k−l (rm , rn )σ (rm )σ (rn ) (31)
Number REPRO/2015/109. Ramo Gençay is grateful to the Natural
Sciences and Engineering Research Council of Canada and Social Stationarity implies that σ (rm,t−k mod T ) = σ (rm ) and
Sciences and Humanities Research Council of Canada for research σ (rn,t−k mod T ) = σ (rn ). ρ k−l represents the cross-serial corre-
support. The authors are grateful to Lieven Baele, Wolfgang Bessler, lation of series rm and rn which are out of sync by k − l intervals.
690 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

Summing across all terms in the cross-covariance matrix and using where rt are the observed returns, M is the moving-average matrix
L j −1 2 and H is the covariance matrix of  t , in turn the stochastic process
the identity l=0 gl = 12 we can write:
underpinning returns at time t − 1. The unobserved synchronized
   j j
C ov νm, j , νn, j = 12 C ov(rm , rn ) price of market j at time t, Sˆt , can be described as a function of
j
L j −2 L j −1 the observed prices St ,
     
+ g j,k g j,l ρ k−l (rm , rn ) + ρ −(k−l ) (rm , rn ) σ (rm )σ (rn ). log Sˆtj = E[log Stj |It ], where It = Stj |t j ≤ t, j = 1, . . . , J (36)
k=0 l=k+1
When future changes in the synchronized returns are unpre-
(32)
dictable, Eq. (36) provides an unbiased estimate of the next
This expresses the wavelet scaling covariance at scale j or, equiv- recorded price,
alently, horizon τ j , as a function of the short-run covariance be-
log Sˆtj = E[log St+1
j
|It ] (37)
tween returns at the original interval plus a correction term ac-
counting for cross-serial correlation between the two series at the Following Burns et al. (1998), the unobserved synchronized returns
original interval. are then given as
Similarly, we can express the wavelet long run, or scaling, vari-
rˆt = log Sˆt − logSˆt−1 (38)
ance for series rm at scale j as:

   j L j −2 L j −1
  = Et [log St+1 ] − Et−1 [log St ] (39)
σ 2 νm, j = 12 σ 2 (rm ) + 2 g j,k g j,l ρ (k−l ) (rm )σ 2 (rm ) (33)
k=0 l=k+1 = Et [rt+1 ] − Et−1 [rt ] + log St − log St−1 (40)
Analogous to the case for covariance, this relates the wavelet long-
run variance to the short-run variance, plus a correction account- = Mt − Mt−1 + rt (41)
ing for serial correlation in the time series.
Combining estimates for long-run covariance and variance, this = t + Mt . (42)
allows us to write the wavelet long-run correlation as follows:
L j −2 L j −1
 
  ( 12 ) Cov(rm ,rn )+
j
g j,k g j,l [ρ k−l (rm ,rn )+ρ −(k−l ) (rm ,rn )]σ (rm )σ (rn ).
ρ νm, j , νn, j = (
Cov νm, j ,νn, j ) =  k=0 l=k+1

( ) (
V ar νm, j V ar νn, j ) L j −2 L j −1 L j −2 L j −1 (34)
   
( 12 ) σ 2 (rm )+2 ( 12 ) σ 2 (rn )+2
j j
g j,k g j,l ρ k−l (rm )σ 2 (rm ) g j,k g j,l ρ k−l (rn )σ 2 (rn )
k=0 l=k+1 k=0 l=k+1

