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com/abstract=1301031

Dynamic portfolio management: an application of Fourier

method for covariance estimation

Maria Elvira Mancino

, Elena Rapini

Abstract

The economic benet of applying the Fourier covariance estimation methodology over

other estimators in the presence of market microstructure noise is studied from the perspec-

tive of an asset-allocation decision problem. We nd that using Fourier methodology yields

statistically signicant gains.

JEL: G11, C14, C22.

Keywords: nonparametric covariance estimation, non-synchronicity, microstructure, Fourier

analysis, optimal portfolio choice.

1 Introduction

The recent availability of large high frequency nancial data sets potentially provides a rich

source of information about asset price dynamics. Specically, nonparametric variance/covariance

measures constructed by summing intra-daily return data (i.e. realized variances and covari-

ances) have the potential to provide very accurate estimates of the underlying quadratic vari-

ation and covariation and, as a consequence, accurate estimation of betas for asset pricing,

index autocorrelation, lead-lag patterns. These measures, however, have been shown to be sen-

sitive to market microstructure noise inherent in the observed asset prices. Moreover, it is well

known from [Epps, 1979] that the non-synchronicity of observed data leads to a bias towards

zero in correlations among stocks as the sampling frequency increases. Motivated by these dif-

culties, some modications of realized covariance type estimators have been proposed in the

literature: [Martens, 2004], [Hayashi and Yoshida, 2005], [Voev and Lunde, 2007], [Large, 2007],

[Barndor-Nielsen and al., 2008].

A dierent methodology has been proposed in [Malliavin and Mancino, 2002], which is

explicitly conceived for the multivariate analysis. This method is based on Fourier analysis

and does not rely on any data synchronization procedure but employs all the available data.

[Mancino and Sanfelici, 2008a] show that the univariate Fourier estimator is robust to market

microstructure eects. The analysis is extended to the multivariate case in [Mancino and Sanfelici, 2008b],

where both the non-synchronicity issue and the eect of (dependent) microstructure noise are

taken into account.

Most of the works concerning the comparison of the eciency of dierent variance/covariances

estimators consider only simple statistics such as bias and mean squared error (MSE). In this

1

Electronic copy available at: http://ssrn.com/abstract=1301031

regard, among the most recent papers [Voev and Lunde, 2007] and [Grin and Oomen, 2006]

investigate the properties of three covariance estimators, namely realized covariance, realized co-

variance plus lead- and lag-adjustments, and the covariance estimator by [Hayashi and Yoshida, 2005],

when the price observations are subject to non-synchronicity and contaminated by (i.i.d.) mi-

crostructure noise. They conclude that the ranking of the covariance estimators in terms of

eciency depends crucially on the level of microstructure noise. [Gatheral and Oomen, 2007]

compare twenty realized variance estimators using simulated data and nd that the best vari-

ance estimator is not always the one suggested by theory. The theoretical properties of the

Fourier estimator are studied by [Mancino and Sanfelici, 2008a, Mancino and Sanfelici, 2008b],

who show that the Fourier estimator of covariance is not signicantly aected by the microstruc-

ture noise.

Nevertheless this approach to the comparison of covariance estimators does not have an

economic basis and treats overestimates and underestimates of volatility of the same magnitude

as equally important. In this paper we consider the gains oered by the Fourier estimator

over other covariance measures from the perspective of an asset-allocation decision problem,

following the approach of [Fleming et al., 2001], [Engle and Colacito, 2006], [Bandi et al., 2006]

and [De Pooter at al., 2008] who study the impact of volatility timing versus unconditional

mean-variance ecient static asset allocation strategies and of selecting the appropriate sampling

frequency or choosing between dierent bias and variance reduction techniques for the realized

covariance matrices. A preliminary result we prove here concerns the positive semi-deniteness

of the estimated covariance matrix using Fourier methodology, when the Fejer kernel is used.

This property has important consequences in the asset allocation framework. An investor is

assumed to choose his/her portfolio to minimize variance subject to a required return constraints.

Investors with dierent covariance forecasts will hold dierent portfolios. Correct covariance

information will allow the investor to achieve lower portfolio volatility. Therefore we study the

forecasting power of the Fourier estimator and of other alternative realized variance measures in

the context of an important economic metric, namely the long-run utility of a conditional mean-

variance investor rebalancing his/her portfolio each period. We show that the Fourier estimator

carefully extracts information from noisy high-frequency asset price data for the purpose of

realized variance/covariance estimation and allows for non-negligible utility gains in portfolio

management.

