Multivariate Asset Return Prediction with Mixture Models
Marc S. Paolella
University of Zurich ; Swiss Finance Institute
November 1, 2011
Swiss Finance Institute Research Paper No. 11-52
The use of mixture distributions for modeling asset returns has a long history in finance. New methods of demonstrating support for the presence of mixtures in the multivariate case are provided. The use of a two-component multivariate normal mixture distribution, coupled with shrinkage via a quasi-Bayesian prior, is motivated, and shown to be numerically simple and reliable to estimate, unlike the majority of multivariate GARCH models in existence. Equally important, it provides a clear improvement over use of GARCH models feasible for use with a large number of assets, such as CCC, DCC, and their extensions, with respect to out-of-sample density forecasting. A generalization to a mixture of multivariate Laplace distributions is motivated via univariate and multivariate analysis of the data, and an EM-algorithm is developed for its estimation in conjunction with a quasi-Bayesian prior. It is shown to deliver significantly better forecasts than the mixed normal, with fast and numerically reliable estimation. Crucially, the distribution theory required for portfolio theory and risk assessment is developed.
Number of Pages in PDF File: 47
Keywords: density forecasting, EM-algorithm, fat tails, mixture distributions, multivariate laplace distribution, Quasi-Bayesian estimation, shrinkage estimation, weighted likelihood
JEL Classification: C51, C53, G11, G17
Date posted: November 11, 2011
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