14
Yes it is a better way.
Just take a look to figure 3, from Buss and Vilkov (2012, RFS):
11
This is indeed an interesting question.
According to this website, a paper by Goldman Sachs [Tierens and Anadu (2004)] proposes three alternative methods for estimating average stock correlations:
Calculate a full correlation matrix, weighting its elements in line
with the weight of the corresponding stocks in the portfolio/index,
and excluding ...
10
Here is the general approach you can follow to generate two correlated random variables. Let's suppose, X and Y are two random variable, such that:
$$X \sim N(\mu_1, \sigma_1^2)$$
$$Y \sim N(\mu_2, \sigma_2^2)$$
and $$cor(X,Y)=\rho$$
Now consider: $y=bx + e_i$, where $x$ $(=\frac{X-\mu_1}{\sigma_1}$) and $y$ $(=\frac{Y-\mu_2}{\sigma_2}$) both follow ...
9
First you need to correct the formula to:
$$
W_t^2 = \rho W_t^1 + \sqrt{1-\rho^2} Z_t,
$$
where $Z_t$ is a BM independent of $W_t^1$
If you calculate the variance and the covariance, then you see that it is true:
$$
V[W_t^1] = t
$$
and
$$
V[W_t^2] = \rho^2 V[W_t^1] + (1-\rho^2) V[Z_t] = \rho^2 t + (1-\rho^2) t = t,
$$
which is the desired variance.
For the ...
9
We can obtain a closed-form expression for price correlation given (log) return correlation when the two stocks follow geometric Brownian motion:
$$S_1(t) = S_1(0)e^{(\mu_1- \frac{1}{2} \sigma_1^2)t}e^{\sigma_1Z_1(t)},\\ S_2(t) = S_2(0)e^{(\mu_2- \frac{1}{2} \sigma_2^2)t}e^{\sigma_2Z_2(t)},$$
where $\text{corr}(Z_1(t),Z_2(t)) = E[Z_1(t)Z_2(t)]=\rho t$. ...
8
To clarify notation, you have an universe of $n=2000 \space$ stocks and two portfolio vectors $\mathbf{a},\mathbf{b}\in\mathbb{R}^{n}$ with $\left\|\mathbf{a}\right\|_{1}=\left\|\mathbf{b}\right\|_{1}=1$. Further, you have Estimators for the true Variance $\operatorname{Var}\left[\mathbf{a}\right]$ resp. $\operatorname{Var}\left[\mathbf{b}\right]$ and the ...
8
I just want to add to vonjd's answer some info on the comparison of the 3 methods. This is too big for a comment so I'm posting as a separate answer but please upvote his answer, not mine.
Do the differences in methodologies matter in practice?
To gauge the practical importance of the biases in methods 2 and 3, we calculate the weighted stock correlation ...
7
I think it's alive and well. I don't think there's a specific "decoupling" time, but if you look at e.g. Munnix et al. "Statistical causes for the Epps effect in microstructure noise", it seems that the biased correlation is about 60% of the real value for 1 min data and about 90% for 5 min data, so you could say that 5 min is pretty safe, but 1 min is ...
7
This is indeed a subtle point. What is generally meant with this statement is that correlation is going up in bear markets, so it is not so much the "turmoil" part (i.e. volatility per se) but the "trend" (i.e. negative in this case) part. Putting it another way is that when you control for volatility not the correlation but the covariance (which is the part ...
7
I personally use the simple Garch(1,1) for volatility filtering in the risk management area.
In fact in most cases I don't even estimate the parameters, I stick 0.94 for mean reversion, 0.04 for the squared error and I get the constant by matching the series variance. My experience is that there is no point pretending to finetune parameters when vol is ...
7
Let us consider a basket $B$ with components $S_1,\dots,S_n$ :
$$B(t) = \sum_{i=1}^nw_iS_i(t)$$
At time $t$, each component has standard deviation $\sigma_i$, $i \in \{1,\dots,n\}$, and pairwise correlations are $\rho_{ij}$, $i \not= j$. Thus:
$$\sigma_B^2=\sum_{i=1}^nw_i^2\sigma_i^2+2\sum_{i=1}^n\sum_{1=j}^iw_iw_j\sigma_i\sigma_j\rho_{ij}$$
The implied ...
7
First of all, I am not sure what you mean by the ratio in your second point. However, I will try to give you a partial answer at least.
There is a very comprehensive overview of these by EDHEC, page 4. What is particularly interesting is that they give you conditions under which these diversification portfolios are optimal in a classical/sharpe ratio sense.
...
6
Extra market volatility alone will cause correlations and stock volatilities to spike as you describe, even when overall market structure remains unchanged.
There's a minor variation of the very simple CAPM model that captures precisely this behavior.
To be specific, let's say every security $S_A, S_B, \dots$ (or yield, if you want bonds in this) has a ...
6
It is hard to find a stable non-trivial dependence structure in financial data. Usually when such is found it is hard to rationalize.
One of my favorite (although I am sure there are others) is the so called "Presidential Puzzle". This is an old finding by Santa-Clara and Valkanov (2003) They find that "
Excess return in the stock market is higher under ...
