PFM in Crisis

DYNAMIC CORRELATIONS, ESTIMATION RISK, AND
PORTFOLIO MANAGEMENT DURING

THE FINANCIAL CRISIS

Luis Garca-lvarez and Richard Luger

CEMFI Working Paper No. 1103

April 2011

CEMFI
Casado del Alisal 5; 28014 Madrid
Tel. (34) 914 290 551 Fax (34) 914 291 056
Internet: www.cemfi.es

CEMFI Working Paper 1103
April 2011

DYNAMIC CORRELATIONS, ESTIMATION RISK, AND
PORFOLIO MANAGEMENT DURING
THE FINANCIAL CRISIS

Abstract

We evaluate alternative multivariate models of dynamic correlations in terms of realized
out-of-sample Sharpe ratios for an active portfolio manager who rebalances a portfolio
of international equities on a daily basis. The evaluation period covers the recent
financial crisis which was marked by increased volatility and correlations across
international stock markets. Our results show that international correlations fluctuate
considerably from day to day, but we find no evidence of decoupling between emerging
and developed stock markets. We also find that the recursively updated dynamic
correlation models display remarkably stable parameter estimates over time, but that
none yields statistically better portfolio performances than the naive diversification
benchmark strategy. The results clearly show the erosive effects of model estimation
risk and transactions costs, the benefits of limiting short sales, and the far greater
importance of including a risk-free security in the asset mix whether or not market
turbulence is high.
.

Keywords: Portfolio selection, DC model, international diversification, decoupling
hypothesis, estimation risk short-sale constraints.

JEL Codes: C53, C58,G11, G15.

Luis Garca-lvarez
CEMFI
l.garcia@cemfi.edu.es
Richard Luger
J. Mack Robinson College of Business
rluger@gsu.edu

1 Introduction
The classical theory of portfolio selection pioneered by Markowitz (1952) remains to this
day an immensely prominent approach to asset allocation and active portfolio manage-
ment. The key inputs to this approach are the expected returns and the covariance
matrix of the assets under consideration in the portfolio selection problem. According
to the classical theory, optimal portfolio weights can be found by minimizing the vari-
ance of the portfolios returns subject to the constraint that the expected portfolio return
achieves a specied target value. In practical applications of mean-variance portfolio the-
ory, the expected returns and the covariance matrix of asset returns obviously need to be
estimated from the historical data. As with any model with unknown parameters, this
immediately gives rise to the well-known problem of estimation risk; i.e., the estimated
optimal portfolio rule is subject to parameter uncertainty and can thus be substantially
dierent from the true optimal rule.
The implementation of mean-variance portfolios with inputs estimated via their sample
analogues is notorious for producing extreme portfolio weights that uctuate substantially
over time and perform poorly out of sample; see Hodges and Brealey (1972), Michaud
(1989), Best and Grauer (1991), and Litterman (2003). A recent study by DeMiguel, Gar-
lappi, and Uppal (2009) casts further doubt on the usefulness of estimated mean-variance
portfolio rules when compared to a naive diversication rule. The naive strategy, or 1/N
rule, simply invests equally across the N assets under consideration, relying neither on
any model nor on any data. Those authors consider various static asset-allocation models
at the monthly frequency and nd that the asset misallocation errors of the suboptimal
(from the mean-variance perspective) 1/N rule are smaller than those of the optimizing
models in the presence of estimation risk. See also Jobson and Korkie (1980), Michaud
and Michaud (2008), and Duchin and Levy (2009) for more on the issue of estimation
errors in the implementation of Markowitz portfolios.
Kirby and Ostdiek (2011) show that the research design in DeMiguel, Garlappi, and
Uppal (2009) places the mean-variance model at an inherent disadvantage relative to naive
diversication because it focuses on the tangency portfolio which targets a conditional
expected return that greatly exceeds the conditional expected return of the 1/N strategy.
The result is that estimation risk is magnied which in turn leads to excessive portfolio
1
turnover and hence poor out-of-sample performance. Kirby and Ostdiek (2011) argue that
if the mean-variance model is implemented by targeting the conditional expected return
of the 1/N portfolio, then the resulting static mean-variance ecient strategies can out-
perform naive diversication for most of the monthly data sets considered by DeMiguel,
Garlappi, and Uppal(2009). Kirby and Ostdiek (2011) note, however, that this nding is
not robust to the presence of transactions costs.
The correlation structure across assets is a key feature of the portfolio allocation
problem since it determines the riskiness of the investment position. It is well known
that these correlations vary over time and the econometrics literature has proposed many
specications to model the dynamic movements and co-movements among nancial asset
returns, which are quite pronounced at the daily frequency. The importance of dynamic
correlation modeling is obvious for risk management because the risk of a portfolio depends
not on what the correlations were in the past, but on what they will be in the future.
Engle and Colacito (2006) take the asset allocation perspective to measure the value
of modeling dynamic correlation structures. Just like DeMiguel, Garlappi, and Uppal
(2009) and Kirby and Ostdiek (2011) (and others), they too study the classical asset
allocation problem, but with forward-looking correlation forecasts obtained from dynamic
correlation models. They consider the realized volatility of optimized portfolios and nd
that it is smallest when the dynamic correlation model is correctly specied. Their focus,
however, is primarily on a setting with only two assetsa stock and a bondand hence
with relatively little estimation risk since few parameters need to be estimated.
In this paper, we further contribute to the literature on portfolio management in the
presence of estimation risk by considering an active portfolio manager who uses forecasts
from dynamic correlation models to rebalance an international equity portfolio on a daily
basis. The asset mix consists of dollar-denominated Morgan Stanley Capital International
(MSCI) stock market indices for ve geographical areas: North America, Europe, Pacic,
Latin America, and Asia. The rst three of those are developed market indices, whereas
the last two represent emerging market indices. The MSCI indices represent a broad
aggregation of national equity markets and are the leading benchmarks for international
portfolio managers. This choice of indices allows us to examine whether there is any evi-
dence supporting the decoupling hypothesis in international nance, namely that recently
2
the evolution of emerging stock markets has decoupled itself from the evolution of more
developed stock markets.
In addition to the usual plug-in method which simply replaces the covariance matrix
by its sample counterpart, we also consider four popular models to forecast the inputs to
the portfolio selection problem. These include the constant conditional correlation (CCC)
model of Bollerslev (1990), the dynamic conditional correlation (DCC) model of Engle
(2002), the time-varying correlation (TVC) model of Tse and Tsui (2002), and the recent
dynamic equi-correlation (DECO) model of Engle and Kelly (2009). Each of these models
builds on a decomposition of the conditional covariance matrix into a product involving the
conditional correlation matrix and a diagonal matrix of conditional standard deviations.
The conditional variances (standard deviations) are specied according to standard gen-
eralized autoregressive conditional heteroskedasticity (GARCH) models (Bollerslev 1986)
and the return innovations are modeled according to a generalized version of the standard
multivariate Student-t distribution proposed by Bauwens and Laurent (2005) that allows
for asymmetries in each of the marginal distributions.
As its name implies, the CCC model restricts the conditional correlations between
each pair of assets to be time invariant. Of all the considered models, the CCC model is
the most tractable one. The DCC model follows the same structure as the CCC model but
allows the correlations to vary over time. The new information in each period about the
volatility-adjusted returns is used to update the correlation estimates in a GARCH-like
recursion. An important alternative to the DCC specication is the TVC model, which
updates the estimates using a rolling-window correlation estimator of the standardized
returns. The DECO model is a middle ground between the CCC model on one hand and
the DCC and TVC models on the other in that all pairwise correlations are restricted to
be equal. Engle and Kelly (2009) propose the DECO model recognizing the need to reduce
the number of parameters and hence estimation risk in dynamic correlation models. The
most sophisticated correlation models we consider have a total of 18 parameters that need
to be estimated, even though we follow Engle and Colacito (2006) and make use of the
correlation targeting method of Engle and Mezrich (1996) to reduce the dimensionality
problem; see Engle (2009) for a discussion of variance and correlation targeting.
Following DeMiguel, Garlappi, and Uppal (2009) and Kirby and Ostdiek (2011), the
3
1/N rule serves as our benchmark strategy for comparison purposes and, as in Kirby
and Ostdiek, we level the playing eld by using the conditional expected return of the
1/N rule as the target expected portfolio return. We hasten to emphasize that our goal
is not to advocate the use of the 1/N rule as an asset allocation strategy, but merely
to use it as a benchmark to assess the performance of the more sophisticated data- and
model-dependent strategies. The evaluation period covers the recent nancial crisis which
was marked by increased volatility and correlations across international stock markets.
We consider portfolios that comprise risky assets only and we also examine the eects of
introducing a risk-free security in the asset mix. As in Frost and Savarino (1988), Chopra
(1993), and Jagannathan and Ma (2003), we examine whether the imposition of short-sale
constraints leads to improved portfolio performance.
We focus on the realized out-of-sample Sharpe ratio as the measure of portfolio per-
formance, which is dened as the ratio of the realized excess return of an investment
to its standard deviation. This choice is motivated by the fact that the Sharpe ratio is
the most ubiquitous risk-adjusted measure used by nancial market practitioners to rank
fund managers and to evaluate the attractiveness of investment strategies in general. For
example, Chicago-based Morningstar calculates the Sharpe ratio for mutual funds in its
Principia investment research and planning software. In order to gauge the statistical
signicance of the dierences between Sharpe ratios we use the block bootstrap inference
methodology proposed by Ledoit and Wolf (2008), which is designed specically for that
purpose.
At the same time, though, the Sharpe ratio is not without its limitations when it comes
to performance evaluation. Fundamentally, the Sharpe ratio is a measure that attempts
to calculate the amount of reward (excess return) per unit of risk (standard deviation)
of an investment. When excess returns are positive, a higher Sharpe ratio indicates a
better performance because it means a higher excess return or a smaller standard devia-
tion, or both. When excess returns are negative, however, the Sharpe ratio can yield an
unreasonable performance ranking. For example, consider two managed portfolios that
achieve the same negative excess return, but with dierent standard deviations. In that
case, the usual Sharpe ratio would indicate that the portfolio with the highest standard
deviation is the better one, even though it achieved the same negative expected return
4
by taking riskier positions. Israelsen (2003, 2005) proposes a simple modication to the
Sharpe ratio that overcomes this shortcoming and yields a correct perfomance ranking
during periods of negative excess returns. We compute the values of this modied Sharpe
ratio and again test for statistical dierences vis-à-vis the 1/N strategy using the Ledoit
and Wolf (2008) bootstrap methodology.
The remainder of the paper is organized as follows. Section 2 presents the modeling
framework. It begins with a description of the multivariate distribution of returns, and
then moves on to present the volatility specication and the various correlation specica-
tions that we consider. Details about how the model parameters are estimated are also
given in that section. Section 3 presents the in-sample estimation results for each model
specication. Section 4 considers the portfolio management problem and presents the
out-of-sample portfolio performance results. Section 5 concludes.
2 Modeling framework
2.1 Multivariate distribution
Consider a collection of N assets whose day-t returns are stacked in the N 1 vector y
t
.
We assume that the daily returns can be represented as
y
t
= +
t
, (1)
t
= H
1/2
t
z
t
, (2)
where is the vector of expected returns,
t
is the vector of unexpected returns, and
z
t
is the vector of innovation terms with conditional moments E(z
t
|I
t1
) = 0 and
V ar(z
t
|I
t1
) = I
N
, the identity matrix. Here I
t
represents the information set avail-
able up to time t. The conditional covariance matrix of y
t
given I
t1
is H
t
and the
matrix H
1/2
t
is its Cholesky factorization. In our empirical application we have N = 5
risky assets and, as will become clear, the number of parameters to be estimated in each
of our model specications is fairly large. So to make the estimation simpler, we follow
the common practice and use auxiliary estimators for unconditional moments. The rst
instance of this is that we replace in (1) by the vector of sample means, y.
5
It is well known that nancial asset returns exhibit excess kurtosis which is at odds
with models that assume a multivariate normal distribution of returns. While the com-
monly used multivariate Student-t distribution can capture heavy tails, it still restricts
returns to be symmetrically distributed around their means. In order to allow for pos-
sible return asymmetries, the z
t
innovation terms in (2) are assumed to be independent
and identically distributed random vectors following the multivariate skewed Student-t
distribution of Bauwens and Laurent (2005), which generalizes the standard multivariate
Student-t distribution by allowing each marginal distribution to have its own asymmetry
parameter. Specically, the density of z
t
, given the shape parameters = (
1
, ...,
N
),
i
> 0, and the degrees-of-freedom parameter v > 2, is given by
f(z
t
; , v) =
_
2
_
N
_
N
i=1
i
s
i
1 +
2
i
_
(
v+N
2
)
(
v
2
)(v 2)
N
2
_
1 +
z
t
z
t
v 2
_
v+N
2
, (3)
where
z
t
= (z
1,t
, ..., z
N,t
)
,
z
i,t
= (s
i
z
i,t
+ m
i
)
I
i
i
,
m
i
=
(
v1
2
)
v 2
(
v
2
)
_
i
_
,
s
2
i
=
_
2
i
+
1
2
i
1
_
m
2
i
,
I
i
=
_
1 if z
i