This relates the long-run correlation between two time series to

the short-run variance of each series, the short-run covariance be-
tween them and a sequence of correction terms accounting for
short-run serial and cross-serial correlations in the original un-
transformed time series. 
Appendix B
B.1. Wavelet long-run correlation – detailed simulation results
To illustrate the performance of wavelet long-run correlation,
we simulate non-synchronous markets as described in Section 3,
incrementally incorporating further features. First, bias and error of
wavelet long-run correlation are contrasted with various alterna-
tive methodologies.22 Second, different wavelet families and a va-
riety of specifications are examined, including long and short sim-
ulated time series both with and without jumps.
We now contrast bias and error from wavelet long-run correla-
tion to estimates from three alternative approaches. First, we con-
sider subsampled returns, created by summing over short horizon
logarithmic returns, resulting in long horizon or low-frequency re-
turns. One potential drawback to subsampled returns is a possibil-
ity of estimation differences surrounding the day of the week or
month chosen in forming subsamples. Second, we follow the ap-
proach proposed by Burns et al. (1998), and later adapted by others
(for example, Chua, Lai, & Wu, 2008; Martens & Poon, 2001), to es-
timate the term structure of correlations. To this end, synchronized
returns are estimated from unsynchronized market closing returns
using a first-order vector moving-average model,
rt = t + Mt−1 , Vt−1 (t ) = Ht
22
 Bias is2defined
 as E[ρˆ ] − ρ , while error is defined using the mean square error
E ρˆ − ρ .
In practise, we estimate M using a vector autoregressive approx-
imation of order p, VAR(p) following the procedure developed by
Galbraith, Ullah, and Zinde-Walsh (2002).
The third approach to overcome the problem of unobserved
synchronized returns is the Kalman filter. Similar to Eq. (20), the
trading day is divided in three and ε t is a vector of the unobserved
log-returns associated with each component. Using the Kalman fil-
ter, the observation equation is given by rt , while the state equa-
tion is et ,
rt = α + Bet + ut (43)
et = δ et−1 + γ vt−1 (44)
where et = (ε1,t , ε2,t , ε3,t , ε1,t−1 )T ,
ut = N (0, u ), vt = N (0, Ie ) and
B represents the exposures to the world market during each co-
hort. The model is then estimated on the returns of the syn-
chronous and unsynchronous markets given by Eqs. (20) and (22),
respectively. Synchronized returns are then calculated by summing
the state variables for each market.
While previous studies have used a GARCH approach to esti-
mate the term structure of correlation, this approach is inappro-
priate here, as our focus is on a constant rather than dynamic cor-
relation. To this end, we adopt a constant conditional correlation
(CCC) GARCH which is time-invariant (Carroll et al., 2017). Combin-
ing the synchronized returns estimated from either the VAR and
Kalman filter approaches detailed with CCC, we now estimate the
correlation for generated data and contrast with wavelet long-run
correlation.
Table B1 provides a comparison between correlation using long-
run wavelet correlation (LA8) and the other methods described. In
(35) each case bias and error for the wavelet long-run correlation is
shown as a proportion of the correlation emanating from the VAR
and KF synchronized data. As highlighted in Fig. 2 in the presence
of jumps and regimes, the LA8 long-run wavelet approach provides
lower bias than any of the alternatives for horizons greater than
Table B1
Simulation contrasting wavelet long-run correlation with alternative approaches. Notes: The accuracy of wavelet long-run correlation estimation is compared with estimates formed using a VAR(1) and Kalman
filter. Wavelet long-run correlation bias and error is given as a proportion of that from the VAR and KF synchronized data. Generated data consisting of long time series of length 10,0 0 0 are examined. Bias is

T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

defined as E[ρˆ ] − ρ , while error is defined using the mean square error E[(ρˆ − ρ )2 ]. Scaling coefficients associated with the maximum overlap discrete wavelet transform are used in the calculation of wavelet
correlation. The model generating returns for two individual markets was simulated 50,0 0 0 times. The world market is specified to have volatility of 20%, each market has a beta of 0.8 and jump intensity is
between 0.01 and 0.05 and has volatility of 200%. Regimes correspond to equally sized regimes with average volatility of 20%. The least asymmetric wavelet of length 8 (LA8) using weakly biased coefficients is
used to calculate long-run correlation. Correlation is estimated at 4, 8, 16, 32, 64, 128, 256 and 512 day horizons.

(a) T = 10,0 0 0, relative performance of wavelet long-run correlation and a VAR(1) model with jumps and regimes.

