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
Date Written: October 25, 2015
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: Suggested Citation