m
i
s
i
,
1 if z
i
<
m
i
s
i
.
Note that m
i
and s
2
i
are functions of
i
, so they do not represent additional parameters.
Here
2
i
determines the skewness in the marginal distribution of z
i,t
. With this speci-
cation, the marginal distribution of z
i,t
is symmetric when log
i
= 0 and it is skewed to
the right (left) when log
i
> 0 (< 0). See Bauwens and Laurent (2005) for the derivation
and further discussion of this distribution. It should be clear that this specication also
implies the same degree of tail heaviness across marginals, controlled by the parameter
v. In a Bayesian setting, Jondeau and Rockinger (2008) consider a more general alterna-
tive where each marginal distribution has its own kurtosis parameter. Further discussion
6
of these generalized multivariate Student-t distributions is found in Jondeau, Poon, and
Rockinger (2007).
2.2 Volatility specication
The conditional covariance matrix of y
t
is written in the familiar form
H
t
= D
t
C
t
D
t
, (4)
where D
t
= diag(h
1/2
11,t
, ..., h
1/2
NN,t
) is a diagonal matrix of conditional standard deviations
and C
t
is the conditional correlation matrix. The elements of D
t
are the square roots
of the expected return variances based on the past information set, specied here as
GARCH(1,1) models of the form
h
ii,t
=
i
+
i
2
i,t1
+
i
h
ii,t1
, (5)
where the restrictions
i
> 0,
i
,
i
0, and
i
+
i
< 1 ensure that the conditional
variance processes are stationary with unconditional (long-run) variances given by
2
i
=
i
/
i
, where
i
= 1
i

i
(Bollerslev 1986). In order to reduce the dimension of the
parameter space and the computational complexity of the estimation problem, we use the
variance targeting method proposed by Engle and Mezrich (1996). The method takes the
models in (5) and rewrittes them as
h
ii,t
=
i
2
i
+
i
2
i,t1
+
i
h
ii,t1
, (6)
with
i
+
i
+
i
= 1, and where the positivity and stationarity constraints become
i
,
2
i
> 0,
i
0, and
i
+
i
1. From (6) we see that todays volatility, h
ii,t
, is
a weighted average of the long-run variance,
2
i
, the square of the lagged unexpected
return,
2
i,t1
, and the lagged volatility, h
ii,t1
. The parameter
i
is the weight on the
long-run variance in that average. Variance targeting here consists of replacing
2
i
in (6)
by the sample variance
2
i
= T
1
T
t=1
(y
i,t
y
i
)
2
and then estimating the
i
s and
i
s
by maximum likelihood. We also follow the common practice and set the initial value
as h
ii,1
=
2
i
. See Francq, Horvath, and Zakoian (2009) for further discussion about the
method of variance targeting. With the volatilities in hand we can then dene the vector
of standardized (or de-GARCHed) returns u
t
= (u
1,t
, ..., u
N,t
)
whose typical element

7
is u
i,t
=
i,t
/
_
h
ii,t
. If a portfolio of the assets comprising y
t
is formed with weights ,
then its conditional return variance is V ar(
y
t
|I
t1
) =
H
t
. In light of (4), this
expression makes clear that the correlation matrix C
t
is a key feature of the portfolio
management problem. We turn next to a description of the various correlation structures
that we consider in our empirical analysis.
2.3 CCC specication
Our starting point is the constant conditional correlation (CCC) model proposed by
Bollerslev (1990) in which the conditional correlations between each pair of asset returns
are restricted to be constant over time. So in the CCC model, the conditional covariance
matrix is dened as
H
t
= D
t
CD
t
, (7)
where C = [
ij
] is a well-dened correlation matrix; i.e., symmetric, positive denite,
and with
ii
= 1 for all i. As Engle (2009) discusses, it is particularly simple to obtain a
well-dened CCC matrix estimate if we use correlation targetinga direct analogue of the
variance targeting methodwhich consists of replacing C by its empirical counterpart:
C = diag
_
1
T
T
t=1
u
1
2
_
1
T
T
t=t
u
_
diag
_
1
T
T
t=1
u
1
2
, (8)
the sample correlation matrix of standardized returns.
2.4 DCC specication
The CCC model has a clear advantage of computational simplicity, but the assumption
of constant conditional correlations in (7) may be too restrictive for practical portfolio
management. The dynamic conditional correlation (DCC) model of Engle (2002) gener-
alizes the CCC model by allowing the correlations to vary over time. It is dened as in
(4) with the following correlation matrix:
C
DCC
t
= diag [Q
t
]
1
2
Q
t
diag [Q
t
]
1
2
, (9)
8
where diag[Q
t
] is a matrix with the same diagonal as Q
t
and zero o-diagonal entries.
The matrix of quasi-correlations Q
t
evolves according to the GARCH-like recursion
Q
t
= (1 a b)
Q+ a(u
t1
u
t1
) + bQ
t1
, (10)
where the persistence parameters a and b are non-negative scalars satisfying a + b <
1 to ensure stationarity of the process. Here we use correlation targeting in (10), as
done in Engle (2002); i.e., we set

Q = T
1
T
t=t
u
. So provided that Q
1
is positive
denite, each subsequent Q
t
will also be positive denite (and hence invertible) since
it is a weighted average of positive denite matrices. Note that the Q
t
s need not be
correlation matrices with unit diagonals. It is the rescaling in (9) that converts Q
t
into
C
DCC
t
, a well-dened correlation matrix for every t.
2.5 TVC specication
An important alternative specication to (9) is the time-varying correlation (TVC) model
of Tse and Tsui (2002). There the correlation dynamics are specied as an ARMA process
of the form
C
TV C
t
= (1 a b)

C + a
t1
+ bC
TV C
t1
, (11)
where the N N matrix
t1
is given by
t1
= diag
_
1
m
t1
=tm
u
1
2
_
1
m
t1
=tm
u
_
diag
_
1
m
t1
=tm
u
1
2
, (12)
a rolling sample estimate of the correlation matrix based on standardized returns between
times tm and t1. A necessary condition for
t1
to be positive denite is that m N.
Here we follow Tse and Tsui (2002) and set m = N. The stationarity of C
TV C
t
is imposed
through the constraints 0 a, b 1 and a + b < 1. These restrictions also imply that
C
TV C
t
is a convex combination of