6
What does 'simulate a covariance matrix' mean?
If the question means, generate an arbitrary correlation matrix for 1000 stocks, then we can choose any symmetric matrix with all 1s down the diagonal, so long as every element is between -1 and 1 and the matrix is positive semi-definite. The large size of the matrix means that putting random values in every ...
5
Accurately stated: Diversification helps during turmoil, but helps less as what would be expected by using $w^T \Omega w$ as the portfolio variance where the off-diagonal covariances are estimated during tranquil periods.
This is because correlations and covariances change during turmoil, typically increasing. This reduces the benefit of diversification ...
5
If $\Sigma$ is the covariance matrix of all assets and $w$ is the column vector of weightings of the asset in a certain portfolio. Then
$$
w^T \Sigma w = VAR
$$
is the variance of the portfolio. The contribution to volatility of asset $i$ is given by
$$
w_i (\Sigma w)_i/\sqrt{VAR},
$$
where $(\Sigma w)_i$ is the $i_{th}$ entry in the vector $\Sigma w$.
Note ...
5
Let $(X_t)_{t\geq 0}$ denote a Geometric Brownian Motion
$$ \frac{dX_t}{X_t} = \mu_X dt + \sigma_X dW^X_t,\ \ \ X(0) = X_0$$
such that $X_t$ is lognormally distributed $\forall t > 0$
$$ X_t = X_0 e^{(\mu_X - \frac{1}{2}\sigma_X ^2)t + \sigma_X W_t^X}$$
Let $(Y_t)_{t\geq 0}$ denote an Arithmetic Brownian Motion
$$ dY_t = \mu_Y dt + \sigma_Y dW_t^Y,\ \ \ ...
5
You could, and it doesn't hurt for you to test this yourself. Some of my best work has come from drawing the opposite conclusion to conventional wisdom or stylized "facts" in publications.
That said, it's trivial to construct an example where you won't be able to spread a correlated pair. Suppose the underlying data generation process is $y_t = x_t^2$, you ...
5
here is how to get covariance matrix from correlations:
5
If you assume that a financial asset price has a change that is a wiener process then you can view the future value of that asset as the initial value plus the sum of the independent daily changes (for equity or returns based then you would need log version of this):
$$ S_t = S_0 + \sum \Delta S_i $$
where $\Delta S_i = S_i - S_{i-1} $ is a wiener process.
...
5
No, because correlation is a unitless quantity. As you use volatilities to do the scaling, the $\sqrt{252}$ factor should already be taken into account in them.
If you take a correlation of 1 between two assets, multiplying your correlation matrix by a factor $C \neq 1$ risks either to underestimate correlations (by hiding perfect (anti)correlations) or have ...
4
If you only need to pick 5 out of 10 and want equal weights then just enumerate all 252 possibilities (as pointed out above) and compute the portfolio volatility
$(\textbf{1}'K^{(i)}\textbf{1})^{1/2} = \left( \sum_{ij}K^{(i)}_{ij} \right)^{1/2}$,
where $K^{(i)}$ is the covariance matrix for the $i$th subset. Then use whatever subset gives the lowest ...
4
Not acutally a paper, but there is even a book on Multifractal Models. It is, to my knowledge, the standard reference on this topic by Calvet and Fisher:
Multifractal Volatility: Theory, Forecasting, and Pricing (Academic Press Advanced Finance)
4
An implied correlation $\rho_i(k_1,k_2)$ is a correlation that matches the $(k_1,k_2)$ tranche price $P_{k_1}^{k_2}$ (usually computed under a gaussian or student t copula)
$$
C(k_1,k_2,\rho_i(k_1,k_2)) = P_{k_1}^{k_2}
$$
For mezzanine tranches, there can sometimes be two different implied correlations matching the tranche price.
A base correlation $b_i(...
4
The clearest and most intuitive article I have seen so far is
Kritzman et al., Regime Shifts: Implications for Dynamic Strategies in FAJ (May / June 2012)
It not only shows how you can use HMM for financial modelling but it also goes through the actual estimation algorithm (Baum-Welch) step-by-step and even gives full Matlab-code.
From the abstract:
...
4
I think you're looking for multivariate GARCH models of which this is an overview paper.
Multivariate GARCH models have one big drawback: they are pretty hard to estimate due to the number of correlations. This paper by Caporin and McAleer might be of interest in that regard.
4
The $\lambda$ value used in the original paper is arbitrary, but you can estimate that by assuming (in the simplest case) 2 assets and running the following model:
$\sigma^2_{12,t+1}$ $=$ $\lambda$$*$$\sigma^2_{12,t-1}$$+$$(1-\lambda)$$r_{1,t}$$*$$r_{2,t}$;
given $r_{1,t}$ and $r_{2,t}$ respectively as the returns for the asset 1 and 2 and $\sigma^2_{12,t}$...
4
He is forced to use some tricks because Excel can only take average of a rectangular area, but he wants the avg of upper non-diagonal elements of the matrix only. So he subtracts $\frac{1}{n}$ (the average of the 1's on the diagonal), then scales the result by $\frac{n^2}{n(n+1)/2}$ which is the number of total elements divided by on-or-below-diagonal ...
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