Bias Error

4 8 16 32 64 128 256 512 4 8 16 32 64 128 256 512

No jumps or regimes 3.897 1.144 0.311 0.180 0.251 0.355 0.486 0.710 3.856 1.140 0.344 0.224 0.313 0.443 0.618 0.916
Jump Int = 0.01 3.560 1.048 0.282 0.137 0.177 0.246 0.370 0.532 3.536 1.045 0.302 0.173 0.223 0.314 0.468 0.689
Jump Int = 0.03 3.182 0.933 0.250 0.100 0.120 0.168 0.234 0.343 3.169 0.933 0.263 0.127 0.152 0.215 0.301 0.446
Jump Int = 0.05 2.973 0.870 0.230 0.079 0.089 0.121 0.176 0.261 2.965 0.869 0.237 0.098 0.112 0.154 0.224 0.344
2 Regimes 1.848 0.542 0.148 0.083 0.109 0.151 0.227 0.323 1.843 0.544 0.164 0.105 0.136 0.192 0.294 0.435
3 Regimes 2.230 0.654 0.177 0.101 0.137 0.198 0.278 0.411 2.220 0.655 0.197 0.128 0.172 0.251 0.361 0.541
4 Regimes 2.484 0.730 0.197 0.117 0.154 0.223 0.311 0.441 2.471 0.731 0.219 0.144 0.192 0.279 0.394 0.590
(b) T = 10,0 0 0, relative performance of wavelet long-run correlation and a Kalman filter model with jumps and regimes.

Bias Error

4 8 16 32 64 128 256 512 4 8 16 32 64 128 256 512

No jumps or regimes 0.975 0.286 0.080 0.050 0.060 0.085 0.132 0.190 0.889 0.262 0.082 0.057 0.069 0.097 0.147 0.212
Jump Int = 0.01 0.966 0.288 0.085 0.040 0.047 0.063 0.099 0.152 0.897 0.268 0.086 0.048 0.056 0.074 0.119 0.183
Jump Int = 0.03 0.935 0.272 0.073 0.029 0.033 0.051 0.070 0.099 0.887 0.259 0.073 0.035 0.039 0.059 0.082 0.119
Jump Int = 0.05 0.925 0.273 0.076 0.026 0.027 0.036 0.050 0.083 0.887 0.263 0.075 0.031 0.035 0.045 0.061 0.105
2 Regimes 0.707 0.209 0.058 0.031 0.043 0.064 0.091 0.131 0.656 0.195 0.058 0.035 0.049 0.072 0.109 0.159
3 Regimes 0.776 0.228 0.061 0.036 0.051 0.069 0.095 0.146 0.716 0.211 0.063 0.043 0.060 0.079 0.109 0.182
4 Regimes 0.816 0.240 0.063 0.037 0.048 0.062 0.097 0.138 0.751 0.222 0.067 0.044 0.053 0.072 0.114 0.161

691
 692
Table B2
Simulation study contrasting wavelet long-run scaling correlation with subsampled correlation for long time series. Notes: The accuracy of wavelet scaling correlation estimation is contrasted to subsampled
correlation for simulated data using weakly biased and unbiased wavelet coefficients. Accuracy as a proportion of subsampled correlation is shown in brackets below each measurement. Bias is defined as
E[ρˆ ] − ρ , while error is defined using the mean square error E[(ρˆ − ρ )2 ], where ρˆ and ρ are the actual and estimated values, respectively. Scaling coefficients associated with the maximum overlap discrete
wavelet transform are used in the calculation of wavelet correlation. The model generating returns for two individual markets was simulated 50,0 0 0 times for time series of length 10,0 0 0. The world market
is specified to have volatility of 20%, each market has a beta of 0.8 and jumps are specified to have frequency 0.01 and volatility of 200%. Subsampled data corresponds to original data sampled at differing

T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

horizons, Haar is the Haar wavelet, LA8 is the least asymmetric wavelet of length 8, C6 is the Coiflet wavelet of length 6 and D8 is the Daubechies wavelet of length 8. Correlation is estimated at 4, 8, 16, 32, 64,
128, 256 and 512 day horizons. The most accurate measurement is highlighted in bold at each horizon.

(a) T = 10,0 0 0, asynchronous trading, jumps and delay frictions, weakly biased coefficients

