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Time-varying factor models for equity portfolio construction

Author

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  • Markus Ebner
  • Thorsten Neumann

Abstract

Most equity risk models applied in practice assume stable return correlations over time. However, there is considerable evidence suggesting that correlations among stock returns and hence, variance-covariance matrices (VCMs) become unstable over time. In this paper, we account for correlation instabilities in US stock returns and derive VCMs from time-varying factor model estimates. To do so, we use three different estimation approaches: (1) moving window least squares, (2) flexible least squares and (3) the random walk model. Our empirical results suggest that a time-varying estimation of return correlations fits the data considerably better than time-invariant estimation and thus, increases the efficiency of risk estimation and portfolio selection.

Suggested Citation

  • Markus Ebner & Thorsten Neumann, 2008. "Time-varying factor models for equity portfolio construction," The European Journal of Finance, Taylor & Francis Journals, vol. 14(5), pages 381-395.
    • Handle: RePEc:taf:eurjfi:v:14:y:2008:i:5:p:381-395
    DOI: 10.1080/13518470801892194
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