Evaluating Covariance Matrix Forecasts in a Value-at-Risk Framework

FRB of San Francisco Working Paper No. 2000-21

52 Pages Posted: 28 Mar 2002

See all articles by Jose A. Lopez

Jose A. Lopez

Federal Reserve Bank of San Francisco

Christian A. Walter

affiliation not provided to SSRN

Date Written: April 17, 2000

Abstract

Covariance matrix forecasts of financial asset returns are an important component of current practice in financial risk management. A wide variety of models, ranging from matrices of simple summary measures to covariance matrices implied from option prices, are available for generating such forecasts. In this paper, we evaluate the relative accuracy of different covariance matrix forecasts using standard statistical loss functions and a value-at-risk (VaR) framework. This framework consists of hypothesis tests examining various properties of VaR models based on these forecasts as well as an evaluation using a regulatory loss function.

Using a foreign exchange portfolio, we find that implied covariance matrix forecasts appear to perform best under standard statistical loss functions. However, within the economic context of a VaR framework, the performance of VaR models depends more on their distributional assumptions than on their covariance matrix specification. Of the forecasts examined, simple specifications, such as exponentially-weighted moving averages of past observations, perform best with regard to the magnitude of VaR exceptions and regulatory capital requirements. These results provide empirical support for the commonly-used VaR models based on simple covariance matrix forecasts and distributional assumptions.

Keywords: covariance matrix, volatility forecasting, value-at-risk

Suggested Citation

Lopez, Jose Antonio and Walter, Christian A., Evaluating Covariance Matrix Forecasts in a Value-at-Risk Framework (April 17, 2000). FRB of San Francisco Working Paper No. 2000-21. Available at SSRN: https://ssrn.com/abstract=305279 or http://dx.doi.org/10.2139/ssrn.305279

Jose Antonio Lopez

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States
415-977-3894 (Phone)
415-974-2168 (Fax)

Christian A. Walter (Contact Author)

affiliation not provided to SSRN

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