Inspired by [Fleming et al., 2001, Bandi et al., 2006], we construct daily variance/covariance

estimates using the Fourier method and the method proposed by [Hayashi and Yoshida, 2005],

as well as estimates obtained by using conventional (in the existing literature) 1-, 5- and 10-

minute intervals and MSE-based optimally sampled continuously-compounded returns for the

realized measures. From each of these series, we derive one-day-ahead forecasts of the vari-

ance/covariance matrix. A conditional mean-variance investor can use these forecasts to opti-

mally rebalance his/her portfolio each period. We compare the investors long-run utility for

optimal portfolio weights constructed from each forecast. Our simulations show that the gains

yielded by the Fourier methodology are statistically signicant and can be economically large,

although the realized covariance with one lead-lag bias correction and suitable sampling fre-

quency can be competitive. The analysis is conducted through Monte Carlo simulations, using

the programming language Matlab.

The paper is organized as follows. In section 2 we describe the Fourier estimation methodol-

ogy and we prove the positive semi-deniteness of the Fourier covariance matrix. In section 3 we

explain the asset allocation framework and metric to evaluate the economic benet of dierent

covariance forecasts. Section 4 presents several numerical experiments to value the gains oered

2

by Fourier estimator methodology in this context. Section 5 concludes.

2 Some properties of the Fourier estimator

The Fourier method for estimating co-volatilities was proposed in [Malliavin and Mancino, 2002]

having in mind the diculties arising in the multivariate setting when applying the quadratic

covariation theorem to the true returns data, given the non-synchronicity of observed prices for

dierent assets. In fact the quadratic covariation formula is unfeasible when applied to estimate

cross-volatilities, because it requires synchronous observations which are not available in real

situations. Being based on the integration of all data, the Fourier estimator does not need any

adjustment to t non-synchronous data. We briey recall the methodology.

Assume that p(t) = (p

1

(t), . . . , p

k

(t)) are Brownian semi-martingales satisfying the following

Ito stochastic dierential equations

dp

j

(t) =

d

i=1

j

i

(t) dW

i

+b

j

(t) dt j = 1, . . . , k, (1)

where W = (W

1

, . . . , W

d

) are independent Brownian motions. The processes are observed on

a xed time window, which can be always reduced to [0, 2] by change of origin and rescaling,

and

and b

(H) E[

_

2

0

(b

i

(t))

2

dt] < , E[

_

2

0

(

j

i

(t))

4

dt] < i = 1, . . . , d, j = 1, . . . , k.

Moreover, we assume that the observed prices are aected by microstructure noise in the

form

p

i

(t) = p

i

(t) +

i

(t) i = 1, . . . , k (2)

where the noise process is i.i.d. and the following assumptions hold:

M1. p and are independent processes, moreover (t) and (s) are independent for s = t

and E[(t)] = 0 for any t.

M2. E[

i

(t)

j

(t)] =

ij

< for any t, i, j = 1, . . . , k.

From the representation (1) we dene the volatility matrix, which in our hypothesis depends

upon time

ij

(t) =

d

r=1

i

r

(t)

j

r

(t).

The Fourier method reconstructs

,

(t) on [0, 2] using the Fourier transform of dp

(t).

The main result in [Malliavin and Mancino, 2005] relates the Fourier transform of

,

to the

Fourier transforms of the log-returns dp

the Fourier transform of dp

j

for j = 1, . . . , k, dened for any integer z by

F(dp

j

)(z) =

1

2

_

2

0

e

izt

dp

j

(t)

and consider the Fourier transform of the cross-volatility function dened for any integer z by

F(

ij

)(z) :=

1

2

_

2

0

e

izt

ij

(t)dt,

3

then the following convergence in probability holds

F(

ij

)(z) = lim

N

2

2N + 1

|s|N

F(dp

i

)(s)F(dp

j

)(z s).

As a particular case (by choosing z = 0) we can compute the integrated covariance, given

the log-returns of stocks, as the following limit in probability

_

]0,2[

ij

(t) dt = lim

N

(2)

2

2N + 1

|s|N

F(dp

i

)(s)F(dp

j

)(s). (3)

From this convergence result, we can derive a suitable estimator for the integrated co-

variance matrix. We assume that the price process for asset j (j = 1, . . . , k) is observed at

high-frequency intra-daily times {t

j

l

, l = 1, . . . , n

j

}, which may be dierent on each daily trading

period normalized to length 2. Set

F(dp

j

n

j

)(s) :=

1

2

n

j

1

l=1

exp(ist

j

l

)

I

j

l

(p

j

),

where

I

j

l

(p

j

) := p

j

(t

j

l+1

)p

j

(t

j

l

). The Fourier estimator of the integrated covariance

_

2

0

ij

(t)dt

is then

ij

N,n

i

,n

j

:=

(2)

2

2N + 1

|s|N

F(dp

i

n

i

)(s)F(dp

j

n

j

)(s) =

n

i

1

u=1

n

j

1

l=1

D

N

(t

i

u

t

j

l

)

I

i

u

(p

i

)

I

j

l

(p

j

), (4)

where D

N

(x) =

1

2N+1

sin[(N+

1

2

)x]

sin

x

2

is the rescaled Dirichlet kernel.