C in (8),
t1
, and C
TV C
t1
. So if C
TV C
1
is positive
denite with unit diagonal elements, then, by recursion, all the successive C
TV C
t
s will
also be well-dened correlation matrices. An apparent dierence between the DCC and
TVC models is that the DCC dynamics of Q
t
in (10) are based on the single lagged term
u
t1
u
t1
(as in a standard GARCH(1,1) model), whereas the complete specication of
the TVC dynamics in (11) depends on a and b, and m in (12).
9
2.6 DECO specication
A middle ground between the CCC model on one hand and the DCC and TVC models on
the other is to maintain the assumption of dynamic correlations, but to restrict all pairwise
correlations to be equal. Such an approach would be expected to work well when the
pairwise correlations are dominated by a common factor. To examine that possibility, we
follow Engle and Kelly (2009) and consider their DCC-based equicorrelation specication.
That model uses the DCC matrix in (9) and then sets the equicorrelation parameter
t
equal to the average of the pairwise DCC correlations:
t
=
1
N(N 1)
_
C
DCC
t
N
_
=
2
N(N 1)
i>j
q
ij,t
q
ii,t
q
jj,t
, (13)
where is an N-vector of ones and q
ij,t
is the (i, j)-th element of the Q
t
matrix in (10).
The DCC-based equicorrelation (DECO) matrix is then
C
DECO
t
= (1
t
)I
N
+
t
J
N
, (14)
where J
N
is an N N matrix of ones. Engle and Kelly show that the transformation
of C
DCC
t
in (9) to the equicorrelation structure via (13) and (14) results in a positive
denite C
DECO
t
matrix.
2.7 Model estimation
Let denote a generic parameter vector. In the benchmark CCC specication, that
vector comprises 16 parameters (
1
, ...,
5
, v,
1
,
1
, ...,
5
,
5
). The DCC, TVC, and DECO
specications add two more parameters (a, b) for a total of 18. Given the sample of
asset returns y
1
, ..., y
T
, we estimate each model by maximizing its sample log-likelihood
function L() =
T
t=1
log f(y
t
|, I
t1
) with respect to , where
f(y
t
|, I
t1
) = |H
t
|
1/2
f
_
H
1/2
t
(y
t
)|, I
t1
_
, (15)
subject to the models positivity and stationarity constraints. The functional form of the
multivariate density is given in (3) and the term |H
t
|
1/2
in (15) is the Jacobian factor
that arises in the transformation from z
t
to y
t
. We should emphasize that the non-normal
distribution used here does not allow the log-likelihood function to be decomposed as in
10
Engle (2002), Engle and Sheppard (2005), and Engle and Kelly (2009). This means that
we cannot employ Engles two-step estimation approach, but instead we estimate the
parameters of the multivariate skewed Student-t distribution together with those of the
conditional variances and covariances processes in one step.
1
3 Estimation results
Our empirical assessment uses daily data on dollar-denominated MSCI stock market in-
dices for ve geographical areas: North America, Europe, Pacic, Latin America, and
Asia. The rst three of those are developed market indices, whereas the last two rep-
resent emerging market indices. In international nance, the traditional argument for
reaping the benets of international diversication has relied on the presence of low cross-
country correlations. While the early literature studied developed markets, here we follow
more recent studies and also examine the benets oered by emerging markets.
2
The
MSCI indices represent a broad aggregation of national equity markets and are the lead-
ing benchmarks for international portfolio managers. The point of view adopted here is
that of a U.S. investor managing an international portfolio, but who does not hedge any
currency risk. The indices data were retrieved from Datastream for the sample period
covering July 16, 1990 to July 16, 2010. For each index, we computed a series of corre-
sponding log-returns and multiplied by 100 so they can be read as percentage returns.
Figure 1 shows the ve return series, each comprising 5219 observations. The presence of
volatility clustering eects is evident in each series and the increased volatility during the
nancial crisis of 2008 is truly astounding.
Table 1 presents some summary statistics of the returns data. The top portion reports
the means, standard deviations, maximum and minimum values, skewness, and kurtosis
of each return series. Each series exhibits negative skewness, except the MSCI Pacic
1
The computations were done in Fortran using IMSL. A quasi-Newton method with nite-dierence
gradients was used for the maximization of the sample likelihood function of each model.
2
Early studies on the benets of international diversication include Solnik (1974) for developed
markets and Errunza (1977) for emerging markets. More recent evidence is found in DeSantis and
Gerard (1997), Errunza, Hogan, and Hung (1999), Bekaert and Harvey (2000), and Christoersen et al.
(2010).
11
returns which have a slight positive skew. Moreover, we see that the kurtosis in every
case is much higher than it would be if the returns were normally distributed. The bottom
portion of Table 1 displays the sample correlation matrix for these ve return series. It is
interesting to note how the pairwise correlations are related to geographic proximity. For
instance, Latin American returns have a 58% correlation with North American returns
and a 54% correlation with European ones, whereas the correlations with the farther
Pacic and Asian markets are much smaller (21% and 32%, respectively). This is further
illustrated by the 54% correlation between Asian and Pacic region returns.
Tables 25 show the maximum-likelihood parameter estimates of the CCC, DCC,
TVC, and DECO models, respectively, using the entire sample of returns data. We began
by estimating the CCC model and retained as nal point estimates those that attained
the highest value of the log-likelihood function over a grid of initial values. We then used
the CCC estimates as starting values for the estimation of the DCC, TVC, and DECO
models. In Tables 25, the numbers in parentheses are the standard errors associated
with each point estimate.
Each model reveals that the marginal distributions of return innovations are skewed to
the left (since log
i
< 0), except for the Pacic region returns under the CCC and DECO
models which appear more symmetric than those of the other regions. The degrees-of-
freedom parameter is around 7.7 in each case, implying tails far thicker than those of
a normal distribution. The GARCH parameter estimates are quite typical of what is
usually found with daily returns; i.e., the weights on the long-run variances
i
and the
ARCH parameters
i
are quite small, while the GARCH parameters
i
are much closer
to one in magnitude.
The estimated a and b parameters in Tables 35 determine the persistence over time of
the respective model-implied conditional correlations. The DCC, TVC, and DECO models
each imply a great deal of persistence, as evidenced by the values of a + b all close to
one, which in turn implies very slow rates of mean-reversion in correlations. To illustrate
these eects, Figures 24 shows the model-implied correlations between the standardized
returns for the ve regions. The horizontal lines in each plot are the correlation implied by
the estimated CCC model, which are seen to be slightly below the corresponding sample
correlations in Table 1. The solid lines in Figures 24 are associated with the DCC model,
12
the dashed lines with the TVC model, and the dotted line (which is the same in each plot)
with the DECO model. The time-varying correlations are unmistakable in each case. Note
that the DCC and TVC models in each case imply very similar patterns over time, while
the DECO model exhibits a dierent pattern since it captures the average correlation
across all pairs of assets. It is interesting to observe the relative increases in correlations
during the nancial crisis. For instance, the North America-Europe conditional correlation
(in the upper left plot) in Figure 2 rises from about 0.4 to 0.7 during that period. This
nding of increasing correlations between stock market indices during volatile periods
(typically bear markets) is in line with the inverse relationship between market value and
correlations documented in Longin and Solnik (1995, 2001), Ang and Chen (2002), and
Engle and Kelly (2009).
Recall that the decoupling hypothesis is the idea that recently the evolution of stock
markets in emerging markets has started decoupling itself from the evolution of more
developed stock markets. This notion is clearly not supported by the evidence presented
here. Indeed, the overall picture that emerges from Figures 24 is that the correlations
between all pairs of indicesdeveloped and emerginguctuate considerably over time,
either around the values implied by the CCC model or have been on an upward trend in the
last decade. Nowhere do we see evidence of recent downward trends in daily correlations,
which clearly contradicts the decoupling hypothesis. Christoersen et al. (2010) reach
the same conclusion with weekly returns during the 19732009 period.
3
Our focus, however, is not on the in-sample comparison of these models, but rather on
their out-of-sample performance in portfolio management. In the application that follows,
the models are used to produce forecasts for time t + 1 using only information available
up to time t, as would be done in real-time forecasting. For the forecasting exercise we
set aside the last 1000 observationsabout 4 years. So at time t each model is used to
produce the one-day-ahead forecasts
t+1|t
and H
t+1|t
. The rst of these one-day-ahead
forecasts is made on 15 September 2006, and every day the returns data available up to
that point in time are used to update the forecasts of the next day. Following Bauwens
3
Despite the evidence of recent upward tends in correlations, Christoersen et al. (2010) argue that
their ndings of very low tail dependence at the end of their sample suggests that there are still benets
from adding emerging markets to a portfolio.
13
and Laurent (2005), the model parameters are reestimated every 50 trading daysabout 2
monthsusing the previous estimates as initial values for the numerical optimization. The
Appendix shows the full set of recursively updated parameter estimates for each model.
It is noteworthy that the parameters estimates change by very little between consecutive
updates, which is perhaps not surprising since each time they merely incorporate the most
recent 50 days worth of observations. What is remarkable though is that the recursively
updated parameter estimates for each of the four model specications appear very stable
by any standard over the entire sample period, from the relatively tranquil days of 2006
07 through the tumultuous days of 200810 (see Figure 1). Indeed, the averages of the
standard deviations of each parameter series for the CCC, DCC, TVC, and DECO models
are 0.003, 0.002, 0.002, and 0.002, respectively. Note that Brownlees, Engle, and Kelly
(2009) have a similar nding with volatility models. It will be important to bear in mind
this remark about parameter stability when interpreting the portfolio performance results.
4 Application to portfolio management
4.1 Management strategies
We consider the problem faced by an active portfolio manager who rebalances a portfolio
of assets on a daily basis. Here we begin by assuming the absence of a risk-free security, so
the portfolio comprises only risky assets. The naive approach to this problem is simply to
invest the initial wealth each day equally across the N risky assets under consideration, so
the fraction of wealth in each asset is 1/N. This is referred to as the naive diversication
(or 1/N) rule. It should be noted that the 1/N rule doesnt entail any estimation risk
since it relies neither on the data nor on any model. And nonetheless DeMiguel, Garlappi,
and Uppal (2009) nd that this portfolio strategy performs remarkably well in out-of-
sample comparisons against more sophisticated approaches based on classical portfolio
optimization using monthly returns data. Here we use the naive 1/N rule as our rst
obvious benchmark for comparison purposes.
According to the classical theory of optimal portfolio selection by Markowitz (1952),
the manager allocates the wealth across the N assets so as to minimize the portfolios
variance subject to the constraint that the expected portfolio return attains a specied
14
target,
t
. Without loss of generality, the initial wealth can be normalized to one so the
portfolio managers problem is to nd the optimal normalized portfolio weights,
t
, as
the solution to:
min
t
t
H
t+1|t
t
s.t.
t+1|t
=
t
,
t
1 = 1,
t
0,
(16)
where 1 is a vector of ones. The non-negativity constraints
t
0 in this formulation of
her problem mean that the portfolio manager is prohibited from making short sales. We
shall also consider a version of (16) without those short-sale constraints so that the optimal
solution,
t
, may contain negative weights (short positions). The portfolio optimization
problem in (16) is a standard quadratic programming problem that is readily solved
numerically. In this formulation of the portfolio problem, the manager only allocates
wealth to a set of risky assets. We also consider the case where she has access to a risk-
free asset with a zero rate of return, which seems quite realistic given that the portfolio
is rebalanced on a daily basis. In the presence of a risk-free asset, the constraint
t
1 = 1
is dropped from (16) so that the portfolio weights need not sum to one; i.e., 1
t
1 is
the share in the risk-free asset.
The quantities that the manager needs to input into (16) are the forecasts
t+1|t
and H
t+1|t
. The so-called plug-in approach simply computes the sample mean y
t
and
covariance matrix of asset returns up to time t and uses those as the inputs to (16). That
approach obviously uses the data, but just like the 1/N rule it remains model-free. The
common plug-in approach is included in our comparisons. The model-based approaches
that we consider are those that use the multivariate model of returns presented in Section
2 with either a CCC, DCC, TVC, or DECO correlation structure. Note that the implied
forecast
t+1|t
in each case is the same as that of the plug-in approach: y
t
. So the plug-in,
CCC, DCC, TVC, and DECO approaches dier only by their forecasts of the conditional
covariance matrix, H
t+1|t
.
The fact that H
t+1|t
is an estimated quantity gives rise to estimation risk (owing to
the uncertainty about the data-generating process) and that risk becomes particularly
important when the cost of rebalancing the portfolio is taken into account. In order
15
to get a sense of the amount of trading required by each portfolio approach, we follow
DeMiguel, Garlappi, and Uppal (2009) and Kirby and Ostdiek (2011) and compute the
portfolio turnover at time t + 1, dened as the sum of the absolute values of the trades
across the N assets. More specically, notice that if we let R
i,t+1
denote the simple return
between times t and t +1 on asset i, then for each dollar invested in the portfolio at time
t there is
i,t+1
(1 + R
i,t+1
) dollars invested in asset i at time t + 1. Note also that at
the daily frequency, log-returns are virtually identical to simple returns. So the share of
wealth in asset i before the portfolio is rebalanced at time t + 1 is

i,t
+ =

i,t
(1 + R
i,t+1
)
N
i=1

i,t
(1 + R
i,t+1
)
and when the portfolio is rebalanced it gives rise to a trade in asset i of magnitude
|
i,t+1

i,t
+|, where
i,t+1
is the optimal portfolio weight on asset i at time t + 1 (after
rebalancing). So the total amount of turnover in the portfolio is
t+1
=
N
i=1
|
i,t+1

