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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

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.

Suggested Citation

  • Edwin J. Elton & Martin J. Gruber & Jonathan Spitzer, 2006. "Improved Estimates of Correlation Coefficients and their Impact on Optimum Portfolios," European Financial Management, European Financial Management Association, vol. 12(3), pages 303-318.
  • Handle: RePEc:bla:eufman:v:12:y:2006:i:3:p:303-318
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    Citations

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    Cited by:

    1. 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.
    2. Eom, Cheoljun, 2017. "Two-faced property of a market factor in asset pricing and diversification effect," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 471(C), pages 190-199.
    3. repec:spr:jglopt:v:68:y:2017:i:2:d:10.1007_s10898-016-0477-6 is not listed on IDEAS
    4. To, W.M., 2014. "Association between energy use and poor visibility in Hong Kong SAR, China," Energy, Elsevier, vol. 68(C), pages 12-20.
    5. 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).
    6. Lan Liu & Hao Lin, 2010. "Covariance estimation: do new methods outperform old ones?," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 34(2), pages 187-195, April.
    7. 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.

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