Rank Reduction of Correlation Matrices by Majorization

29 Pages Posted: 25 Mar 2004

Date Written: September 18, 2004

Abstract

A novel algorithm is developed for the problem of finding a low-rank correlation matrix nearest to a given correlation matrix. The algorithm is based on majorization and, therefore, it is globally convergent. The algorithm is computationally efficient, is straightforward to implement, and can handle arbitrary weights on the entries of the correlation matrix. A simulation study suggests that majorization compares favourably with competing approaches in terms of the quality of the solution within a fixed computational time. The problem of rank reduction of correlation matrices occurs when pricing a derivative dependent on a large number of assets, where the asset prices are modelled as correlated log-normal processes. Mainly, such an application concerns interest rates.

Keywords: rank, correlation matrix, majorization, lognormal price processes, low-rank approximation

JEL Classification: G13

Suggested Citation

Pietersz, Raoul and Groenen, Patrick J. F., Rank Reduction of Correlation Matrices by Majorization (September 18, 2004). Available at SSRN: https://ssrn.com/abstract=519086 or http://dx.doi.org/10.2139/ssrn.519086

Patrick J. F. Groenen

Erasmus University Rotterdam (EUR) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

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