Bias Error

4 8 16 32 64 128 256 512 4 8 16 32 64 128 256 512

Sub-sampled −6.504 −3.252 −1.643 −0.862 −0.471 −0.339 −0.358 −0.619 6.648 3.763 3.136 3.891 5.410 7.648 10.861 15.601
Haar −6.510 −3.250 −1.632 −0.858 −0.470 −0.307 −0.296 −0.483 6.615 3.593 2.705 3.193 4.406 6.209 8.778 12.470
(1.001) (0.999) (0.994) (0.995) (0.999) (0.904) (0.828) (0.779) (0.995) (0.955) (0.863) (0.820) (0.814) (0.812) (0.808) (0.799)
LA8 −5.229 −1.536 −0.417 −0.136 −0.108 −0.136 −0.237 −0.483 5.375 2.300 2.483 3.519 5.007 7.096 10.057 14.364
(0.804) (0.472) (0.254) (0.158) (0.230) (0.400) (0.662) (0.780) (0.808) (0.611) (0.792) (0.904) (0.926) (0.928) (0.926) (0.921)
C6 −5.665 −1.996 −0.648 −0.224 −0.133 −0.138 −0.224 −0.452 5.793 2.590 2.442 3.387 4.815 6.823 9.667 13.786
(0.871) (0.614) (0.395) (0.260) (0.283) (0.406) (0.626) (0.730) (0.871) (0.688) (0.779) (0.870) (0.890) (0.892) (0.890) (0.884)
D8 −5.229 −1.538 −0.418 −0.137 −0.109 −0.135 −0.234 −0.475 5.375 2.302 2.483 3.519 5.008 7.097 10.060 14.366
(0.804) (0.473) (0.254) (0.159) (0.231) (0.398) (0.653) (0.768) (0.808) (0.612) (0.792) (0.904) (0.926) (0.928) (0.926) (0.921)
(b) T = 10,0 0 0, asynchronous trading, jumps and delay frictions unbiased coefficients

Bias Error

4 8 16 32 64 128 256 512 4 8 16 32 64 128 256 512

Sub-sampled −6.504 −3.252 −1.643 −0.862 −0.471 −0.340 −0.358 −0.619 6.648 3.763 3.136 3.892 5.410 7.648 10.861 15.601
Haar −6.510 −3.251 −1.633 −0.860 −0.472 −0.308 −0.289 −0.490 6.615 3.595 2.706 3.193 4.405 6.210 8.778 12.474
(1.001) (1.0 0 0) (0.994) (0.997) (1.002) (0.908) (0.808) (0.791) (0.995) (0.955) (0.863) (0.821) (0.814) (0.812) (0.808) (0.800)
D8 −5.227 −1.536 −0.418 −0.138 −0.116 −0.143 −0.258 −0.605 5.373 2.302 2.493 3.541 5.066 7.280 10.576 15.964
(0.804) (0.472) (0.254) (0.160) (0.246) (0.421) (0.722) (0.978) (0.808) (0.612) (0.795) (0.910) (0.936) (0.952) (0.974) (1.023)
C6 −5.663 −1.996 −0.650 −0.227 −0.139 −0.144 −0.230 −0.542 5.792 2.591 2.449 3.403 4.851 6.943 9.998 14.762
(0.871) (0.614) (0.396) (0.263) (0.295) (0.423) (0.641) (0.876) (0.871) (0.689) (0.781) (0.874) (0.897) (0.908) (0.921) (0.946)
LA8 −5.228 −1.537 −0.420 −0.140 −0.117 −0.141 −0.257 −0.616 5.374 2.304 2.495 3.542 5.070 7.290 10.605 16.043
(0.804) (0.473) (0.255) (0.162) (0.249) (0.416) (0.718) (0.996) (0.808) (0.612) (0.795) (0.91) (0.937) (0.953) (0.976) (1.028)
Table B3
Simulation study contrasting wavelet long-run scaling correlation with subsampled correlation for long time series. Notes: The accuracy of wavelet scaling correlation estimation is contrasted to subsampled
correlation for simulated data with and without delays and jumps. Accuracy as a proportion of subsampled correlation is shown in brackets below each measurement. Bias is defined as E[ρˆ ] − ρ , while error
is defined using the mean square error E[(ρˆ − ρ )2 ], where ρˆ and ρ are the actual and estimated values, respectively. Scaling coefficients associated with the maximum overlap discrete wavelet transform are
used in the calculation of wavelet correlation. The model generating returns for two individual markets was simulated 50,0 0 0 times for long time series of length 10,0 0 0, both with and without jumps. The
world market is specified to have volatility of 20%, each market has a beta of 0.8 and jumps are specified to have frequency 0.01 and volatility of 200%. Subsampled data corresponds to original data sampled at

T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

differing horizons, Haar is the Haar wavelet, LA8 is the least asymmetric wavelet of length 8, C6 is the Coiflet wavelet of length 6 and D8 is the Daubechies wavelet of length 8. Correlation is estimated at 4, 8,
16, 32, 64, 128, 256 and 512 day horizons. Weakly biased wavelet coefficients are employed in both panels. The most accurate measurement is highlighted in bold at each horizon.

