Improved estimation of the covariance matrix of stock returns with an application to portofolio selection
AbstractThis paper proposes to estimate the covariance matrix of stock returns by an optimally weighted average of two existing estimators: the sample covariance matrix and single-index covariance matrix. This method is generally known as shrinkage, and it is standard in decision theory and in empirical Bayesian statistics. Our shrinkage estimator can be seen as a way to account for extra-market covariance without having to specify an arbitrary multi-factor structure. For NYSE and AMEX stock returns from 1972 to 1995, it can be used to select portfolios with significantly lower out-of-sample variance than a set of existing estimators, including multi-factor models.
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Bibliographic InfoPaper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 586.
Date of creation: Nov 2001
Date of revision:
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Web page: http://www.econ.upf.edu/
Covariance matrix estimation; factor models; portofolio selection; shrinkage;
Other versions of this item:
- Ledoit, Olivier & Wolf, Michael, 2003. "Improved estimation of the covariance matrix of stock returns with an application to portfolio selection," Journal of Empirical Finance, Elsevier, vol. 10(5), pages 603-621, December.
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ECM-2001-12-19 (Econometrics)
- NEP-ETS-2001-12-19 (Econometric Time Series)
- NEP-FMK-2001-12-19 (Financial Markets)
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