Hierarchical PCA and Applications to Portfolio Management

29 Pages Posted: 21 Oct 2019

See all articles by Marco Avellaneda

Marco Avellaneda

New York University (NYU) - Courant Institute of Mathematical Sciences; Finance Concepts LLC

Date Written: October 10, 2019

Abstract

It is widely known that the common risk-factors derived from PCA beyond the first eigenportfolio are generally difficult to interpret and thus to use in practical portfolio management. We explore a alternative approach (HPCA) which makes strong use of the partition of the market into sectors. We show that this approach leads to no loss of information with respect to PCA in the case of equities (constituents of the S&P 500) and also that the associated common factors admit simple interpretations. The model can also be used in markets in which the sectors have asynchronous price information, such as single-name credit default swaps, generalizing the works of Cont and Kan (2011) and Ivanov (2016).

Keywords: PCA, Industry Sectors, Common Risk Factors, Hierarchical Models

JEL Classification: C1, C57, G11

Suggested Citation

Avellaneda, Marco, Hierarchical PCA and Applications to Portfolio Management (October 10, 2019). Available at SSRN: https://ssrn.com/abstract=3467712 or http://dx.doi.org/10.2139/ssrn.3467712

Marco Avellaneda (Contact Author)

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

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Finance Concepts LLC ( email )

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