(a) T= 10,0 0 0, asynchronous trading, jumps and without delay frictions weakly biased coefficients

Bias Error

4 8 16 32 64 128 256 512 4 8 16 32 64 128 256 512

Sub-sampled −6.294 −3.160 −1.603 −0.839 −0.496 −0.391 −0.414 −0.660 6.442 3.680 3.109 3.880 5.396 7.671 10.921 15.620
Haar −6.293 −3.153 −1.595 −0.823 −0.464 −0.313 −0.286 −0.426 6.400 3.503 2.676 3.171 4.387 6.208 8.809 12.513
(1.0 0 0) (0.998) (0.995) (0.981) (0.935) (0.800) (0.693) (0.646) (0.993) (0.952) (0.861) (0.817) (0.813) (0.809) (0.807) (0.801)
LA8 −5.060 −1.495 −0.424 −0.144 −0.114 −0.155 −0.237 −0.483 5.208 2.269 2.479 3.501 4.992 7.098 10.107 14.421
(0.804) (0.473) (0.264) (0.172) (0.230) (0.397) (0.573) (0.732) (0.809) (0.616) (0.798) (0.902) (0.925) (0.925) (0.925) (0.923)
C6 −5.480 −1.940 −0.646 −0.229 −0.138 −0.154 −0.226 −0.451 5.610 2.543 2.436 3.370 4.799 6.824 9.711 13.840
(0.871) (0.614) (0.403) (0.273) (0.277) (0.393) (0.547) (0.683) (0.871) (0.691) (0.784) (0.869) (0.889) (0.89) (0.889) (0.886)
D8 −5.061 −1.496 −0.424 −0.145 −0.114 −0.154 −0.238 −0.490 5.209 2.269 2.480 3.501 4.991 7.099 10.109 14.423
(0.804) (0.473) (0.265) (0.172) (0.230) (0.394) (0.575) (0.742) (0.809) (0.617) (0.798) (0.902) (0.925) (0.925) (0.926) (0.923)
(b) T= 10,0 0 0, asynchronous trading, no jumps and without delay frictions weakly biased coefficients

Bias Error

4 8 16 32 64 128 256 512 4 8 16 32 64 128 256 512

Sub−sampled −15.196 −7.603 −3.812 −1.923 −0.989 −0.549 −0.381 −0.416 15.211 7.634 3.885 2.128 1.539 1.727 2.355 3.580
Haar −15.197 −7.604 −3.809 −1.915 −0.979 −0.528 −0.336 −0.316 15.206 7.619 3.847 2.033 1.343 1.376 1.830 2.784
(1.0 0 0) (1.0 0 0) (0.999) (0.996) (0.991) (0.961) (0.882) (0.758) (1.0 0 0) (0.998) (0.99) (0.956) (0.873) (0.777) (0.777) (0.778)
LA8 −12.212 −3.596 −0.963 −0.258 −0.092 −0.078 −0.135 −0.300 12.222 3.624 1.098 0.763 1.020 1.461 2.166 3.417
(0.804) (0.473) (0.253) (0.134) (0.093) (0.142) (0.355) (0.722) (0.804) (0.475) (0.283) (0.359) (0.663) (0.846) (0.920) (0.954)
C6 −13.227 −4.673 −1.507 −0.469 −0.164 −0.099 −0.131 −0.262 13.237 4.694 1.595 0.840 0.989 1.395 2.039 3.126
(0.870) (0.615) (0.395) (0.244) (0.165) (0.181) (0.343) (0.630) (0.870) (0.615) (0.410) (0.395) (0.643) (0.807) (0.866) (0.873)
D8 −12.214 −3.599 −0.966 −0.261 −0.096 −0.082 −0.140 −0.306 12.225 3.627 1.101 0.764 1.021 1.463 2.170 3.429
(0.804) (0.473) (0.253) (0.136) (0.097) (0.149) (0.367) (0.735) (0.804) (0.475) (0.283) (0.359) (0.663) (0.847) (0.921) (0.958)

