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Rank reduction of correlation matrices by majorization

  • Pietersz, R.
  • Groenen, P.J.F.

In this paper a novel method is developed for the problem of finding a low-rank correlation matrix nearest to a given correlation matrix. The method is based on majorization and therefore it is globally convergent. The method is computationally efficient, is straightforward to implement, and can handle arbitrary weights on the entries of the correlation matrix. A simulation study suggests that majorization compares favourably with competing approaches in terms of the quality of the solution within a fixed computational time. The problem of rank reduction of correlation matrices occurs when pricing a derivative dependent on a large number of assets, where the asset prices are modelled as correlated log-normal processes.

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Paper provided by Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute in its series Econometric Institute Research Papers with number EI 2004-11.

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Date of creation: 01 Apr 2004
Date of revision:
Handle: RePEc:ems:eureir:1202
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  1. Frank de Jong & Joost Driessen & Antoon Pelsser, 2004. "On the Information in the Interest Rate Term Structure and Option Prices," Review of Derivatives Research, Springer, vol. 7(2), pages 99-127, 08.
  2. Henk Kiers & Patrick Groenen, 1996. "A monotonically convergent algorithm for orthogonal congruence rotation," Psychometrika, Springer, vol. 61(2), pages 375-389, June.
  3. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. " Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-30, March.
  4. Alan Brace & Dariusz G´┐Żatarek & Marek Musiela, 1997. "The Market Model of Interest Rate Dynamics," Mathematical Finance, Wiley Blackwell, vol. 7(2), pages 127-155.
  5. Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330.
  6. Igor Grubisic & Raoul Pietersz, 2005. "Efficient Rank Reduction of Correlation Matrices," Finance 0502007, EconWPA.
  7. Willard I. Zangwill, 1969. "Convergence Conditions for Nonlinear Programming Algorithms," Management Science, INFORMS, vol. 16(1), pages 1-13, September.
  8. Kiers, Henk A. L., 2002. "Setting up alternating least squares and iterative majorization algorithms for solving various matrix optimization problems," Computational Statistics & Data Analysis, Elsevier, vol. 41(1), pages 157-170, November.
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