Dynamic Equicorrelation

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. KEY WORDS: Conditional covarianceDynamic conditional correlationEquicorrelationMultivariate GARCH ACKNOWLEDGMENT The authors thank two anonymous referees, the associate editor, and editors Arthur Lewbel and Jonathan Wright for helpful comments. Kelly’s research was supported in part by the Neubauer Family Foundation.