Modeling and Forecasting (Un)Reliable Realized Covariances for More Reliable Financial Decisions

38 Pages Posted: 6 Apr 2016

See all articles by Tim Bollerslev

Tim Bollerslev

Duke University - Finance; Duke University - Department of Economics; National Bureau of Economic Research (NBER)

Andrew J. Patton

Duke University - Department of Economics

Rogier Quaedvlieg

Erasmus University Rotterdam (EUR) - Department of Business Economics

Date Written: April 5, 2016

Abstract

We propose a new framework for modeling and forecasting common financial risks based on (un)reliable realized covariance measures constructed from high-frequency intraday data. Our new approach explicitly incorporates the effect of measurement errors and time-varying attenuation biases into the covariance forecasts, by allowing the ex-ante predictions to respond more (less) aggressively to changes in the ex-post realized covariance measures when they are more (less) reliable. Applying the new procedures in the construction of minimum variance and minimum tracking error portfolios results in reduced turnover and statistically superior positions compared to existing procedures. Translating these statistical improvements into economic gains, we find that under empirically realistic assumptions a risk-averse investor would be willing to pay up to 170 basis points per year to shift to using the new class of forecasting models.

Keywords: Common risks, realized covariances, forecasting, asset allocation, portfolio construction

JEL Classification: C32, C58, G11, G32

Suggested Citation

Bollerslev, Tim and Patton, Andrew J. and Quaedvlieg, Rogier, Modeling and Forecasting (Un)Reliable Realized Covariances for More Reliable Financial Decisions (April 5, 2016). Available at SSRN: https://ssrn.com/abstract=2759388 or http://dx.doi.org/10.2139/ssrn.2759388

Tim Bollerslev

Duke University - Finance ( email )

Durham, NC 27708-0120
United States
919-660-1846 (Phone)
919-684-8974 (Fax)

Duke University - Department of Economics

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Andrew J. Patton

Duke University - Department of Economics ( email )

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

HOME PAGE: http://econ.duke.edu/~ap172/

Rogier Quaedvlieg (Contact Author)

Erasmus University Rotterdam (EUR) - Department of Business Economics ( email )

Netherlands

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