1

Estimating High Dimensional

Covariance Matrix and
Volatility Index by making
Use of Factor Models
Celine Sun
R/Finance 2013
2
Outline
Introduction
Proposed estimation of covariance matrix:
Estimator 1: Factor-Model Based
Estimator 2: SVD based
Empirical testing results
Proposed volatility estimation:
Cross-section volatility (CSV)
Empirical Results
Conclusion

3
Two new estimators are
proposed in this work:
We propose two new covariance matrix
estimators :
1. Allow non-parametrically time-varying:
Estimate the monthly realized covariance matrix using daily data
2. Allow full rank for N>T:
Using the factor model and SVD to estimate such that the
covariance estimator is full rank
The new estimators are different from the commonly used
estimators and approaches


E

4
Covariance matrix estimation
based on FM (factor models)
We propose an estimation of
covariance matrix, based on a statistical
factor model with k factors (k < N).



Here, { } are the loadings,
{ } are the regression errors.
Note: The estimator matrix is full rank.
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FM
RCOV
FM
RCOV
5
Covariance matrix estimation
based on SVD method
I propose the 2nd estimation of
covariance matrix, based on SVD:



Here, { } and { } are from the usual eigen
decomposition of the NxN realized variance matrix, and
having , with k < N.
{ } = the remaining terms from reconstructing
the return matrix by { } and { }
SVD
RCOV
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V
o
l
a
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i
l
i
t
y

Global minimum portfolio
Shrinkage
FM
SVD
Empirical testing:
1 Year Rolling Volatility for S&P 500
7
Empirical testing:
1 Year Rolling Volatility for S&P 500
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V
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Mean variance efficient portfolio with mean=8%
Shrinkage
FM
SVD
Volatility Index
A number of drawbacks of current volatility index
Not based on actual stock returns
The index only available to liquid options
Only available at broad market level
Advantage of CSV
Observable at any frequency
Model-free
Available for every region, sector, and style of the
equity markets
Don't need to resort option market

8
9
Cross-sectional volatility
Cross-sectional volatility (CSV) is defined
as the standard deviation of a set of asset
returns over a period.
The relationship between cross-sectional
volatility, time-series volatility and average
correlation is given by:

( ) o o ~ 1
x
10
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Monthly cross-sectional volatility vs.
average volatility & average correlation
cross-vol
vol*sqrt(1-corr)
Correlation: 0.85
Empirical testing:
1 Year Rolling Volatility for S&P 500
11
Decomposing Cross-Sectional
Volatility
Apply the factor model on return

The change of beta is more persistent
Cross-sectional volatility of the specific
return is a proxy for the future volatility
The correlation between VIX and CSV of
specific return is 0.62.




) ( ) ( ) (
i t i i
CSV f CSV R CSV c | + =
12
Conclusion
Constructed covariance matrix estimators
which are full rank
The portfolios constructed based on my
estimators have lower volatility
Applying factor model structure to CSV
gives us a good estimation of the volatility.
It could be used at any frequency and at
any set of stocks