Forecasting a Large Dimensional Covariance Matrix of a Portfolio of Different Asset Classes

Lillie Lam, Laurence Fung and Ip-wing Yu
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Lillie Lam: Research Department, Hong Kong Monetary Authority
Laurence Fung: Research Department, Hong Kong Monetary Authority
Ip-wing Yu: Research Department, Hong Kong Monetary Authority

No 901, Working Papers from Hong Kong Monetary Authority

Abstract: In portfolio and risk management, estimating and forecasting the volatilities and correlations of asset returns plays an important role. Recently, interest in the estimation of the covariance matrix of large dimensional portfolios has increased. Using a portfolio of 63 assets covering stocks, bonds and currencies, this paper aims to examine and compare the predictive power of different popular methods adopted by i) market practitioners (such as the sample covariance, the 250-day moving average, and the exponentially weighted moving average); ii) some sophisticated estimators recently developed in the academic literature (such as the orthogonal GARCH model and the Dynamic Conditional Correlation model); and iii) their combinations. Based on five different criteria, we show that a combined forecast of the 250-day moving average, the exponentially weighted moving average and the orthogonal GARCH model consistently outperforms the other methods in predicting the covariance matrix for both one-quarter and one-year ahead horizons.

Keywords: Volatility forecasting; Risk management; Portfolio management; Model evaluation (search for similar items in EconPapers)
JEL-codes: C52 G17 G32 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2009-01
New Economics Papers: this item is included in nep-ecm, nep-for, nep-ore and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:hkg:wpaper:0901

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