Projected dynamic conditional correlations

Llorens-Terrazas, Jordi; Brownlees, Christian, 1979-

doi:http://dx.doi.org/10.1016/j.ijforecast.2022.06.003

Projected dynamic conditional correlations

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Llorens-Terrazas J, Brownlees C. Projected dynamic conditional correlations. Int J Forecast. 2023;39:1761-76. DOI: 10.1016/j.ijforecast.2022.06.003

Abstract

We propose a novel specification of the Dynamic Conditional Correlation (DCC) model based on an alternative normalization of the pseudo-correlation matrix called Projected DCC (Pro-DCC). Our modification consists in projecting, rather than rescaling, the pseudo-correlation matrix onto the set of correlation matrices in order to obtain a well defined conditional correlation matrix. A simulation study shows that projecting performs better than rescaling when the dimensionality of the correlation matrix is large. An empirical application to the constituents of the S&P 100 shows that the proposed methodology performs favorably to the standard DCC in an out-of-sample asset allocation exercise.