693
694 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696

Table B4
Simulation study contrasting wavelet long-run scaling correlation with subsampled correlation for short time series. Notes: The accuracy of wavelet
scaling correlation estimation is contrasted to subsampled correlation for simulated data using weakly biased and unbiased wavelet coefficients.
Accuracy as a proportion of subsampled correlation is shown in brackets below each measurement. Bias is defined as E[ρˆ ] − ρ , while error is defined
using the mean square error E[(ρˆ − ρ )2 ], where ρˆ and ρ are the actual and estimated values, respectively. Scaling coefficients associated with the
maximum overlap discrete wavelet transform are used in the calculation of wavelet correlation. The model generating returns for two individual
markets was simulated 50,0 0 0 times for short time series of length 1250. The world market is specified to have volatility of 20%, each market has a
beta of 0.8 and jumps are specified to have frequency 0.01 and volatility of 200%. Subsampled data corresponds to original data sampled at differing
horizons, Haar is the Haar wavelet, LA8 is the least asymmetric wavelet of length 8, C6 is the Coiflet wavelet of length 6 and D8 is the Daubechies
wavelet of length 8. Correlation is estimated at 4, 8, 16, 32, 64 and 128 day horizons. The most accurate measurement is highlighted in bold at each
horizon.

(a) T = 1250, asynchronous trading, jumps and delay frictions, weakly biased coefficients

Bias Error

4 8 16 32 64 128 4 8 16 32 64 128

Subsampled −6.639 −3.371 −1.714 −1.033 −0.814 −1.150 7.487 5.823 6.927 9.669 13.775 19.883
Haar −6.641 −3.350 −1.725 −0.981 −0.711 −0.792 7.266 5.110 5.710 7.835 11.097 15.791
(1.0 0 0) (0.994) (1.006) (0.950) (0.874) (0.689) (0.971) (0.878) (0.824) (0.810) (0.806) (0.794)
LA8 −5.336 −1.604 −0.480 −0.273 −0.391 −0.753 6.187 4.652 6.358 9.297 13.869 22.006
(0.804) (0.476) (0.280) (0.264) (0.480) (0.655) (0.826) (0.799) (0.918) (0.961) (1.007) (1.107)
C6 −5.781 −2.076 −0.722 −0.361 −0.411 −0.703 6.537 4.679 6.096 8.811 12.933 19.686
(0.871) (0.616) (0.421) (0.349) (0.505) (0.612) (0.873) (0.804) (0.880) (0.911) (0.939) (0.990)
D8 −5.342 −1.611 −0.486 −0.285 −0.383 −0.726 6.193 4.662 6.372 9.328 13.936 22.210
(0.805) (0.478) (0.284) (0.276) (0.470) (0.632) (0.827) (0.801) (0.920) (0.965) (1.012) (1.117)
(b) T = 1250, asynchronous trading, jumps and delay frictions, unbiased coefficients

Bias Error

4 8 16 32 64 128 4 8 16 32 64 128
Subsampled −6.414 −3.264 −1.723 −1.077 −0.881 −1.211 7.278 5.752 6.926 9.677 13.805 19.977
Haar −6.407 −3.239 −1.681 −0.986 −0.761 −0.910 7.037 5.022 5.667 7.797 11.053 15.711
(0.999) (0.992) (0.976) (0.916) (0.864) (0.751) (0.967) (0.873) (0.818) (0.806) (0.801) (0.786)
LA8 −5.160 −1.560 −0.500 −0.334 −0.490 −0.859 6.011 4.570 6.174 8.859 12.691 18.188
(0.804) (0.478) (0.290) (0.310) (0.556) (0.709) (0.826) (0.794) (0.891) (0.915) (0.919) (0.910)
C6 −5.586 −2.010 −0.722 −0.407 −0.485 −0.804 6.346 4.598 5.960 8.513 12.181 17.423
(0.871) (0.616) (0.419) (0.378) (0.551) (0.664) (0.872) (0.799) (0.861) (0.880) (0.882) (0.872)
D8 −5.165 −1.566 −0.502 −0.334 −0.489 −0.860 6.018 4.574 6.174 8.855 12.686 18.172
(0.805) (0.480) (0.291) (0.310) (0.555) (0.710) (0.827) (0.795) (0.891) (0.915) (0.919) (0.910)

