Manipulating Valid Correlation Matrices
Andreas Steiner Consulting GmbH
July 3, 2011
Correlations play an important role in the construction of investment portfolios. In this research note, we explain why the manipulation of a valid correlation matrix is challenging. We also propose three methods to perform the following tasks: 1) Increase all correlations such that they converge to one in the limit. This method can be used to model unexpected high correlation values (for example, in a system crisis as experienced just recently). 2) Decrease correlations such that they shrink to zero or a minimum correlation. This procedure is needed to analyze hedged portfolios or, more generally formulated, absolute return strategies. 3) Change individual correlation values. Many times, analysts have a need to change an individual correlation to a certain value or in a certain direction. As we will see, this method is also a starting point to generate random correlations.
Number of Pages in PDF File: 8
Keywords: Portfolio, Diversification, Risk, Correlation, Stress Test, Scenario Analysis, Matrixworking papers series
Date posted: July 6, 2011
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