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Improved Estimates of Correlation Coefficients and their Impact on Optimum Portfolios

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  • Edwin J. Elton
  • Martin J. Gruber
  • Jonathan Spitzer
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    Abstract

    "To implement mean variance analysis one needs a technique for forecasting correlation coefficients. In this article we investigate the ability of several techniques to forecast correlation coefficients between securities. We find that separately forecasting the average level of pair-wise correlations and individual pair-wise differences from the average improves forecasting accuracy. Furthermore, forming homogenous groups of firms on the basis of industry membership or firm attributes (e.g. size) improves forecast accuracy. Accuracy is evaluated in two ways: First, in terms of the error in estimating future correlation coefficients. Second, in the characteristics of portfolios formed on the basis of each forecasting technique. The ranking of forecasting techniques is robust across both methods of evaluation and the better techniques outperform prior suggestions in the literature of financial economics". Copyright Blackwell Publishers Ltd, 2006.

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    Bibliographic Info

    Article provided by European Financial Management Association in its journal European Financial Management.

    Volume (Year): 12 (2006)
    Issue (Month): 3 ()
    Pages: 303-318

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    Handle: RePEc:bla:eufman:v:12:y:2006:i:3:p:303-318

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    Cited by:
    1. Lan Liu & Hao Lin, 2010. "Covariance estimation: do new methods outperform old ones?," Journal of Economics and Finance, Springer, vol. 34(2), pages 187-195, April.
    2. Jing-zhi Huang & Zhaodong Zhong, 2013. "Time Variation in Diversification Benefits of Commodity, REITs, and TIPS," The Journal of Real Estate Finance and Economics, Springer, vol. 46(1), pages 152-192, January.
    3. Kempf, Alexander & Korn, Olaf & Sa├čning, Sven, 2014. "Portfolio optimization using forward-looking information," CFR Working Papers 11-10 [rev.], University of Cologne, Centre for Financial Research (CFR).
    4. Kwan, Clarence C.Y., 2008. "Estimation error in the average correlation of security returns and shrinkage estimation of covariance and correlation matrices," Finance Research Letters, Elsevier, vol. 5(4), pages 236-244, December.

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