i,t
+|. (17)
Roughly speaking, the turnover is the average percentage of wealth traded each period.
It is important to remark that with the naive strategy,
i,t
=
i,t+1
= 1/N, but
i,t
+ may
be dierent owing to changes in asset prices between times t and t + 1. If c denotes the
proportional transaction cost, then the total cost to rebalance the portfolio is c
t+1
. Let
R
p
=
N
i=1
R
i,t+1

i,t
denote the portfolio return from a given strategy before rebalancing
occurs. The evolution of wealth invested according to a given strategy is then given by
W
t+1
= W
t
(1 + R
p
)(1 c
t+1
) (18)
and the simple return net of rebalancing costs is r
t+1
= W
t+1
/W
t
1. Since the portfolio
t
is formed using only information available at time t and held for one day before being
rebalanced at time t + 1, the return r
t+1
represents the one-day out-of-sample return.
The target
t
in (16) needs to be specied. Kirby and Ostdiek (2010) argue that
the amount of turnover in the portfolio is very sensitive to the selected target value.
So here we follow those authors and set
t
equal to the estimated conditional expected
return of the benchmark 1/N portfolio; i.e.,
t
= y
t
1/N. The 1/N portfolio is expected
to have relatively low turnover, so this choice levels the playing eld between the naive
16
approach, the plug-in approach, and the four model-based approaches. Figure 5 shows
the time-series plot of the daily portfolio target returns (in basis points) on each day from
September 15, 2006 to July 15, 2010 that the portfolio is rebalanced. We see that the
target return values vary between about 1 and 3 basis points (or between 2.5 and 7.5%
in annual terms).
It remains to discuss how we evaluate portfolio performance. For that we choose
the out-of-sample realized Sharpe ratio because it is the most ubiquitous risk-adjusted
measure used by nancial market practitioners to rank fund managers and to evaluate the
attractiveness of investment strategies in general. We use an expanding-window procedure
to compare the portfolio performances. Let T denote the total number of returns under
consideration in the data set and let t
1
be the rst day of portfolio formation. With daily
rebalancing, we obtain a time-series of out-of-sample returns r
t
for t = t
1
+ 1, ..., T. In
our empirical assessments, we consider three out-of-sample periods: (i) September 18,
2006 to July 16, 2010, (ii) September 18, 2006 to August 15, 2008, and (iii) August 18,
2008 to July 16, 2010. The rst of those represents the entire out-of-sample evaluation
period with 999 returns, and the second and third periods each comprise 499 return
observations.
4
As in Brownless, Engle, and Kelly (2009), we consider September 2008
the month in which Lehman Brothers led for Chapter 11 bankruptcy protectionas the
beginning of the nancial crisis, so the period from September 18, 2006 to August 15,
2008 represents our pre-crisis subsample. The Sharpe ratio of strategy i is then computed
as SR
i
= r
i
/
_

2
i
, where r
i
is the average of the out-of-sample returns to strategy i and

2
i
is the corresponding sample variance. We also report the average portfolio turnover

i
, computed as the out-of-sample average of (17) for each strategy.
The Sharpe ratio works well as a performance gauge when excess returns are posi-
tive. In that case, higher the Sharpe ratio, the better; and at a given level of excess
return, lower the standard deviation of return, the better. During periods of negative
excess returns, however, the Sharpe ratio yields unreasonable performance rankings. For
instance, consider two portfolios that achieve the same negative excess return, but with
dierent standard deviations. According to the usual Sharpe ratio, the one with the larger
standard deviation would be ranked higher! In recognition of this shortcoming, Israelsen
4
Note that one observation is lost when computing r
t
, the returns net of rebalancing costs.
17
(2003, 2005) proposes to modify the Sharpe ratio as follows:
SR-m =
_
r/

