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How much structure is best? A comparison of market model, factor model and unstructured equity covariance matrices

Briner, Beat G. and Connor, Gregory (2008) How much structure is best? A comparison of market model, factor model and unstructured equity covariance matrices. Journal of Risk, 10 (4). pp. 3-30. ISSN 1465-1211

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Abstract

This paper compares three approaches to estimating equity covariance matrices: a factor model, a market model and an unstructured asset-by-asset model. These approaches make different trade-offs between estimation variance and model specification error. We explore this trade-off with a simulation experiment and with an empirical analysis of UK equity portfolios. The factor model is found to perform best for large investment universes and typical sample lengths. The market model underperforms due to excessive specification error while an asset-by-asset model with a short half-life of 22 days underperforms due to high estimation variance. The importance of properly accounting for serial correlation is highlighted.

Item Type: Article
Additional Information: Postprint version of original published article. The definitive version is available at http://www.thejournalofrisk.com/
Keywords: structure; comparison; market model; factor model; unstructured equity; covariance matrices; estimation; variance; asset-by-asset;
Subjects: Social Sciences > Economics, Finance & Accounting
Item ID: 3521
Depositing User: Gregory Connor
Date Deposited: 06 Mar 2012 16:33
Journal or Publication Title: Journal of Risk
Publisher: Risk Journals
Refereed: Yes
URI:

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