Robert F. Engle
New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)
Bryan T. Kelly
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
June 1, 2011
NYU Working Paper No. FIN-08-038
Chicago Booth Research Paper No. 12-07
Fama-Miller Working Paper
A new covariance matrix estimator is proposed under the assumption that at every time period all pairwise correlations are equal. This assumption, which is pragmatically applied in various areas of finance, makes it possible to estimate arbitrarily large covariance matrices with ease. The model, called DECO, involves first adjusting for individual volatilities and then estimating correlations. A quasi-maximum likelihood result shows that DECO provides consistent parameter estimates even when the equicorrelation assumption is violated. We demonstrate how to generalize DECO to block equicorrelation structures. DECO estimates for US stock return data show that (block) equicorrelated models can provide a better fit of the data than DCC. Using out-of-sample forecasts, DECO and Block DECO are shown to improve portfolio selection compared to an unrestricted dynamic correlation structure.
Number of Pages in PDF File: 40
Date posted: March 9, 2009 ; Last revised: November 10, 2015
© 2016 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollobot1 in 2.406 seconds