Table B5
Simulation study contrasting wavelet long-run scaling correlation with subsampled correlation for short time series. Notes: The accuracy of wavelet
scaling correlation estimation is contrasted to subsampled correlation for simulated data with and without delays and jumps. Accuracy as a proportion
of subsampled correlation is shown in brackets below each measurement. Bias is defined as E[ρˆ ] − ρ , while error is defined using the mean square
error E[(ρˆ − ρ )2 ], where ρˆ and ρ are the actual and estimated values, respectively. The scaling coefficients associated with the maximum overlap
discrete wavelet transform are used in the calculation of wavelet correlation. The model generating returns for two individual markets was simulated
50,0 0 0 times for short time series of length 1250, both with and without jumps. The world market is specified to have volatility of 20%, each market
has a beta of 0.8 and jumps are specified to have frequency 0.01 and volatility of 200%. Subsampled data corresponds to original data sampled at
differing horizons, Haar is the Haar wavelet, LA8 is the least asymmetric wavelet of length 8, C6 is the Coiflet wavelet of length 6 and D8 is the
Daubechies wavelet of length 8. Correlation is estimated at 4, 8, 16, 32, 64 and 128 day horizons. Weakly biased coefficients are employed in both
panels. The most accurate measurement is highlighted in bold at each horizon.

(a) T = 1250, asynchronous trading, jumps and no delay frictions, weakly biased coefficients

Bias Error

4 8 16 32 64 128 4 8 16 32 64 128

Subsampled −6.420 −3.269 −1.737 −1.090 −0.900 −1.234 7.292 5.776 6.949 9.606 14.246 22.924
Haar −6.425 −3.255 −1.704 −0.989 −0.764 −0.922 7.062 5.035 5.680 7.784 11.431 17.930
(1.001) (0.996) (0.981) (0.907) (0.849) (0.747) (0.968) (0.872) (0.817) (0.810) (0.802) (0.782)
LA8 −5.161 −1.558 −0.488 −0.273 −0.416 −0.876 6.031 4.618 6.343 9.263 13.847 21.986
(0.804) (0.476) (0.281) (0.251) (0.462) (0.710) (0.827) (0.799) (0.913) (0.964) (0.972) (0.959)
C6 −5.592 −2.016 −0.725 −0.362 −0.428 −0.739 6.365 4.635 6.080 8.770 12.703 19.697
(0.871) (0.617) (0.418) (0.332) (0.475) (0.599) (0.873) (0.802) (0.875) (0.913) (0.892) (0.859)
D8 −5.166 −1.563 −0.493 −0.274 −0.405 −0.856 6.037 4.627 6.356 9.292 13.914 22.222
(0.805) (0.478) (0.284) (0.251) (0.450) (0.694) (0.828) (0.801) (0.915) (0.967) (0.977) (0.969)
(b) T = 1250, asynchronous trading, no jumps and no delay frictions, unbiased coefficients

