Understanding the interplay between covariance forecasting factor models and risk-based portfolio allocations in currency carry trades

Matthew Ames, Guillaume Bagnarosa (), Gareth Peters and Pavel Shevchenko
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Matthew Ames: Institute of Statistical Mathematics - University of Graduate Studies
Guillaume Bagnarosa: ESC Rennes School of Business - ESC [Rennes] - ESC Rennes School of Business
Gareth Peters: Department of Actuarial Mathematics and Statistics [Edinburgh] - HWU - Heriot-Watt University [Edinburgh], Oxford-Man - Oxford-Man Institute of Quantitative Finance - University of Oxford, SRC - Systemic Risk Center, London School of Economics
Pavel Shevchenko: Macquarie University [Sydney]

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Abstract: With the exception of naive methods for portfolio selection, such as the equal weighted approaches, all other methods of portfolio allocation are more or less sensitive to the quality of the inputs considered in constructing the models and risk measures utilised in the allocation framework. The extensively used factor model proposed initially by Sharpe has provided a robust backdrop for development of relevant, micro, macro and context specific or asset specific explanatory variables to be incorporated in a statistical manner as inputs to forecasting models that can then be used to obtain risk measures upon which portfolio allocations are based. However, like all statistical models a set of statistical assumptions accompany this factor model regression framework, one of which has recently been highlighted as seemingly non-validated in financial data. This is of course the assumption such factor models make on homoskedasticity or weak sense covariance stationarity of the returns processes being modelled. Such factor models, therefore have typically failed to cope with an important and ubiquitous feature of financial assets data which often demonstrates heteroskedasticity of the returns variances and covariances.

Keywords: Covariance Forecasting; Currency Carry Trade; Covariance Regression; Generalised Multi-Factor Model; Portfolio Optimisation (search for similar items in EconPapers)
Date: 2018-12
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Citations: View citations in EconPapers (1)

Published in International Journal of Forecasting, 2018, 37 (8), pp.805-831. ⟨10.1002/for.2505⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-01953605

DOI: 10.1002/for.2505

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