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Directional Variance Adjustment: Bias Reduction in Covariance Matrices Based on Factor Analysis with an Application to Portfolio Optimization

Robust and reliable covariance estimates play a decisive role in financial and many other applications. An important class of estimators is based on factor models. Here, we show by extensive Monte Carlo simulations that covariance matrices derived from the statistical Factor Analysis model exhibit a...

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Detalles Bibliográficos
Autores principales: Bartz, Daniel, Hatrick, Kerr, Hesse, Christian W., Müller, Klaus-Robert, Lemm, Steven
Formato: Online Artículo Texto
Lenguaje:English
Publicado: Public Library of Science 2013
Materias:
Acceso en línea:https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3701014/
https://www.ncbi.nlm.nih.gov/pubmed/23844016
http://dx.doi.org/10.1371/journal.pone.0067503
Descripción
Sumario:Robust and reliable covariance estimates play a decisive role in financial and many other applications. An important class of estimators is based on factor models. Here, we show by extensive Monte Carlo simulations that covariance matrices derived from the statistical Factor Analysis model exhibit a systematic error, which is similar to the well-known systematic error of the spectrum of the sample covariance matrix. Moreover, we introduce the Directional Variance Adjustment (DVA) algorithm, which diminishes the systematic error. In a thorough empirical study for the US, European, and Hong Kong stock market we show that our proposed method leads to improved portfolio allocation.