Understanding the Interplay between Covariance Forecasting Factor Models and Risk Based Portfolio Allocations in Currency Carry Trades

25 Pages Posted: 5 Dec 2015

See all articles by Matthew Ames

Matthew Ames

The Institute of Statistical Mathematics

Guillaume Bagnarosa

ESC Rennes School of Business

Gareth Peters

Department of Actuarial Mathematics and Statistics, Heriot-Watt University; University College London - Department of Statistical Science; University of Oxford - Oxford-Man Institute of Quantitative Finance; London School of Economics & Political Science (LSE) - Systemic Risk Centre; University of New South Wales (UNSW) - Faculty of Science

Pavel V. Shevchenko

Macquarie University; Macquarie University, Macquarie Business School

Date Written: December 4, 2015

Abstract

With the exception of naive methods for portfolio selection, such as the equal weighted approaches, all other methods of portfolio allocation are more or less sensitive to the quality of the inputs considered in constructing the models and risk measures utilised in the allocation framework. The extensively used factor model proposed initially by Sharpe has provided a robust backdrop for development of relevant, micro, macro and context specific or asset specific explanatory variables to be incorporated in a statistical manner as inputs to forecasting models that can then be used to obtain risk measures upon which portfolio allocations are based. However, like all statistical models a set of statistical assumptions accompany this factor model regression framework, one of which has recently been highlighted as seemingly non-validated in financial data. This is of course the assumption such factor models make on homoskedasticity or weak sense covariance stationarity of the returns processes being modelled. Such factor models, therefore have typically failed to cope with an important and ubiquitous feature of financial assets data which often demonstrates heteroskedasticity of the returns variances and covariances.

We propose a novel generalised multi-factor forecasting structure utilizing a covariance regression model which allows us to incorporate the required heteroskedasticity effects whilst also admitting potential dependence in the idiosyncratic error terms. We argue that such a modelling approach allows for more explicit relationships to be interpreted between the driving factors and the conditional responses of the portfolio returns. We then compare the forecasting performances of our model with the multi-factor model and the time series DCC model through a currency portfolio application.

Keywords: Covariance Forecasting, Currency Carry Trade, Covariance Regression, Generalised Multi-Factor Model, Portfolio Optimisation

JEL Classification: C1, C5, F31, G11

Suggested Citation

Ames, Matthew and Bagnarosa, Guillaume and Peters, Gareth and Shevchenko, Pavel V., Understanding the Interplay between Covariance Forecasting Factor Models and Risk Based Portfolio Allocations in Currency Carry Trades (December 4, 2015). Available at SSRN: https://ssrn.com/abstract=2699020 or http://dx.doi.org/10.2139/ssrn.2699020

Matthew Ames (Contact Author)

The Institute of Statistical Mathematics ( email )

Tokyo
Japan

Guillaume Bagnarosa

ESC Rennes School of Business ( email )

2, RUE ROBERT D'ARBRISSEL
Rennes, 35065
France

Gareth Peters

Department of Actuarial Mathematics and Statistics, Heriot-Watt University ( email )

Edinburgh Campus
Edinburgh, EH14 4AS
United Kingdom

HOME PAGE: http://garethpeters78.wixsite.com/garethwpeters

University College London - Department of Statistical Science ( email )

1-19 Torrington Place
London, WC1 7HB
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

University of Oxford Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

London School of Economics & Political Science (LSE) - Systemic Risk Centre ( email )

Houghton St
London
United Kingdom

University of New South Wales (UNSW) - Faculty of Science ( email )

Australia

Pavel V. Shevchenko

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

HOME PAGE: http://www.businessandeconomics.mq.edu.au/contact_the_faculty/all_fbe_staff/pavel_shevchenko

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

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