Faculty Advisor or Committee Member

Marcel Blais, Advisor

Faculty Advisor or Committee Member

Luca Capogna

Identifier

etd-050914-140237

Abstract

Estimation of the covariance matrix of asset returns is a key component of portfolio optimization. Inherent in any estimation technique is the capacity to inaccurately reflect current market conditions. Typical of Markowitz portfolio optimization theory, which we use as the basis for our analysis, is to assume that asset returns are stationary. This assumption inevitably causes an optimized portfolio to fail during a market crash since estimates of covariance matrices of asset returns no longer reflect current conditions. We use the market crash of 2008 to exemplify this fact. A current industry-standard benchmark for estimation is the Ledoit covariance matrix, which attempts to adjust a portfolio’s aggressiveness during varying market conditions. We test this technique against the CALM (Covariance Adjustment for Liability Management Method), which incorporates forward-looking signals for market volatility to reduce portfolio variance, and assess under certain criteria how well each model performs during recent market crash. We show that CALM should be preferred against the sample convariance matrix and Ledoit covariance matrix under some reasonable weight constraints.

Publisher

Worcester Polytechnic Institute

Degree Name

MS

Department

Mathematical Sciences

Project Type

Thesis

Date Accepted

2014-05-09

Accessibility

Unrestricted

Subjects

covariance matrix estimation, Ledoit's model, shrink-

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