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Building portfolios of stocks in the S\~ao Paulo Stock Exchange using Random Matrix Theory

Leonidas Sandoval Junior, Adriana Bruscato and Maria Kelly Venezuela

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Abstract: By using Random Matrix Theory, we build covariance matrices between stocks of the BM&F-Bovespa (Bolsa de Valores, Mercadorias e Futuros de S\~ao Paulo) which are cleaned of some of the noise due to the complex interactions between the many stocks and the finiteness of available data. We also use a regression model in order to remove the market effect due to the common movement of all stocks. These two procedures are then used to build stock portfolios based on Markowitz's theory, trying to obtain better predictions of future risk based on past data. This is done for years of both low and high volatility of the Brazilian stock market, from 2004 to 2010. The results show that the use of regression to subtract the market effect on returns greatly increases the accuracy of the prediction of risk, and that, although the cleaning of the correlation matrix often leads to portfolios that better predict risks, in periods of high volatility of the market this procedure may fail to do so.

Date: 2012-01, Revised 2013-03
New Economics Papers: this item is included in nep-fmk
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Published in Physica A 410 (2013) 94-109

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