### Abstract

High dimensionality comparable to sample size is common in many statistical problems. We examine covariance matrix estimation in the asymptotic framework that the dimensionality p tends to ∞ as the sample size n increases. Motivated by the Arbitrage Pricing Theory in finance, a multi-factor model is employed to reduce dimensionality and to estimate the covariance matrix. The factors are observable and the number of factors K is allowed to grow with p. We investigate the impact of p and K on the performance of the model-based covariance matrix estimator. Under mild assumptions, we have established convergence rates and asymptotic normality of the model-based estimator. Its performance is compared with that of the sample covariance matrix. We identify situations under which the factor approach increases performance substantially or marginally. The impacts of covariance matrix estimation on optimal portfolio allocation and portfolio risk assessment are studied. The asymptotic results are supported by a thorough simulation study.

Original language | English (US) |
---|---|

Pages (from-to) | 186-197 |

Number of pages | 12 |

Journal | Journal of Econometrics |

Volume | 147 |

Issue number | 1 |

DOIs | |

State | Published - Nov 1 2008 |

### All Science Journal Classification (ASJC) codes

- Economics and Econometrics

### Keywords

- Asymptotic properties
- Covariance matrix estimation
- Diverging dimensionality
- Factor model
- Portfolio management

## Fingerprint Dive into the research topics of 'High dimensional covariance matrix estimation using a factor model'. Together they form a unique fingerprint.

## Cite this

*Journal of Econometrics*,

*147*(1), 186-197. https://doi.org/10.1016/j.jeconom.2008.09.017