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I have calculated weights of selected assets in a market-neutral portfolio (presumably with min variance) using PCA and simple data covariance matrix.

The question is :

It is obvious that Cov Matrix contains estimation error so i need to shrink it, the best choice probably would be to implement Ledoit-Wolf estimator but seems that i do not completely understand the formula for Shrinkage Intensity here, could somebody provide a link displaying how to use it on finite samples?

As an alternative i also found this explanation why covariance matrix is often inverted before solving eigenproblem : http://scikit-learn.org/stable/modules/covariance.html#sparse-inverse-covariance

As far as i understood - inverse of covariance matrix it is so called precision matrix (or sparse estimator) which helps to eliminate spurious relationships caused by estimation error of covariance matrix and thus i would like to ask - can simply inverted covariance matrix be a replacement for more complex estimator like Ledoit-Wolf?

P. S. in general i need a good estimator for covariance matrix but in case of Ledoit-Wolf would be good to see how it is calculated on a real data to understand how exactly it works and how to implement it e.g. using C++.

Update : as for the question about general algorithm of the code below, as far as i understand Ledoit-Wolf estimator is kind of mix of the smart averaging and weighting coefficients and the main idea is to decrease spurious variances by recalculating them with averaged values where each values has its own intensity.

The more basic algorithm (just a suggestion) would be to set growing weighting coefficients from recent return to older ones (sorry, do not remember exact book where it was described).

Unfortunately, i tried to apply this estimator on Forex market and could not find significant differences between original covariance matrix and the one with applied estimator. This is part of another question but i decided to use existing library for PCA instead of improving my own so i switched to alglib.

Edit. Ok, i implemented mentioned estimator and to make sure whether it is correct or not i am trying to do the same thing in R. At the moment i have following implementation.

struct SSeries // supposed to be an array of structures of different assets
{
    string mName;
    double mMean;
    double mPoints[]; // returns of specific asset
};

// series - array of returns, size N x M, N - number of assets, M - returns
// covs - covariance matrix, N X N
// estimators - buffer for calculated estimation matrix
// order = N
// depth = M

void GetEstimator(SSeries& series[], SSeries& covs[], SSeries& estimators[], const int order, const int depth)
{
    double 
        R = 0, // average return (first 2 lines with formulas in Appendix A)
        A = 0, // value of "П" in the formula below (Pi)
        B = 0, // value of "p"
        C = 0, // value of "v" (gamma)
        cross = 0;

    // Shrink Target

    for (int k = 0; k < order; k++) 
    {
        double summary = 0;

        for (int n = k + 1; n < order; n++) 
        {
            double divisor = covs[k].mPoints[k] * covs[n].mPoints[n] > 0 ? 1 : -1; // just to make sure that MathSqrt will apply to positive number (square root)
            summary += covs[k].mPoints[n] / MathSqrt(covs[k].mPoints[k] * covs[n].mPoints[n] * divisor) * divisor;
        }

        R += summary;
    }

    R = R * 2 / ((order - 1) * order); // average return

    // Shrink Intensity - weighting coefficient for items in covariance matrix k = (П - p) / v

    for (int k = 0; k < order; k++) 
    {
        double summaryA = 0;

        for (int n = 0; n < order; n++) 
        {
            double Akn = 0; // equivalent of П[i][j]

            for (int i = 0; i < depth; i++)
            {
                double X = series[k].mPoints[i] - series[k].mMean; // substract mean from first series
                double Y = series[n].mPoints[i] - series[n].mMean; // substract mean from second series
                Akn += (X * Y - covs[k].mPoints[n]) * (X * Y - covs[k].mPoints[n]);
            }

            double divisor = covs[k].mPoints[k] * covs[n].mPoints[n] > 0 ? 1 : -1; // make value positiove before taking its square root

            estimators[k].mPoints[n] = k == n ? covs[k].mPoints[n] : R * MathSqrt(covs[k].mPoints[k] * covs[n].mPoints[n] * divisor) * divisor; // for diagonal elements use variance instead of covariance
            summaryA += Akn / depth; // calculation of "П" in the formula above
            cross += k == n ? summaryA : 0; // calculate only variances (diagonal)
        }

        A += summaryA; // "П" - sum of asymptotic variances of the entries of the sample covariance matrix scaled by
    }

    for (int k = 0; k < order; k++) 
    {
        double summaryB = 0, summaryC = 0; // calculation of "p" and "v" using existing cov matrix and recently calculated average return R

        for (int n = 0; n < order; n++) 
        {
            double aCovKk = 0, aCovNn = 0;

            for (int i = 0; i < depth; i++)
            {
                double X = series[k].mPoints[i] - series[k].mMean;
                double Y = series[n].mPoints[i] - series[n].mMean;
                aCovKk += (X * X - covs[k].mPoints[k]) * (X * Y - covs[k].mPoints[n]);
                aCovNn += (Y * Y - covs[n].mPoints[n]) * (X * Y - covs[k].mPoints[n]);
            }

            double divisorA = covs[n].mPoints[n] / covs[k].mPoints[k] > 0 ? 1 : -1;
            double divisorB = covs[k].mPoints[k] / covs[n].mPoints[n] > 0 ? 1 : -1;

            aCovKk /= aCovKk;
            aCovNn /= aCovNn;
            summaryB += k == n ? 0 : (R / 2) * (aCovKk * MathSqrt(covs[n].mPoints[n] / covs[k].mPoints[k] * divisorA) * divisorA + aCovNn * MathSqrt(covs[k].mPoints[k] / covs[n].mPoints[n] * divisorB) * divisorB);
            summaryC += (estimators[k].mPoints[n] - covs[k].mPoints[n]) * (estimators[k].mPoints[n] - covs[k].mPoints[n]);
        }

        B += summaryB;
        C += summaryC;
    }

    B += cross; // "p" supposed to be a sum of asymptotic variances and covariances

    double intensity = MathMax(0, MathMin(1, ((A - B) / C) / depth)); // formula for weighting coefficient

    for (int k = 0; k < order; k++) 
    {
        for (int n = 0; n < order; n++) 
        {
            estimators[k].mPoints[n] = estimators[k].mPoints[n] * intensity + (1 - intensity) * covs[k].mPoints[n]; // apply calculated intensity - formula (2) in the chapter "3.3 Shrinkage Constant"
        }
    }
}
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1  
This is a very interesting question and very helpful that you provide code. Would you like to provide pseudo-code or something similar just to show the steps that your algorithm does? This would be somewhat clearer. –  Richard Mar 3 at 15:17
    
@Richard: i took formulas only from this book - repositori.upf.edu/bitstream/handle/10230/560/… - Appendix A and B. I will add some comments in the code above. –  Art Mar 16 at 22:30
    
I thought the paper had provided recipe of consistent estimators for finite samples for all the parameters needed and one just needed to plug in the data. Is that what you are asking for? Or are you asking for more detailed explanation of the derivation? –  Hans Mar 17 at 22:56
    
I am not sure what question exactly you are asking. It would be helpful if you would be specific about the question you intend to ask. –  Hans Mar 18 at 20:03
    
@Hansen : in a few words - most assets are not mean-reversal by nature so they need to be normalized by subtracting the mean from each value, e.g. for Cov Matrix, i was told that it is not reliable way but unfortunately that guy did not tell me why is that but advised to take a look at this estimator. So i needed to understand physical nature of this estimator, its general purpose and how to use it within my timseries. Now i can presume that this is just a way to "cut off useles" elements from the matrix which went too far from main spread, according to PCA terms. –  Art Sep 24 at 21:21

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