2
, if r 0,
r

2
, if r < 0.
So when returns are negative, a portfolio with a smaller standard deviation gets ranked
higher than one that took more risk. Whereas when returns are positive, the Sharpe ratio
and its modied version yield the same performance ranking. The modied Sharpe ratio
is thus entirely consistent with the basic principle of risk-adjusted returns, which is that
higher risk is only preferable if accompanied by higher return.
5
To assess the statistical signicance of the dierences between the Sharpe ratio of the
benchmark 1/N strategy (SR
1/N
) and those of the plug-in and model-based strategies,
we use a bootstrap inference method. Specically, we test the equality of Sharpe ratios
according to the block bootstrap proposed in Ledoit and Wolf (2008) which is designed
to accommodate serially correlated and heteroskedastic time series of returns. The null
hypothesis is H
0
: SR
i
SR
1/N
= 0 for which we compute a two-sided p-value using
Ledoit and Wolfs studentized circular block bootstrap with block size equal to 5 and
1000 bootstrap replications. Following the suggestion in Ledoit and Wolf (2008), we
use the same methodology to test for statistical dierences between the modied Sharpe
ratios.
4.2 Portfolio performance results
Tables 6 and 7 report the portfolio performance results over the entire out-of-sample
period (September 18, 2006 to July 16, 2010) when the portfolio comprises only risky
assets (Table 6) and when a risk-free security is part of the asset mix (Table 7). Tables 8
and 9 show the corresponding results over the pre-crisis period from September 18, 2006
to August 15, 2008, and Tables 9 and 10 pertain to the later period from August 18, 2008
to July 16, 2010. The results for the benchmark 1/N strategy are given in the leading row
of each table. The subsequent rows refer to the plug-in and model-based strategies, with
and without short selling. For the portfolios of risky assets only (in Tables 6, 8, and 10),
5
As Israelsen (2005) notes, there is an odd feature of the modied Sharpe ratio: its magnitude can be
quite large. So its interest here is mainly as a ranking criterion.
18
the short selling constraints are not binding for the plug-in strategy. The reported out-
of-sample portfolio results include the annualized mean return, the annualized standard
deviation of returns, the annualized Sharpe ratio (SR), the annualized modied Sharpe
ratio (SR-m), and the average turnover (Turnover).
6
The entries in the columns labeled
p-value are the two-sided bootstrap p-values for the null hypothesis of equal Sharpe
ratios vis-à-vis the 1/N strategy. Following Kirby and Ostdiek (2011), each table shows
the results when there are no transactions costs and assuming proportional transactions
costs of 50 basis points (bps) for c in (18).
Table 6 shows that when the portfolio comprises risky assets only over the entire
out-of-sample period, the plug-in and the model-based strategies yield signicantly worse
Sharpe and modied Sharpe ratios than the 1/N rule. The only two noticeable exceptions
occur with 50 bps transactions costs for the plug-in method and the TVC model when
short sales are allowed. In those two instances the p-values are 0.75 and 0.15 for the
Sharpe ratio and 0.62 and 0.52 for the modied Sharpe ratio, respectively, indicating
no signicant dierences with the 1/N rule. In every other case, however, the p-values
never exceed 9% at best, indicating that portfolio performances with negative Sharpe
(or modied Sharpe) ratios are indeed signicantly worse than what is achieved through
naive diversication.
The portfolio performance results change dramatically as soon as the manager has
access to a risk-free asset, even if it yields a zero return. Comparing Tables 6 and 7, we
clearly see how the introduction of a risk-free asset leads to increased mean returns and
much smaller standard deviations. So in the presence of a risk-free asset the Sharpe ratios
delivered by the plug-in and model-based strategies continue to be lower than that of the
1/N rule, but the dierences are unmistakably nowhere statistically signicant. The only
apparent exceptions are for the CCC, DCC, and TVC Sharpe ratios when short sales
are allowed and with 50 bps transactions costs, but even those dierences cease to be
signicant under the modied Sharpe ratio performance measure. The following quote
from Amenc and Martellini (2011) summarizes well this nding:
6
The annualized mean return is computed here as the daily mean return times 252 and the annualized
standard deviation of returns, SR, and SR-m are obtained by multiplying their daily counterparts by the
square root of 252.
19
Any attempt at improving portfolio diversication techniques, either by
introducing sophisticated time- and state-dependent risk models, or by ex-
tending them to higher-order moments, is also equally misleading if the goal
is again to hope for protection in 2008-like market conditions. When there is
simply no place to hide, even the most sophisticated portfolio diversication
techniques are expected to fail.
Table 6 shows what happens when there is no place to hide (i.e. when the portfolio
manager can only take risky positions) and Table 7 shows that even if the risk-free rate
of return is zero, having access to a risk-free investment vehicle provides valuable pro-
tection against downside risk. Indeed, the fact that the statistically signicant negative
performance measures in Table 6 cease to be signicantly dierent vis-à-vis the 1/N rule
(in Table 7) once the constraint
t
1 = 1 is dropped from (16) is quite remarkable.
7
It
is also interesting to note the eects of short-sale constraints in Tables 6 and 7. When
that constraint binds, the reduction in the amount of portfolio turnover can be quite
important. For instance, in Table 7 we see that prohibiting short sales with the CCC
model reduces portfolio turnover from 13.28 to 1.93, lower than the turnover value of 3.2
achieved by the 1/N rule. Similar reductions in turnover can be seen for the other models
as well. These results are in line with the ndings of Jagannathan and Ma (2003) who
show that imposing a short-selling constraint amounts to shrinking the extreme elements
of the covariance matrix and thereby stabilizes the portfolio weights. As in DeMiguel,
Garlappi, and Uppal (2009) though, we nd that even restraining short sales is not suf-
cient to completely mitigate the error in estimating the covariance matrix and thus to
provide better portfolio Sharpe ratios than the naive 1/N rule, which ignores the data
altogether.
Tables 8 and 9 show the corresponding analysis during our pre-crisis period from
September 18, 2006 to August 15, 2008. During this period the performance of the 1/N
rule is even better, with an annualized Sharpe ratio of 0.37 in the absence of transactions
7
Note that relaxing the constraint is the main eect here, since the two series of portfolio target
returns (in Figure 5) are very close. We further conrmed this by performing the portfolio exercises with
a risk-free asset in the mix (so N=6) but targeting the return implied by the 1/5 rule. The results were
virtually identical to those reported in Tables 7, 9, and 11.
20
costs and of 0.12 with 50 bps transactions costs. Without transactions costs, the plug-in
method performs statistically as well as the 1/N rule (p-values of 0.11 and 0.20). However,
its negative Sharpe ratio (-0.23) in the presence of transactions costs is signicantly worse
with a p-value of 0.06, though its modied Sharpe ratio has a p-value of 0.14. Furthermore,
we see that all the model-based strategies continue to yield signicantly much worse
performances than the 1/N rule. As before, Table 9 shows that introducing a risk-free asset
in the mix eliminates those statistical dierences. The two exceptions are the DCC and
TVC models which maintain their signicantly negative Sharpe ratios when transactions
costs are 50 bps (p-values of 0.06 and 0.01, respectively), but those p-values increase (to
0.29 and 0.17, respectively) under the modied performance measure.
The results for the crisis period from August 18, 2008 to July 16, 2010 are reported in
Tables 10 and 11. As we would expect, we see from those tables that the performance of
the 1/N and plug-in strategies deteriorates during the nancial crisis. For instance, the
1/N rule Sharpe ratios are positive in Tables 8 and 9 and turn negative in Tables 10 and
11, and the plug-in method doesnt fare well either during the crisis. Even though their
Sharpe ratios remain negative, the model-based strategies do slightly better during the
crisis when the portfolio comprises risky assets only. In sharp contrast to what we see
in Tables 6 and 8, the performance measures in Table 10 for the model-based portfolio
strategies are clearly not signicantly dierent from those of the 1/N rule. And this holds
with and without transactions costs and whether or not short sales are allowed. The
comparison between Tables 8 and 10 shows just how misleading the usual Sharpe ratio
can be. Indeed the Sharpe ratios of each model-based strategy in the pre-crisis period
(Table 8) appear to have improved (i.e. become less negative) during the nancial crisis
(Table 10), when in fact the returns and standard deviations are generally worse during
the high-turbulence period. On the contrary, the modied Sharpe ratios correctly indicate
a deterioration of performance during the nancial crisis.
Table 11 shows how the crisis results change in the presence of a risk-free asset. The
deterioration of performance is seen again here and, as before, the reported p-values show
that in general the performance measures for the plug-in and model-based strategies
are statistically indistinguishable from those of the 1/N rule. Although generally not
statistically dierent (owing to the far greater volatility of returns in the 1/N portfolio),
21
it it nonetheless interesting to observe from Table 11 that the the modied Sharpe ratio
ranks the performances of the model-based strategies above that of naive diversication,
except in the case of the DCC model with 50 bps transactions costs. The reversal of
rankings between the model-based strategies and the naive one, when moving from Table
10 to Table 11, further illustrates the important role played by the risk-free asset in
portfolio risk management.
So what do we learn from these portfolio performance comparisons? For starters,
the signicantly poorer performance of the model-based strategies over the entire out-of-
sample period (from September 18, 2006 to July 16, 2010) in Table 6 is driven by the
pre-crisis subsample ending on August 15, 2008 (Table 8). Indeed from August 18, 2008
to July 16, 2010, the model-based strategies are not statistically dierent from the 1/N
rule (Tables 10 and 11). Recall also that the recursively updated parameter estimates of
each considered model are remarkably stable over the entire period, but that the portfolio
strategies are extremely sensitive to whether a risk-free asset is available. Comparing
Table 6 versus 7, and 8 versus 9, shows that this constraint plays a far more important
role than the short-sale constraints. Indeed, the eects of limiting short sales on the
statistical signicance of the portfolio performances is tiny compared to the eects of
relaxing the constraint that the portfolio weights (of the risky assets) sum to one, which
changes the performance results from much worse to not statistically dierent from the
1/N rule. This is not to say that limiting the amount of short selling is not important. In
Table 10 for instance, prohibiting short sales reduces the turnover of the TVC portfolio
from 43 to 2.9, and that value is further reduced to 0.75 in Table 11 by the introduction
of a risk-free asset.
5 Conclusion
In a recent study, DeMiguel, Garlappi, and Uppal (2009) cast serious doubt on the value
of mean-variance optimization as a method of portfolio selection. They consider various
static asset-allocation models at the monthly frequency and nd that there is no single
model that delivers an out-of-sample Sharpe ratio that is higher than that of the naive 1/N
portfolio. Kirby and Ostdiek (2011) argue that the research design in DeMiguel, Gralppi,
22
and Uppal casts mean-variance optimization in an unfavorable light because it targets a
conditional expected return that greatly exceeds the conditional expected return of the
1/N strategy. This has the eect of magnifying estimation risk and leads to excessive
portfolio turnover. Kirby and Ostdiek argue further that if the mean-variance model
is instead implemented by targeting the conditional expected return of the 1/N rule, it
generally performs better than the naive strategy at least in the absence of transactions
costs. They nd nevertheless that the 1/N strategy remains a statistically challenging
benchmark to match when transactions cost are considered.
For the purpose of modeling the dynamic movements and co-movements among nan-
cial asset returns, which are quite pronounced at the daily frequency, the econometrics
literature has proposed many specications. In order to measure the value of modeling
such dynamic variances and correlations, Engle and Colacito (2006) propose an asset al-
location perspective. Their main focus, however, is on a setting with only two assetsa
stock and a bondand hence with relatively few parameters that need to be estimated. In
the same spirit as Engle and Colacito, we conduct and empirical assessment of alternative
time-series models for variances and correlations for the purpose of portfolio management
at the daily frequency.
In addition to the usual plug-in method which simply replaces the covariance matrix
by its sample counterpart, we also consider four popular models to forecast the inputs
to the portfolio selection problem. These include the CCC model of Bollerslev (1990),
the DCC model of Engle (2002), the TVC model of Tse and Tsui (2002), and the recent
DECO model of Engle and Kelly (2009). Here we examine a portfolio of ve international
MSCI equity indices, which results in a total of 18 parameters that need to be estimated
for the most sophisticated correlation models we consider, even though we make use
of correlation targeting to reduce the dimensionality problem, as in Engle and Colacito
(2006). Following DeMiguel, Gralppi, and Uppal (2009) and Kirby and Ostdiek (2011),
the 1/N rule serves as our benchmark strategy for comparison purposes and, as in Kirby
and Ostdiek, the conditional expected return of the 1/N rule is used as the target expected
portfolio return.
Our empirical assessment reveals that in the two years leading up to the recent -
nancial crisis, the 1/N strategy delivered positive out-of-sample Sharpe ratios while the
23
model-based strategies were statistically worse with negative average returns when the
portfolio manager could only take risky positions. During the nancial crisis, the plug-in
strategy and the model-based strategies are surprisingly not statistically dierent from
the deteriorated 1/N portfolio strategy. These results provide further evidence that the
desire to elaborate multivariate conditional heteroskedasticity and correlation models is
necessarily accompanied by greater estimation risk. And that parameter uncertainty can
easily translate into quite poor out-of-sample risk-adjusted portfolio performances, even
during relatively tranquil markets. A very important nding here is that the recursively
updated parameter estimates of each considered model specication appear remarkably
stable over the entire evaluation period. This sheds more light on the fragility of mean-
variance optimizing portfolios. Our results clearly show the benets of limiting short sales
and the far greater importance for the portfolio manager of including a risk-free security
in the asset mix, even if it yields a zero return.
24
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28
Table 1: Summary statistics of daily MSCI index log-returns
Developed markets Emerging markets
North America Europe Pacic Latin America Asia
Mean 0.021 0.015 -0.002 0.051 0.009
Std Dev 1.148 1.230 1.348 1.767 1.372
Max. 10.427 10.697 10.823 15.363 12.651
Min. -9.504 -10.178 -9.182 -15.060 -8.620
Skewness -0.285 -0.159 0.084 -0.332 -0.227
Kurtosis 12.312 12.088 7.840 12.943 8.822
Correlation matrix
North America 1
Europe 0.484 1
Pacic 0.105 0.356 1
Latin America 0.588 0.543 0.211 1
Asia 0.175 0.374 0.547 0.319 1
Notes: The data consists of daily percentage log-returns on dollar-denominated MSCI stock
market indices for ve geographical areas: North America, Europe, Pacic, Latin America, and
Asia. The rst two of those are developed market indices, whereas the last two are emerging
market indices. The entire sample period comprises 5219 return observations from July 17,
1990 to July 16, 2010.
29
Table 2: Parameter estimates of the CCC model
Shape parameters
i
0.9385 0.9251 1.0072 0.9352 0.9484
(0.0176) (0.0211) (0.0191) (0.0171) (0.0206)
Degrees-of-freedom parameter
v 7.7551
(0.4463)
GARCH parameters
i
0.0087 0.0118 0.0150 0.0213 0.0098
(0.0032) (0.0031) (0.0051) (0.0048) (0.0034)
i
0.0616 0.0625 0.0559 0.0861 0.0646
(0.0057) (0.0014) (0.0043) (0.0051) (0.0059)
i
0.9295 0.9256 0.9289 0.8925 0.9254
(0.0048) (0.0052) (0.0061) (0.0063) (0.0053)
Log-likelihood -36764.4
Notes: This table shows the maximum-likelihood parameter estimates of the constant conditional
correlation model based on the entire sample of returns data. The numbers in parentheses are
standard errors.
30
Table 3: Parameter estimates of the DCC model
Shape parameters
i
0.9266 0.9153 0.9866 0.9245 0.9522
(0.0128) (0.0160) (0.0144) (0.0125) (0.0162)
v 7.7873
(0.3446)
GARCH parameters
i
0.0061 0.0085 0.0123 0.0154 0.0068
(0.0018) (0.0021) (0.0048) (0.0041) (0.0021)
i
0.0606 0.0579 0.0586 0.0778 0.0590
(0.0022) (0.0026) (0.0062) (0.0043) (0.0024)
i
0.9331 0.9334 0.9290 0.9066 0.9341
(0.0034) (0.0036) (0.0049) (0.0047) (0.0037)
DCC persistence parameters
a 0.0076
(0.0221)
b 0.9905
(0.0243)
Notes: This table shows the maximum-likelihood parameter estimates of the dynamic conditional
standard errors.
31
Table 4: Parameter estimates of the TVC model
Shape parameters
i
0.9257 0.9296 0.9973 0.9240 0.9474
(0.0162) (0.0180) (0.0191) (0.0185) (0.0196)
v 7.7544
(0.4332)
GARCH parameters
i
0.0051 0.0076 0.0123 0.0124 0.0062
(0.0019) (0.0020) (0.0037) (0.0031) (0.0021)
i
0.0578 0.0594 0.0591 0.0757 0.0607
(0.0039) (0.0038) (0.0030) (0.0031) (0.0041)
i
0.9370 0.9329 0.9284 0.9117 0.9329
(0.0063) (0.0068) (0.0076) (0.0074) (0.0070)
TVC persistence parameters
a 0.0077
(0.0441)
b 0.9909
(0.0357)
Notes: This table shows the maximum-likelihood parameter estimates of the time-varying
standard errors.
32
Table 5: Parameter estimates of the DECO model
Shape parameters
i
0.9289 0.9258 1.0071 0.9089 0.9582
(0.0164) (0.0202) (0.0180) (0.0181) (0.0179)
v 7.7529
(0.5975)
GARCH parameters
i
0.0057 0.0069 0.0131 0.0130 0.0067
(0.0015) (0.0018) (0.0044) (0.0036) (0.0021)
i
0.0577 0.0598 0.0595 0.0813 0.0623
(0.0023) (0.0024) (0.0039) (0.0035) (0.0024)
i
0.9365 0.9331 0.9272 0.9056 0.9309
(0.0050) (0.0054) (0.0061) (0.0064) (0.0055)
DECO persistence parameters
a 0.0123
(0.0221)
b 0.9862
(0.0425)
Notes: This table shows the maximum-likelihood parameter estimates of the dynamic equicorrelation
model based on the entire sample of returns data. The numbers in parentheses are standard errors.
33
Table 6: Portfolio of risky assets only: September 18, 2006 to July 16, 2010
No transactions costs Transactions costs = 50 bps
Strategy Mean Std Dev SR p-value SR-m p-value Turnover Mean Std Dev SR p-value SR-m p-value
1/N 0.29 23.75 0.01 1.00 0.01 1.00 3.20 -3.74 23.71 -0.15 1.00 -0.35 1.00
Short sales allowed
Plug-in -2.93 22.77 -0.12 0.09 -0.26 0.08 23.63 -32.73 54.98 -0.59 0.75 -7.14 0.62
CCC -5.96 22.60 -0.26 0.00 -0.53 0.01 2.84 -9.47 22.56 -0.42 0.00 -0.84 0.03
DCC -8.69 22.19 -0.39 0.00 -0.76 0.01 5.04 -14.98 22.45 -0.66 0.00 -1.33 0.01
TVC -8.47 22.22 -0.38 0.00 -0.74 0.01 23.40 -37.92 54.09 -0.70 0.15 -8.14 0.52
DECO -6.77 22.77 -0.29 0.00 -0.61 0.01 3.11 -10.66 22.72 -0.46 0.00 -0.96 0.01
Short sales prohibited
CCC -5.66 22.64 -0.25 0.00 -0.50 0.01 2.90 -9.26 22.59 -0.40 0.01 -0.83 0.03
DCC -7.67 22.31 -0.34 0.00 -0.67 0.01 3.03 -11.43 22.25 -0.51 0.00 -1.00 0.02
TVC -7.51 22.33 -0.33 0.00 -0.66 0.00 5.25 -14.06 22.82 -0.61 0.00 -1.27 0.03
DECO -6.19 22.80 -0.27 0.01 -0.56 0.02 2.92 -9.82 22.75 -0.43 0.01 -0.88 0.02
Notes: This table reports the daily out-of-sample portfolio performances of the 1/N strategy, the plug-in strategy, and four
model-based strategies. The portfolio return statistics are the annualized mean, the annualized standard deviation, the annualized
Sharpe ratio, the annualized modied Sharpe ratio, and the average turnover. The p-values are for the null hypothesis that the
(modied) Sharpe ratio of a given strategy equals the (modied) Sharpe ratio of the 1/N strategy. Values less than 0.01 are
reported as zero.
Table 7: Portfolio of risky assets and a risk-free asset: September 18, 2006 to July 16, 2010
1/N 0.24 19.79 0.01 1.00 0.01 1.00 3.20 -3.80 19.76 -0.19 1.00 -0.29 1.00
Short sales allowed
Plug-in -1.45 11.65 -0.12 0.61 -0.06 0.82 3.69 -6.07 11.66 -0.52 0.28 -0.28 0.98
CCC -2.81 11.70 -0.24 0.41 -0.13 0.74 13.28 -19.54 20.27 -0.96 0.09 -1.57 0.28
DCC -3.22 11.09 -0.29 0.42 -0.14 0.76 10.02 -15.83 12.80 -1.23 0.01 -0.80 0.40
TVC -3.72 11.21 -0.33 0.35 -0.16 0.71 7.64 -13.34 11.83 -1.12 0.03 -0.62 0.63
DECO -0.51 12.69 -0.04 0.89 -0.02 0.94 9.61 -12.64 14.99 -0.84 0.21 -0.75 0.52
Plug-in -0.33 12.44 -0.02 0.83 -0.02 0.91 2.01 -2.86 12.42 -0.23 0.85 -0.14 0.72
CCC -2.91 12.59 -0.23 0.21 -0.14 0.62 1.93 -5.32 12.58 -0.42 0.27 -0.26 0.94
DCC -2.37 12.36 -0.19 0.34 -0.11 0.71 1.15 -3.80 12.32 -0.31 0.59 -0.18 0.80
TVC -2.44 12.43 -0.20 0.28 -0.12 0.67 1.31 -4.07 12.39 -0.32 0.52 -0.20 0.82
DECO -2.33 12.61 -0.18 0.32 -0.11 0.65 2.22 -5.12 12.65 -0.40 0.30 -0.25 0.92
Notes: See footnote of Table 6.
34
Table 8: Portfolio of risky assets only: September 18, 2006 to August 15, 2008
1/N 5.79 15.52 0.37 1.00 0.37 1.00 3.02 1.98 15.50 0.12 1.00 0.12 1.00
Short sales allowed
Plug-in 2.24 14.07 0.16 0.11 0.16 0.20 4.46 -3.38 14.23 -0.23 0.06 -0.19 0.14
CCC -5.11 14.06 -0.36 0.00 -0.28 0.00 3.66 -9.66 14.09 -0.68 0.00 -0.54 0.00
DCC -8.97 13.97 -0.64 0.00 -0.49 0.00 2.99 -12.67 13.94 -0.91 0.00 -0.70 0.00
TVC -8.73 14.02 -0.62 0.00 -0.48 0.00 3.01 -12.44 13.99 -0.88 0.00 -0.69 0.00
DECO -6.09 14.06 -0.43 0.00 -0.34 0.00 2.87 -9.66 14.02 -0.68 0.00 -0.53 0.01
CCC -4.62 14.08 -0.32 0.00 -0.26 0.00 3.75 -9.29 14.12 -0.65 0.00 -0.52 0.01
DCC -6.80 14.04 -0.48 0.00 -0.38 0.00 2.72 -10.16 14.02 -0.72 0.00 -0.56 0.01
TVC -6.66 14.08 -0.47 0.00 -0.37 0.00 7.54 -16.10 15.69 -1.02 0.00 -1.00 0.03
DECO -5.11 14.09 -0.36 0.00 -0.28 0.00 2.52 -8.24 14.05 -0.58 0.00 -0.45 0.02
Table 9: Portfolio of risky assets and a risk-free asset: September 18, 2006 to August 15, 2008
1/N 4.83 12.93 0.37 1.00 0.37 1.00 3.02 1.01 12.93 0.07 1.00 0.07 1.00
Short sales allowed
Plug-in 4.14 10.38 0.39 0.91 0.39 0.93 3.15 0.13 10.37 0.01 0.83 0.01 0.82
CCC -0.21 10.31 -0.02 0.23 -0.01 0.32 22.58 -28.71 25.60 -1.12 0.14 -2.91 0.31
DCC -1.65 10.33 -0.16 0.14 -0.07 0.27 5.73 -8.85 11.19 -0.79 0.06 -0.39 0.29
TVC -1.47 10.34 -0.14 0.16 -0.06 0.28 7.45 -10.85 11.16 -0.97 0.01 -0.48 0.17
DECO 1.39 11.18 0.12 0.66 0.12 0.63 12.76 -14.70 15.76 -0.93 0.16 -0.92 0.24
Plug-in 4.33 10.37 0.41 0.88 0.41 0.87 2.96 0.59 10.40 0.05 0.92 0.05 0.94
CCC -0.36 10.36 -0.03 0.16 -0.01 0.26 1.77 -2.58 10.34 -0.24 0.25 -0.10 0.53
DCC -0.46 10.38 -0.04 0.16 -0.02 0.28 1.56 -2.41 10.35 -0.23 0.31 -0.09 0.57
TVC -0.51 10.40 -0.05 0.17 -0.02 0.24 1.87 -2.85 10.38 -0.27 0.23 -0.11 0.56
DECO 0.40 10.30 0.04 0.23 0.04 0.31 1.71 -1.74 10.27 -0.16 0.38 -0.07 0.60
35
Table 10: Portfolio of risky assets only: August 18, 2008 to July 16, 2010
1/N -4.97 29.83 -0.16 1.00 -0.58 1.00 3.38 -9.26 29.77 -0.31 1.00 -1.09 1.00
Short sales allowed
Plug-in -8.11 29.01 -0.28 0.35 -0.93 0.31 42.85 -62.18 76.52 -0.81 0.81 -0.18 0.65
CCC -6.73 28.76 -0.23 0.47 -0.77 0.49 2.01 -9.23 28.67 -0.32 0.92 -1.05 0.83
DCC -8.34 28.15 -0.29 0.45 -0.93 0.40 7.09 -17.26 28.57 -0.60 0.15 -1.95 0.25
TVC -8.15 28.17 -0.28 0.42 -0.91 0.45 43.84 -63.45 75.29 -0.84 0.53 -18.96 0.58
DECO -7.37 29.02 -0.25 0.43 -0.84 0.41 3.37 -11.58 28.95 -0.40 0.41 -1.33 0.44
CCC -6.64 28.80 -0.23 0.46 -0.75 0.50 2.04 -9.17 28.71 -0.32 0.93 -1.04 0.80
DCC -8.48 28.30 -0.30 0.41 -0.95 0.45 3.34 -12.64 28.22 -0.44 0.41 -1.41 0.47
TVC -8.30 28.32 -0.29 0.42 -0.93 0.41 2.96 -11.98 28.25 -0.42 0.45 -1.34 0.52
DECO -7.18 29.05 -0.24 0.44 -0.82 0.42 3.31 -11.33 28.99 -0.39 0.47 -1.30 0.50
Table 11: Portfolio of risky assets and a risk-free asset: August 18, 2008 to July 16, 2010
1/N -4.14 24.86 -0.16 1.00 -0.41 1.00 3.39 -8.44 24.82 -0.34 1.00 -0.83 1.00
Short sales allowed
Plug-in -7.06 12.80 -0.55 0.34 -0.35 0.96 4.24 -12.30 12.83 -0.95 0.13 -0.62 0.90
CCC -5.42 12.95 -0.41 0.57 -0.27 0.91 4.01 -10.44 12.96 -0.80 0.32 -0.53 0.85
DCC -4.76 11.81 -0.40 0.69 -0.22 0.89 14.33 -22.84 14.23 -1.60 0.07 -1.29 0.76
TVC -5.96 12.04 -0.49 0.54 -0.28 0.92 7.85 -15.85 12.48 -1.27 0.10 -0.78 0.97
DECO -2.51 14.06 -0.17 0.98 -0.14 0.84 6.49 -10.73 14.22 -0.75 0.54 -0.61 0.87
Plug-in -4.96 14.22 -0.34 0.50 -0.28 0.89 1.06 -6.28 14.18 -0.44 0.71 -0.35 0.69
CCC -5.42 14.50 -0.37 0.45 -0.31 0.91 2.08 -8.02 14.49 -0.55 0.46 -0.46 0.77
DCC -4.21 14.08 -0.29 0.66 -0.23 0.85 0.75 -5.14 14.03 -0.36 0.92 -0.28 0.62
TVC -4.31 14.18 -0.30 0.59 -0.24 0.85 0.75 -5.24 14.14 -0.37 0.91 -0.29 0.63
DECO -5.05 14.57 -0.34 0.51 -0.29 0.89 2.73 -8.48 14.66 -0.57 0.41 -0.49 0.80
36
1
0
0
1
0

