A Non-Elliptical Orthogonal GARCH Model for Portfolio Selection under Transaction Costs

Marc S. Paolella, Pawel Polak and Patrick S. Walker
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Marc S. Paolella: University of Zurich - Department of Banking and Finance; Swiss Finance Institute
Pawel Polak: Stevens Institute of Technology, Department of Mathematical Sciences
Patrick S. Walker: University of Zurich, Department of Banking and Finance

No 19-51, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Covariance matrix forecasts for portfolio optimization have to balance sensitivity to new data points with stability in order to avoid excessive rebalancing. To achieve this, a new robust orthogonal GARCH model for a multivariate set of non-Gaussian asset returns is proposed. The conditional return distribution is multivariate generalized hyperbolic and the dispersion matrix dynamics are driven by the leading factors in a principle component decomposition. Each of these leading factors is endowed with a univariate GARCH structure, while the remaining eigenvalues are kept constant over time. Joint maximum likelihood estimation of all model parameters is performed via an expectation maximization algorithm, and is applicable in high dimensions. The new model generates realistic correlation forecasts even for large asset universes and captures rising pairwise correlations in periods of market distress better than numerous competing models. Moreover, it leads to improved forecasts of an eigenvalue-based financial systemic risk indicator. Crucially, it generates portfolios with much lower turnover and superior risk-adjusted returns net of transaction costs, outperforming the equally weighted strategy even under high transaction fees.

Keywords: Dynamic Conditional Correlations; Multivariate GARCH; Multivariate Generalized Hyperbolic Distribution; Principle Component Analysis; Financial Systemic Risk (search for similar items in EconPapers)
JEL-codes: C32 C53 G11 G17 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2019-09
New Economics Papers: this item is included in nep-ecm and nep-ets
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