Shrinkage = Factor Model
Portfolio Management
2016-08-02 v2 Risk Management
Abstract
Shrunk sample covariance matrix is a factor model of a special form combining some (typically, style) risk factor(s) and principal components with a (block-)diagonal factor covariance matrix. As such, shrinkage, which essentially inherits out-of-sample instabilities of the sample covariance matrix, is not an alternative to multifactor risk models but one out of myriad possible regularization schemes. We give an example of a scheme designed to be less prone to said instabilities. We contextualize this within multifactor models.
Cite
@article{arxiv.1511.04764,
title = {Shrinkage = Factor Model},
author = {Zura Kakushadze},
journal= {arXiv preprint arXiv:1511.04764},
year = {2016}
}
Comments
5 pages; a trivial typo corrected; to appear as an Invited Editorial in Journal of Asset Management