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Covariance Averaging for Improved Estimation and Portfolio Allocation

Author

Listed:
  • Dimitrios D. Thomakos

    (Department of Economics, University of Peloponnese, Greece; Quantf Research, Greece; Rimini Centre for Economic Analysis, Italy)

  • Fotis Papailias

    (Queen's University Management School, Queen's University Belfast, UK; Quantf Research, Greece)

Abstract

We propose a new method for estimating the covariance matrix of a multivariate time series of financial returns. The method is based on estimating sample covariances from overlapping windows of observations which are then appropriately weighted to obtain the final covariance estimate. We extend the idea of (model) covariance averaging offered in the covariance shrinkage approach by means of greater ease of use, flexibility and robustness in averaging information over different data segments. The suggested approach does not suffer from the curse of dimensionality and can be used without problems of either approximation or any demand for numerical optimization.

Suggested Citation

  • Dimitrios D. Thomakos & Fotis Papailias, 2013. "Covariance Averaging for Improved Estimation and Portfolio Allocation," Working Paper series 66_13, Rimini Centre for Economic Analysis.
    • Handle: RePEc:rim:rimwps:66_13
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    References listed on IDEAS

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    24. Chan, Louis K C & Karceski, Jason & Lakonishok, Josef, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 937-974.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    averaging; covariance estimation; financial returns; multivariate time series; portfolio allocation; risk management; rolling window;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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