Shrinkage = Factor Model

Journal of Asset Management 17(2) (2016) 69-72, Invited Editorial

5 Pages Posted: 4 Nov 2015 Last revised: 14 Feb 2016

See all articles by Zura Kakushadze

Zura Kakushadze

Quantigic Solutions LLC; Free University of Tbilisi

Date Written: October 25, 2015

Abstract

Shrunk sample covariance matrix is a factor model of a special form combining some (typically, style) risk factor(s) and principal components with a (block-)diagonal factor covariance matrix. As such, shrinkage, which essentially inherits out-of-sample instabilities of the sample covariance matrix, is not an alternative to multifactor risk models but one out of myriad possible regularization schemes. We give an example of a scheme designed to be less prone to said instabilities. We contextualize this within multifactor models.

Keywords: Shrinkage, factor models, principal components, sample covariance matrix, regularization scheme, style risk factors, industry risk factors, specific risk, factor risk, factor covariance matrix, out-of-sample stability

JEL Classification: G00

Suggested Citation

Kakushadze, Zura, Shrinkage = Factor Model (October 25, 2015). Journal of Asset Management 17(2) (2016) 69-72, Invited Editorial. Available at SSRN: https://ssrn.com/abstract=2685720

Zura Kakushadze (Contact Author)

Quantigic Solutions LLC ( email )

1127 High Ridge Road #135
Stamford, CT 06905
United States
6462210440 (Phone)
6467923264 (Fax)

HOME PAGE: http://www.linkedin.com/in/zurakakushadze

Free University of Tbilisi ( email )

Business School and School of Physics
240, David Agmashenebeli Alley
Tbilisi, 0159
Georgia

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