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On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model

  • Louis K.C. Chan
  • Jason Karceski
  • Josef Lakonishok
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    We evaluate the performance of different models for the covariance structure of stock returns, focusing on their use for optimal portfolio selection. Comparisons are based on forecasts of future covariances as well as the out-of-sample volatility of optimized portfolios from each model. A few factors capture the general covariance structure but adding more factors does not improve forecast power. Portfolio optimization helps for risk control, but the different covariance models yield similar results. Using a tracking error volatility criterion, larger differences appear, with particularly favorable results for a heuristic approach based on matching the benchmark's attributes.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7039.

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    Date of creation: Mar 1999
    Date of revision:
    Publication status: published as The Review of Financial Studies (Winter 1999).
    Handle: RePEc:nbr:nberwo:7039
    Note: AP
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    12. Chan, Louis K. C. & Karceski, Jason & Lakonishok, Josef, 1998. "The Risk and Return from Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(02), pages 159-188, June.
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    16. Gregory Connor and Robert Korajczyk., 1987. "Risk and Return in an Equilibrium APT," Research Program in Finance Working Papers 174, University of California at Berkeley.
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