Bias Error

4 8 16 32 64 128 4 8 16 32 64 128
Subsampled −15.228 −7.653 −3.885 −2.053 −1.189 −0.943 15.326 7.847 4.333 3.140 3.575 5.224
Haar −15.237 −7.659 −3.885 −2.021 −1.133 −0.798 15.295 7.756 4.120 2.679 2.657 3.549
(1.001) (1.001) (1.0 0 0) (0.984) (0.953) (0.846) (0.998) (0.988) (0.951) (0.853) (0.743) (0.679)
LA8 −12.233 −3.631 −1.024 −0.360 −0.284 −0.579 12.302 3.805 1.709 1.952 2.916 5.037
(0.803) (0.474) (0.264) (0.176) (0.239) (0.615) (0.803) (0.485) (0.394) (0.622) (0.816) (0.964)
C6 −13.258 −4.721 −1.581 −0.580 −0.345 −0.508 13.322 4.859 2.075 1.931 2.729 4.391
(0.871) (0.617) (0.407) (0.283) (0.290) (0.539) (0.869) (0.619) (0.479) (0.615) (0.764) (0.841)
D8 −12.247 −3.650 −1.045 −0.383 −0.308 −0.631 12.316 3.825 1.726 1.966 2.937 5.110
(0.804) (0.477) (0.269) (0.187) (0.259) (0.669) (0.804) (0.487) (0.398) (0.626) (0.822) (0.978)
 T. Conlon et al. / European Journal of Operational Research 271 (2018) 676–696
8 days. Moreover, we provide evidence that the wavelet approach
provides outperformance even without non-parametric features, in
keeping with the use of predetermined weights and no estimation
error for wavelets. At a horizon of 32 days, the wavelet long-run
correlation has bias and error which is 7.9% and 9.8% of that from
the VAR(1) model with jump intensity set to 0.05. In the case of
regimes, maximal outperformance is achieved by the wavelet ap-
proach for 3 regimes. Consistent outperformance is evident for the
wavelet correlation relative to the KF (panel (b)), with bias and er-
ror from wavelets as little as 2.6% and 3.1% of the KF filter, respec-
tively.
Next, we consider the performance of the wavelet methodol-
ogy across different wavelet families for alternative simulation pa-
rameters. Results are detailed in Table B2, for time series of length
10,0 0 0, chosen to closely match the baseline data sample exam-
ined in the empirical analysis. Panel (a) details results for weakly
biased boundary coefficients and panel (b) unbiased coefficients,
both showing results for markets with jumps, delays due to fric-
tions and non-synchronized market trading. Examining first the
impact on estimation bias induced, we note that short horizon cor-
relation estimates suffer from a downward bias. In other words,
the estimated correlation in all cases is lower than the expected
value without frictions. For longer horizons, decreasing bias is evi-
dent. These findings using generated data are in keeping with the
premise, highlighted in previous research on systematic risk, that
short-horizon correlations are downward biased by frictions and
that one needs to look to longer horizons to obtain more accu-
rate estimates of frictionless correlation. The implication of these
results is that correlation estimated at short horizons may misrep-
resent the opportunities for diversification.
In Table B2, different wavelet families (LA8, C6 and D8) are
shown to have considerably lower bias than either subsampled
or Haar for all horizons. At long horizons, weakly biased coeffi-
cients provide substantially lower bias than their unbiased coun-
terparts, helping to support their application throughout the em-
pirical analysis. The level of bias relative to subsampled data for
the LA8 wavelet ranges from 15.8% to 80.4% of that from subsam-
pling for weakly biased coefficients. At the longest 512 horizon ex-
amined, wavelet long-run correlation provides estimates with bias
up to 27% lower than using traditional subsampling of data.
In terms of mean-square error, the LA8 wavelet ranges from
61.1% to 91.1% of that found using subsampling. From horizons of
32 days, the Haar wavelet provides further benefits, perhaps driven
by the ability to accurately filter discontinuities or jumps in data.
These findings support our assertion that wavelets provide consis-
tent performance benefits in terms of measurement bias and er-
ror in the estimation of long-run correlation. Since limited perfor-
mance differences are evident between the sophisticated wavelets
examined, in particular LA8 and D8, the LA8 is chosen for our em-
pirical analysis due to small shifts and low distortion in feature
localization. Since Haar wavelets provide lower error at long hori-
zons, the main empirical findings are also examined for robustness
using this wavelet type.
Table B3 relaxes some of the assumptions for long time series.
Panel (a) examines our long-run correlation performance when
frictions due to market delays are removed, while panel (b) de-
tails performance without jumps or delays. In both cases, the rel-
ative performance of wavelet long-run correlation using weakly-
biased coefficients is strongest. Of particular note, the Haar wavelet
no longer provides the lowest error for the majority of hori-
zons when the large irregular jumps are removed from the gen-
erated data. These findings again support the use of sophisticated
wavelets in measuring long-run correlation in the presence of non-
synchronous market trading.
We next examine apply wavelet long-run correlation estimation
to the small sample problem. Table B4 relays results for weakly
695
biased and unbiased coefficients in the presence of jumps, delays
and non-synchronized trading for data of size 1250. Findings are
in keeping with those detailed for long time series, for horizons
of up to 128 days. The wavelet long-run correlation provides es-
timates with lower bias and error relative to traditional subsam-
pling. Table B5 relaxes the assumptions of delay and jumps. Consis-
tent with previous findings, performance from long-run correlation
using sophisticated wavelets provides the most accurate estimation
of frictionless correlation levels. Moreover, performance differences
between the various sophisticated wavelets examined are found to
be minimal.
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