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Multivariate Asset Return Prediction with Mixture Models

47 Pages Posted: 11 Nov 2011  

Marc S. Paolella

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Date Written: November 1, 2011

Abstract

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.

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

Suggested Citation

Paolella, Marc S., Multivariate Asset Return Prediction with Mixture Models (November 1, 2011). Swiss Finance Institute Research Paper No. 11-52. Available at SSRN: https://ssrn.com/abstract=1956462 or http://dx.doi.org/10.2139/ssrn.1956462

Marc Paolella (Contact Author)

University of Zurich - Department of Banking and Finance

Plattenstr. 14
Z├╝rich, 8032
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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