A Simple Method for Predicting Covariance Matrices of Financial Returns

DOI10.1561/0800000047MaRDI QIDQ6180229OpenAlexFDO

Authors

Publication date 19 December 2023

Published in Foundations and Trends® in Econometrics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/2305.19484

zbMATH Keywords

optimizationstatistical/machine learning

Mathematics Subject Classification ID

Statistics (62-XX)

Abstract: We consider the well-studied problem of predicting the time-varying covariance matrix of a vector of financial returns. Popular methods range from simple predictors like rolling window or exponentially weighted moving average (EWMA) to more sophisticated predictors such as generalized autoregressive conditional heteroscedastic (GARCH) type methods. Building on a specific covariance estimator suggested by Engle in 2002, we propose a relatively simple extension that requires little or no tuning or fitting, is interpretable, and produces results at least as good as MGARCH, a popular extension of GARCH that handles multiple assets. To evaluate predictors we introduce a novel approach, evaluating the regret of the log-likelihood over a time period such as a quarter. This metric allows us to see not only how well a covariance predictor does over all, but also how quickly it reacts to changes in market conditions. Our simple predictor outperforms MGARCH in terms of regret. We also test covariance predictors on downstream applications such as portfolio optimization methods that depend on the covariance matrix. For these applications our simple covariance predictor and MGARCH perform similarly.

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Cited in

(3)

• Filtering time-dependent covariance matrices using time-independent eigenvalues
• A nonparametric eigenvalue-regularized integrated covariance matrix estimator for asset return data
• Estimating correlation and covariance matrices by weighting of market similarity

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