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Shrinkage = Factor Model

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  • Zura Kakushadze

Abstract

Shrunk sample covariance matrix is a factor model of a special form combining some (typically, style) risk factor(s) and principal components with a (block-)diagonal factor covariance matrix. As such, shrinkage, which essentially inherits out-of-sample instabilities of the sample covariance matrix, is not an alternative to multifactor risk models but one out of myriad possible regularization schemes. We give an example of a scheme designed to be less prone to said instabilities. We contextualize this within multifactor models.

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  • Zura Kakushadze, 2015. "Shrinkage = Factor Model," Papers 1511.04764, arXiv.org, revised Dec 2015.
    • Handle: RePEc:arx:papers:1511.04764
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    1. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    2. Zura Kakushadze, 2014. "Russian-Doll Risk Models," Papers 1412.4342, arXiv.org, revised Nov 2017.
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    Cited by:

    1. Zura Kakushadze & Willie Yu, 2022. "ETF Risk Models," Bulletin of Applied Economics, Risk Market Journals, vol. 9(1), pages 1-17.
    2. Zura Kakushadze & Willie Yu, 2016. "Statistical Risk Models," Papers 1602.08070, arXiv.org, revised Jan 2017.

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