Evaluating conditional covariance estimates via a new targeting approach and a networks-based analysis

Abstract: Modeling and forecasting of dynamically varying covariances have received much attention in the literature. The two most widely used conditional covariances and correlations models are BEKK and DCC. In this paper, we advance a new method to introduce targeting in both models to estimate matrices associated with financial time series. Our approach is based on specific groups of highly correlated assets in a financial market, and these relationships remain unaltered over time. Based on the estimated parameters, we evaluate our targeting method on simulated series by referring to two well-known loss functions introduced in the literature and Network analysis. We find all the maximal cliques in correlation graphs to evaluate the effectiveness of our method. Results from an empirical case study are encouraging, mainly when the number of assets is not large.