The construction of the estimator (4) can be modied by considering the Fejer summation,

therefore in the sequel we will consider the variant obtained through the Fejer kernel

ij

N,n

i

,n

j

:=

n

i

1

u=1

n

j

1

l=1

F

N

(t

i

u

t

j

l

)

I

i

u

(p

i

)

I

j

l

(p

j

) (5)

where F

N

(x) =

_

sin Nx

Nx

_

2

. This estimator has the advantage to preserve positivity of the covari-

ance matrix, as it is stated by the following

Proposition 2.1 The Fourier estimator

N

is positive semi-denite.

Proof. Using Bochner theorem (see [Malliavin, 1995] pg 255) it suces to prove that

_

0

sin

2

t

t

2

e

itx

dt 0 x R.

As the Fourier transform of

[

1

2

,

1

2

]

(t) is the function

sinx

x

,

_

0

sin

2

t

t

2

e

itx

dt =

2

_

0

[

1

2

,

1

2

]

(x t)

[

1

2

,

1

2

]

(t)dt 0 x R.

4

For the sake of completeness we now recall the denition of the other estimators of covari-

ance which will be considered in our analysis.

The realized covariance-type estimators are based on the choice of a synchronization pro-

cedure, which gives the observations times {0 =

1

2

n

2} for both assets. The

quadratic covariation-realized covariance estimator is dened by

RC

ij

:=

n1

u=1

u

(p

i

)

u

(p

j

),

where

u

(p

) = p

(

u+1

) p

(

u

). It is known that the realized covariance estimator is not

consistent under asynchronous trading, [Hayashi and Yoshida, 2005].

The realized covariance plus leads and lags estimator is dened by

RCLL

ij

:=

u

L

h=l

u+h

(p

i

)

u

(p

j

). (6)

The estimator (6) has good properties under microstructure noise contaminations of the prices,

but it is still not consistent for asynchronous observations. This is due to the fact that all

the realized covariance type estimators need a data synchronization procedure, because of the

denition of the quadratic covariation process. Nevertheless, the introduction of one lead and

one lag appears to provide a correction for the downward bias by non-synchronous trading.

The [Hayashi and Yoshida, 2005] All-Overlapping (AO) estimator is

AO

ij

n

1

,n

2

:=

l,u

I

i

l

(p

i

)

I

j

u

(p

j

)I

(I

i

l

I

j

u

=)

, (7)

where I

(P)

= 1 if proposition P is true and I

(P)

= 0 if proposition P is false. It is unbiased in

the absence of noise. From the practitioners point of view both this estimator and the Fourier

estimator are easy to implement as they do not rely on any choices of synchronization methods

and sampling schemes. However, in [Grin and Oomen, 2006, Voev and Lunde, 2007] the AO

estimator is proved to be not ecient in the presence of microstructure noise.

The theoretical properties of the Fourier estimator are studied by [Mancino and Sanfelici, 2008a,

Mancino and Sanfelici, 2008b], who show that the bias of the covariance estimator is not aected

by the presence of i.i.d. noise. The Fourier estimator of covariance under microstructure noise is

asymptotically unbiased, as in the case of the univariate Fourier estimator under microstructure

noise. Moreover, if the number of the Fourier coecients N is conveniently chosen, the mean

squared error of the Fourier estimator does not diverge and it is not signicantly aected by

the microstructure noise. In contrast, the realized covariation and the AO estimator are not

biased by i.i.d. noise; nevertheless both realized covariation and AO estimator are inconsis-

tent under i.i.d. noise, because the MSE diverges as the number of observations increases, see

[Mancino and Sanfelici, 2008b] for details on this point.

3 Forecasting and asset allocation

We use the methodology suggested by [Fleming et al., 2001] and [Bandi et al., 2006] to evaluate

the economic benet of the Fourier estimator of integrated covariance in the context of an asset

allocation strategy. Specically, we compare the utility obtained by virtue of covariance forecasts

5

based on the Fourier estimator to the utility obtained through covariance forecasts constructed

using the more familiar realized covariance and other recently proposed estimators. In the fol-

lowing, we adopt a notation which is common in the literature about portfolio management. It

will not be dicult for the reader to match it with the one in the previous section.

