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Dynamic Equicorrelation

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  • Robert Engle
  • Bryan Kelly

Abstract

A new covariance matrix estimator is proposed under the assumption that at every time period all pairwise correlations are equal. This assumption, which is pragmatically applied in various areas of finance, makes it possible to estimate arbitrarily large covariance matrices with ease. The model, called DECO, involves first adjusting for individual volatilities and then estimating correlations. A quasi-maximum likelihood result shows that DECO provides consistent parameter estimates even when the equicorrelation assumption is violated. We demonstrate how to generalize DECO to block equicorrelation structures. DECO estimates for U.S. stock return data show that (block) equicorrelated models can provide a better fit of the data than DCC. Using out-of-sample forecasts, DECO and Block DECO are shown to improve portfolio selection compared to an unrestricted dynamic correlation structure.

Suggested Citation

  • Robert Engle & Bryan Kelly, 2011. "Dynamic Equicorrelation," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 30(2), pages 212-228, July.
    • Handle: RePEc:taf:jnlbes:v:30:y:2011:i:2:p:212-228
    DOI: 10.1080/07350015.2011.652048
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    References listed on IDEAS

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    1. White,Halbert, 1996. "Estimation, Inference and Specification Analysis," Cambridge Books, Cambridge University Press, number 9780521574464, November.
    2. Cavit Pakel & Neil Shephard & Kevin Sheppard & Robert F. Engle, 2021. "Fitting Vast Dimensional Time-Varying Covariance Models," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 39(3), pages 652-668, July.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Multivariate volatility forecasting (2)
      by Eran Raviv in Eran Raviv on 2015-08-29 01:29:22

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