VCov

Question 1

Shrinkage Method

Answer 1

Used to improve the stability of the estimated covariance matrix by adjusting extreme values toward a target (e.g., average correlation).

key Idea: Combines the sample covariance matrix with a structured estimator to reduce estimation error.

Used for portfolio optimisation with limited data or high dimensionality.

Question 2

Single Index Model

Answer 2

A simplified asset return model where each asset’s return is related to the market index.

Key Idea: Asset returns are driven by market movements + firm-specific noise.

Question 3

Constant Correlation

Answer 3

A simplified approach that assumes all asset pairs have the same average correlation.

Key Idea: Replace all pairwise correlations with the average simple correlation.

Used to create a more stable and less noisy correlation matrix, especially with many assets.

Question 4

Options Method

Answer 4

Uses option-implied data instead of historical returns.

Assumes that option prices reflect market expectations of future risk and correlation.