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I am looking to compare the ex-ante predictions against the post values. I am using a look back period of ranges from 1 year to 5 years to construct my covariance matrix that I am using for my ex-ante predictions (calculation below). I am unsure of how to determine the best look back period?

   te_ante = sqrt(relative_wgts * cov_matrix * relative_wgts') * sqrt(4)
  • I'm calculating the te_ante every quarter hence the sqrt(4) to give me an annualised te_ante.
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  • $\begingroup$ Hi, do you want to compare ex-ante TE to ex-post TE? It depends on the purpose but this does not make too much sense too me. If you don't have a lot of trading then the numbers will be very close if you put in the same data, if you have a lot of trading then they will differ a lot. $\endgroup$
    – Ric
    Mar 13 '14 at 10:39
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    $\begingroup$ What would make sense is to estimte TE ex-ante and then look at future active return. Similar to VaR back-testing. $\endgroup$
    – Ric
    Mar 13 '14 at 10:40
  • $\begingroup$ sorry a mistake on my part. Having read your comments about taking the TE ex-ante and looking at the future active return its clear that is what I was been asked to do. $\endgroup$
    – mHelpMe
    Mar 13 '14 at 13:17
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As pointed out by Hull (2012). Options, futures and other derivatives. (8th edition, p305):

"A compromise that seems to work reasonably well is to use closing prices from daily data over the most recent 90 to 180 days. Alternatively, as a rule of thumb, n can be set equal to the number of days to which the volatility is to be applied."

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  • $\begingroup$ I've seen people using monthly data seem to take 180 months (same as 180 days for daily data). Guess I'm asking why this is the case. It appears its just an arbitrage number that's been picked out? Or is there is something I am missing? $\endgroup$
    – mHelpMe
    Mar 13 '14 at 9:42

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