1990 1995 2000 2005 2010
North America
1
0
0
1
0

1990 1995 2000 2005 2010
Europe
5
5

1990 1995 2000 2005 2010
Pacific
1
5
0
1
5

1990 1995 2000 2005 2010
Latin America
5
5

1990 1995 2000 2005 2010
Asia
Figure 1: Time-series plots of the daily log-returns (in percentages) on 3 MSCI developed markets indices (North America, Europe, Pacic)
and 2 MSCI emerging markets indices (Latin America, Asia) from July 17, 1990 to July 16, 2010.
3
7
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
North AmericaEurope
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
North AmericaPacific
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
North AmericaLatin America
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
North AmericaAsia
Figure 2: Time-series plots of the model-implied conditional correlations between the standardized returns on the MSCI indices for North America
and Europe (upper left), North America and the Pacic region (upper right), North America and Latin America (lower left), and North America and
Asia (lower right). The horizontal lines correspond to the CCC model, the solid lines correspond to the DCC model, the dashed lines correspond to
the TVC model, and the dotted line (which is the same in each plot) corresponds to the DECO model.
3
8
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
EuropePacific
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
EuropeLatin America
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
EuropeAsia
Figure 3: Time-series plots of the model-implied conditional correlations between the standardized returns on the MSCI indices for Europe and the
Pacic region (upper left), Europe and Latin America (upper right), and Europe and Asia (lower left). The horizontal lines correspond to the CCC
model, the solid lines correspond to the DCC model, the dashed lines correspond to the TVC model, and the dotted line (which is the same in each
plot) corresponds to the DECO model.
3
9
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
PacificLatin America
0
.
0
0
.
2
0
.
4
0
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6
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8

1990 1995 2000 2005 2010
PacificAsia
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8

1990 1995 2000 2005 2010
Latin AmericaAsia
Figure 4: Time-series plots of the model-implied conditional correlations between the standardized returns on the MSCI indices for the Pacic region
and Latin America (upper left), the Pacic region and Asia (upper right), and Latin America and Asia (lower left). The horizontal lines correspond to
the CCC model, the solid lines correspond to the DCC model, the dashed lines correspond to the TVC model, and the dotted line (which is the same
in each plot) corresponds to the DECO model.
4
0
1
.
0
1
.
5
2
.
0
2
.
5
3
.
0

2007 2008 2009 2010
Figure 5: Time-series plot of the daily portfolio target returns (in basis points) from September
15, 2006 to July 15, 2010. The solid lines is the target return when the portfolio comprises risky
assets only and the dashed line is the target return when the asset mix includes a risk-free security.
Appendix
The tables in this appendix show the maximum-likelihood parameter estimates of the four
model specications based on the sample of returns data from July 17, 1990 up to the given
date. The dates are in the format Month/Day/Year. The updated estimates on a given
date are found using the previous ones as initial values for the numerical optimization of
the likelihood function. The shape parameters are
i
, the degrees-of-freedom parameter
is v, the GARCH parameters are
i
and
i
(
i
= 1
i

i
are not shown), and the
parameters of the conditional correlation process are a and b. The parameter subscripts
refer to: (1) North America, (2) Europe, (3) the Pacic region, (4) Latin America, and
(5) Asia.
42
Table A1: Recursively updated parameter estimates of the CCC model
Date
1

2

3

4

5
v
1

2

3

4

5

1

2

3

4

5
09/15/2006 0.9457 0.9286 1.0058 0.9382 0.9595 7.7565 0.0083 0.0127 0.0180 0.0256 0.0096 0.0489 0.0494 0.0564 0.0871 0.0622
11/24/2006 0.9458 0.9283 1.0041 0.9359 0.9591 7.7568 0.0075 0.0131 0.0169 0.0270 0.0093 0.0468 0.0497 0.0560 0.0863 0.0621
02/02/2007 0.9459 0.9281 1.0041 0.9354 0.9585 7.7569 0.0072 0.0129 0.0156 0.0270 0.0099 0.0469 0.0495 0.0565 0.0861 0.0611
04/13/2007 0.9458 0.9280 1.0041 0.9353 0.9587 7.7569 0.0071 0.0129 0.0158 0.0271 0.0097 0.0468 0.0495 0.0565 0.0861 0.0611
06/22/2007 0.9467 0.9286 1.0035 0.9351 0.9587 7.7571 0.0072 0.0139 0.0159 0.0289 0.0099 0.0469 0.0506 0.0574 0.0854 0.0611
08/31/2007 0.9466 0.9288 1.0035 0.9353 0.9586 7.7572 0.0071 0.0135 0.0154 0.0284 0.0097 0.0467 0.0507 0.0573 0.0857 0.0615
11/09/2007 0.9461 0.9289 1.0032 0.9343 0.9584 7.7572 0.0075 0.0146 0.0154 0.0284 0.0099 0.0456 0.0514 0.0563 0.0859 0.0608
01/18/2008 0.9456 0.9283 1.0037 0.9337 0.9592 7.7573 0.0075 0.0145 0.0157 0.0288 0.0100 0.0460 0.0521 0.0559 0.0849 0.0607
03/28/2008 0.9457 0.9284 1.0040 0.9346 0.9595 7.7574 0.0073 0.0134 0.0161 0.0281 0.0094 0.0464 0.0527 0.0565 0.0853 0.0611
06/06/2008 0.9416 0.9248 1.0003 0.9318 0.9600 7.7582 0.0079 0.0161 0.0166 0.0258 0.0101 0.0491 0.0584 0.0562 0.0816 0.0629
08/15/2008 0.9392 0.9225 0.9997 0.9312 0.9610 7.7586 0.0075 0.0151 0.0160 0.0273 0.0106 0.0467 0.0558 0.0561 0.0827 0.0627
10/24/2008 0.9354 0.9213 0.9963 0.9272 0.9570 7.7607 0.0072 0.0139 0.0159 0.0233 0.0093 0.0504 0.0594 0.0601 0.0877 0.0619
01/02/2009 0.9334 0.9204 0.9928 0.9271 0.9571 7.7612 0.0070 0.0127 0.0161 0.0215 0.0093 0.0538 0.0625 0.0620 0.0881 0.0639
03/13/2009 0.9324 0.9204 0.9926 0.9265 0.9568 7.7614 0.0067 0.0120 0.0149 0.0206 0.0092 0.0552 0.0629 0.0616 0.0878 0.0646
05/22/2009 0.9324 0.9204 0.9926 0.9265 0.9568 7.7614 0.0066 0.0119 0.0149 0.0206 0.0092 0.0553 0.0629 0.0616 0.0878 0.0646
07/31/2009 0.9322 0.9204 0.9921 0.9270 0.9567 7.7614 0.0069 0.0117 0.0156 0.0213 0.0090 0.0555 0.0630 0.0612 0.0874 0.0645
10/09/2009 0.9323 0.9198 0.9914 0.9266 0.9568 7.7618 0.0074 0.0121 0.0151 0.0222 0.0091 0.0577 0.0634 0.0612 0.0885 0.0647
12/18/2009 0.9321 0.9200 0.9912 0.9267 0.9558 7.7618 0.0073 0.0117 0.0154 0.0216 0.0093 0.0574 0.0634 0.0607 0.0885 0.0638
02/26/2010 0.9324 0.9200 0.9921 0.9265 0.9569 7.7620 0.0079 0.0119 0.0155 0.0227 0.0093 0.0593 0.0625 0.0603 0.0880 0.0635
05/07/2010 0.9324 0.9201 0.9922 0.9266 0.9569 7.7620 0.0081 0.0122 0.0155 0.0229 0.0093 0.0596 0.0626 0.0605 0.0882 0.0638
4
3
Table A2: Recursively updated parameter estimates of the DCC model
Date
1

2

3

4

5
v
1

2

3

4

5

1

2

3

4

5
a b
09/15/2006 0.9349 0.9170 0.9907 0.9229 0.9556 7.7888 0.0065 0.0116 0.0149 0.0250 0.0080 0.0465 0.0488 0.0562 0.0828 0.0593 0.0078 0.9871
11/24/2006 0.9356 0.9174 0.9908 0.9226 0.9559 7.7890 0.0060 0.0113 0.0155 0.0246 0.0079 0.0468 0.0494 0.0566 0.0831 0.0596 0.0067 0.9893
02/02/2007 0.9356 0.9174 0.9908 0.9225 0.9560 7.7891 0.0057 0.0114 0.0151 0.0247 0.0083 0.0468 0.0493 0.0567 0.0830 0.0593 0.0069 0.9896
04/13/2007 0.9363 0.9177 0.9909 0.9226 0.9565 7.7892 0.0056 0.0117 0.0145 0.0251 0.0078 0.0466 0.0496 0.0564 0.0828 0.0595 0.0072 0.9893
06/22/2007 0.9367 0.9186 0.9908 0.9222 0.9567 7.7893 0.0058 0.0120 0.0140 0.0262 0.0086 0.0469 0.0497 0.0571 0.0831 0.0595 0.0074 0.9892
08/31/2007 0.9367 0.9186 0.9908 0.9222 0.9567 7.7893 0.0058 0.0120 0.0140 0.0262 0.0086 0.0469 0.0497 0.0571 0.0831 0.0595 0.0075 0.9894
11/09/2007 0.9364 0.9197 0.9912 0.9218 0.9561 7.7897 0.0058 0.0122 0.0142 0.0248 0.0084 0.0466 0.0504 0.0565 0.0828 0.0596 0.0074 0.9898
01/18/2008 0.9364 0.9197 0.9912 0.9218 0.9561 7.7898 0.0057 0.0123 0.0142 0.0247 0.0084 0.0466 0.0504 0.0565 0.0828 0.0596 0.0074 0.9898
03/28/2008 0.9366 0.9197 0.9909 0.9215 0.9570 7.7900 0.0057 0.0111 0.0142 0.0240 0.0082 0.0471 0.0519 0.0566 0.0820 0.0596 0.0075 0.9897
06/06/2008 0.9366 0.9197 0.9909 0.9215 0.9570 7.7900 0.0057 0.0111 0.0142 0.0240 0.0082 0.0471 0.0519 0.0566 0.0820 0.0596 0.0075 0.9897
08/15/2008 0.9371 0.9191 0.9913 0.9201 0.9572 7.7908 0.0056 0.0129 0.0134 0.0228 0.0086 0.0473 0.0557 0.0546 0.0794 0.0596 0.0077 0.9895
10/24/2008 0.9350 0.9178 0.9909 0.9187 0.9566 7.7914 0.0053 0.0110 0.0124 0.0182 0.0076 0.0505 0.0565 0.0561 0.0793 0.0588 0.0076 0.9897
01/02/2009 0.9350 0.9175 0.9912 0.9186 0.9569 7.7917 0.0049 0.0099 0.0126 0.0157 0.0070 0.0510 0.0579 0.0579 0.0785 0.0596 0.0078 0.9896
03/13/2009 0.9346 0.9173 0.9916 0.9186 0.9569 7.7918 0.0048 0.0093 0.0120 0.0154 0.0069 0.0523 0.0584 0.0583 0.0782 0.0597 0.0081 0.9892
05/22/2009 0.9337 0.9178 0.9922 0.9185 0.9587 7.7919 0.0048 0.0093 0.0112 0.0143 0.0066 0.0536 0.0593 0.0583 0.0771 0.0585 0.0079 0.9897
07/31/2009 0.9339 0.9178 0.9919 0.9200 0.9588 7.7921 0.0052 0.0089 0.0120 0.0147 0.0064 0.0555 0.0591 0.0587 0.0761 0.0580 0.0081 0.9893
10/09/2009 0.9336 0.9177 0.9916 0.9199 0.9587 7.7921 0.0053 0.0084 0.0119 0.0142 0.0066 0.0558 0.0586 0.0586 0.0757 0.0584 0.0081 0.9898
12/18/2009 0.9336 0.9176 0.9915 0.9201 0.9587 7.7922 0.0053 0.0085 0.0121 0.0144 0.0065 0.0557 0.0585 0.0585 0.0756 0.0583 0.0081 0.9896
02/26/2010 0.9336 0.9176 0.9915 0.9201 0.9587 7.7922 0.0053 0.0085 0.0121 0.0144 0.0065 0.0557 0.0585 0.0585 0.0756 0.0583 0.0081 0.9896
05/07/2010 0.9330 0.9176 0.9908 0.9197 0.9588 7.7925 0.0058 0.0086 0.0119 0.0146 0.0067 0.0579 0.0584 0.0578 0.0752 0.0588 0.0077 0.9903
4
4
Table A3: Recursively updated parameter estimates of the TVC model
Date
1

2

3

4

5
v
1

2

3

4

5

1

2

3

4

5
a b
09/15/2006 0.9395 0.9324 0.9988 0.9225 0.9572 7.7564 0.0056 0.0106 0.0150 0.0220 0.0075 0.0448 0.0503 0.0588 0.0822 0.0596 0.0065 0.9904
11/24/2006 0.9394 0.9324 0.9988 0.9224 0.9572 7.7564 0.0053 0.0106 0.0151 0.0220 0.0074 0.0449 0.0503 0.0587 0.0821 0.0596 0.0065 0.9905
02/02/2007 0.9396 0.9324 0.9990 0.9225 0.9574 7.7565 0.0049 0.0106 0.0149 0.0221 0.0078 0.0450 0.0503 0.0587 0.0821 0.0595 0.0064 0.9909
04/13/2007 0.9398 0.9323 0.9987 0.9220 0.9575 7.7565 0.0049 0.0109 0.0147 0.0219 0.0078 0.0449 0.0503 0.0585 0.0820 0.0598 0.0065 0.9911
06/22/2007 0.9398 0.9323 0.9987 0.9220 0.9575 7.7565 0.0049 0.0109 0.0147 0.0219 0.0078 0.0449 0.0503 0.0585 0.0820 0.0598 0.0065 0.9911
08/31/2007 0.9393 0.9317 0.9977 0.9225 0.9582 7.7569 0.0050 0.0108 0.0137 0.0219 0.0079 0.0454 0.0505 0.0577 0.0819 0.0602 0.0067 0.9910
11/09/2007 0.9397 0.9316 0.9979 0.9223 0.9581 7.7570 0.0050 0.0113 0.0136 0.0219 0.0078 0.0452 0.0506 0.0573 0.0821 0.0600 0.0070 0.9910
01/18/2008 0.9397 0.9316 0.9979 0.9223 0.9581 7.7570 0.0050 0.0113 0.0136 0.0219 0.0078 0.0452 0.0506 0.0573 0.0821 0.0600 0.0070 0.9910
03/28/2008 0.9400 0.9325 0.9977 0.9225 0.9584 7.7571 0.0048 0.0099 0.0140 0.0217 0.0078 0.0461 0.0514 0.0574 0.0822 0.0609 0.0073 0.9906
06/06/2008 0.9399 0.9307 0.9969 0.9216 0.9589 7.7576 0.0050 0.0114 0.0129 0.0205 0.0078 0.0462 0.0544 0.0559 0.0799 0.0608 0.0071 0.9909
08/15/2008 0.9399 0.9306 0.9969 0.9217 0.9589 7.7576 0.0050 0.0114 0.0130 0.0205 0.0078 0.0462 0.0544 0.0559 0.0799 0.0608 0.0071 0.9908
10/24/2008 0.9395 0.9302 0.9955 0.9225 0.9586 7.7577 0.0044 0.0095 0.0122 0.0169 0.0076 0.0464 0.0548 0.0575 0.0799 0.0610 0.0073 0.9905
01/02/2009 0.9356 0.9279 0.9946 0.9213 0.9582 7.7584 0.0046 0.0088 0.0125 0.0142 0.0067 0.0524 0.0592 0.0603 0.0807 0.0623 0.0074 0.9907
03/13/2009 0.9354 0.9278 0.9947 0.9211 0.9583 7.7584 0.0043 0.0084 0.0121 0.0140 0.0067 0.0525 0.0592 0.0602 0.0807 0.0621 0.0074 0.9908
05/22/2009 0.9354 0.9275 0.9946 0.9211 0.9582 7.7585 0.0044 0.0078 0.0111 0.0132 0.0063 0.0530 0.0595 0.0600 0.0804 0.0616 0.0077 0.9906
07/31/2009 0.9356 0.9271 0.9945 0.9213 0.9584 7.7586 0.0045 0.0078 0.0113 0.0130 0.0063 0.0540 0.0590 0.0596 0.0795 0.0608 0.0078 0.9904
10/09/2009 0.9351 0.9273 0.9939 0.9211 0.9583 7.7587 0.0045 0.0077 0.0109 0.0130 0.0062 0.0547 0.0585 0.0587 0.0788 0.0608 0.0078 0.9906
12/18/2009 0.9351 0.9270 0.9939 0.9210 0.9582 7.7587 0.0046 0.0076 0.0111 0.0130 0.0062 0.0546 0.0585 0.0585 0.0785 0.0608 0.0079 0.9905
02/26/2010 0.9351 0.9270 0.9939 0.9210 0.9582 7.7587 0.0046 0.0076 0.0111 0.0130 0.0062 0.0546 0.0585 0.0585 0.0785 0.0608 0.0079 0.9905
05/07/2010 0.9351 0.9269 0.9938 0.9208 0.9581 7.7587 0.0047 0.0075 0.0111 0.0132 0.0063 0.0548 0.0585 0.0585 0.0784 0.0607 0.0075 0.9910
4
5
Table A4: Recursively updated parameter estimates of the DECO model
Date
1

2

3

4

5
v
1

2

3

4

5

1

2

3

4

5
a b
09/15/2006 0.9324 0.9220 1.0101 0.9121 0.9697 7.7546 0.0058 0.0097 0.0154 0.0200 0.0078 0.0458 0.0499 0.0587 0.0834 0.0610 0.0126 0.9824
11/24/2006 0.9357 0.9199 1.0105 0.9149 0.9708 7.7552 0.0058 0.0099 0.0157 0.0203 0.0076 0.0467 0.0515 0.0579 0.0834 0.0603 0.0126 0.9845
02/02/2007 0.9360 0.9200 1.0105 0.9150 0.9708 7.7553 0.0059 0.0101 0.0158 0.0213 0.0079 0.0466 0.0519 0.0584 0.0838 0.0602 0.0122 0.9846
04/13/2007 0.9367 0.9195 1.0098 0.9151 0.9704 7.7554 0.0055 0.0096 0.0148 0.0221 0.0079 0.0445 0.0505 0.0571 0.0834 0.0606 0.0125 0.9848
06/22/2007 0.9369 0.9196 1.0098 0.9153 0.9703 7.7554 0.0057 0.0099 0.0147 0.0220 0.0082 0.0446 0.0503 0.0568 0.0837 0.0604 0.0123 0.9847
08/31/2007 0.9369 0.9196 1.0097 0.9153 0.9703 7.7554 0.0056 0.0099 0.0147 0.0219 0.0081 0.0446 0.0503 0.0568 0.0836 0.0604 0.0123 0.9847
11/09/2007 0.9367 0.9192 1.0097 0.9156 0.9703 7.7554 0.0056 0.0100 0.0147 0.0219 0.0081 0.0445 0.0503 0.0566 0.0835 0.0606 0.0126 0.9848
01/18/2008 0.9369 0.9187 1.0098 0.9160 0.9705 7.7555 0.0057 0.0103 0.0152 0.0213 0.0085 0.0454 0.0514 0.0565 0.0840 0.0617 0.0117 0.9858
03/28/2008 0.9368 0.9172 1.0095 0.9161 0.9699 7.7556 0.0057 0.0100 0.0151 0.0208 0.0076 0.0448 0.0530 0.0575 0.0837 0.0619 0.0123 0.9851
06/06/2008 0.9381 0.9171 1.0088 0.9166 0.9716 7.7557 0.0061 0.0116 0.0153 0.0211 0.0082 0.0467 0.0570 0.0573 0.0838 0.0630 0.0118 0.9856
08/15/2008 0.9381 0.9163 1.0092 0.9166 0.9717 7.7558 0.0058 0.0116 0.0146 0.0208 0.0082 0.0464 0.0577 0.0577 0.0846 0.0638 0.0123 0.9848
10/24/2008 0.9347 0.9123 1.0092 0.9146 0.9708 7.7563 0.0056 0.0091 0.0142 0.0164 0.0074 0.0509 0.0586 0.0600 0.0861 0.0634 0.0126 0.9851
01/02/2009 0.9342 0.9120 1.0086 0.9140 0.9703 7.7563 0.0048 0.0082 0.0137 0.0145 0.0072 0.0511 0.0590 0.0607 0.0857 0.0640 0.0128 0.9848
03/13/2009 0.9340 0.9119 1.0085 0.9140 0.9701 7.7563 0.0046 0.0075 0.0134 0.0143 0.0071 0.0511 0.0591 0.0606 0.0854 0.0640 0.0128 0.9848
05/22/2009 0.9336 0.9115 1.0078 0.9142 0.9705 7.7563 0.0047 0.0072 0.0125 0.0137 0.0065 0.0515 0.0590 0.0605 0.0849 0.0636 0.0129 0.9849
07/31/2009 0.9336 0.9112 1.0082 0.9150 0.9713 7.7562 0.0048 0.0071 0.0124 0.0137 0.0067 0.0539 0.0589 0.0582 0.0829 0.0627 0.0134 0.9844
10/09/2009 0.9336 0.9112 1.0081 0.9150 0.9713 7.7562 0.0048 0.0071 0.0124 0.0137 0.0066 0.0539 0.0589 0.0582 0.0829 0.0627 0.0134 0.9844
12/18/2009 0.9336 0.9110 1.0076 0.9152 0.9714 7.7562 0.0049 0.0068 0.0125 0.0132 0.0066 0.0540 0.0587 0.0585 0.0835 0.0632 0.0131 0.9851
02/26/2010 0.9334 0.9114 1.0075 0.9154 0.9715 7.7562 0.0051 0.0070 0.0127 0.0136 0.0067 0.0544 0.0590 0.0578 0.0823 0.0623 0.0126 0.9858
05/07/2010 0.9334 0.9114 1.0075 0.9154 0.9715 7.7562 0.0051 0.0070 0.0127 0.0136 0.0067 0.0544 0.0590 0.0578 0.0824 0.0623 0.0125 0.9858
4
6
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