Let R

f

and R

t+1

be the risk-free return and the return vector on k risky assets over a day

[t, t +1], respectively. Dene

t

= E

t

[R

t+1

] and

t

= E

t

[(R

t+1

t

)(R

t+1

t

)

] the conditional

expected value and the conditional covariance matrix of R

t+1

. We consider a mean-variance

investor who solves the program

min

w

t

w

t

w

t

,

subject to

w

t

+ (1 w

t

1

k

)R

f

=

p

,

where w

t

is a k-vector of portfolio weights,

p

is a target expected return on the portfolio, and

1

k

is a k 1 vector of ones. The solution to this program is

w

t

=

(

p

R

f

)

1

t

(

t

R

f

1

k

)

(

t

R

f

1

k

)

1

t

(

t

R

f

1

k

)

. (8)

We estimate

t

using one-day-ahead forecasts

C

t

given a time series of daily covariance

estimates, obtained using the Fourier estimator, the realized covariance estimator, the realized

covariance plus leads and lags estimator and the AO estimator. The out-of-sample forecast is

based on a univariate ARMA model.

Given sensible choices of R

f

,

p

and

t

, each one-day-ahead forecast leads to the deter-

mination of a daily portfolio weight w

t

. The time series of daily portfolio weights then leads

to daily portfolio returns. In order to concentrate ourselves on volatility approximation and to

abstract from the issues that would be posed by expected stock return predictability, for all

times t we set the components of the vector

t

= E

t

[R

t+1

] equal to the sample means of the

returns on the risky assets over the forecasting horizon. Finally, we employ the investors long-

run mean-variance utility as a metric to evaluate the economic benet of alternative covariance

forecasts

C

t

, i.e.

U

=

R

p

2

1

m

m

t=1

(R

p

t+1

R

p

)

2

,

where R

p

t+1

= R

f

+ w

t

(R

t+1

R

f

1

k

) is the return on the portfolio with estimated weights w

t

,

R

p

=

1

m

m

t=1

R

p

t+1

is the sample mean of the portfolio returns across m n days, and is a

coecient of risk-aversion.

Following [Bandi et al., 2006], in order to avoid contaminations induced by noisy rst mo-

ment estimation, we simply look at the variance component of U

, namely

U =

2

1

m

m

t=1

(R

p

t+1

R

p

)

2

, (9)

see [Engle and Colacito, 2006] for further justications of this approach. The dierence between

two utility estimations, say U

A

U

B

, can be interpreted as the fee that the investor would be

willing to pay to switch from covariance forecasts based on estimator A to covariance forecasts

based on estimator B. In other words, U

A

U

B

is the utility gain that can be obtained by

investing in portfolio B, with the lowest variance for a given target return

p

.

6

4 Valuing the economic benet by simulations

In the following sections we show several numerical experiments to assess the gains oered by the

Fourier estimator over other estimators in terms of in-sample and out-of-sample properties and

from the perspective of an asset-allocation decision problem. In Section 4.1 our attention is fo-

cused mainly on covariance estimation, since in this respect eects due to both non-synchronicity

and microstructure noise become eective. Nevertheless, the results in Sections 4.2, 4.3 and 4.4

can be fully justied only by considering the properties of the dierent estimators for both the

variance and the covariance measures.

Following a large literature, we simulate discrete data from the continuous time bivariate

Heston model

dp

1

(t) = (

1

2

1

(t)/2)dt +

1

(t)dW

1

dp

2

(t) = (

2

2

2

(t)/2)dt +

2

(t)dW

2

d

2

1

(t) = k

1

(

1

2

1

(t))dt +

1

1

(t)dW

3

,

d

2

2

(t) = k

2

(

2

2

2

(t))dt +

2

2

(t)dW

4

,

where corr(W

1

, W

2

) = 0.35, corr(W

1

, W

3

) = 0.5 and corr(W

2

, W

4

) = 0.55. The other pa-

rameters of the model are as in [Zhang et al., 2005]:

1

= 0.05,

2

= 0.055, k

1

= 5, k

2

= 5.5,

1

= 0.05,

2

= 0.045,

1

= 0.5,

2

= 0.5. The volatility parameters satisfy the Fellers condition

2k

2

which makes the zero boundary unattainable by the volatility process. Moreover, we as-

sume that the additive logarithmic noises

1

(t),

2

(t) are i.i.d. Gaussian, contemporaneously cor-

related and independent from p. The correlation is set to 0.5 and we assume (E[

2

])

1/2

= 0.002,

i.e. the standard deviation of the noise is 0.2% of the value of the asset price. From the simu-

lated data, integrated covariance estimates can be compared to the value of the true covariance

quantities.

We generate (through simple Euler Monte Carlo discretization) high frequency evenly sam-

pled ecient and observed returns by simulating second-by-second return and variance paths

over a daily trading period of h = 6 hours, for a total of 21600 observation per day. In order to

simulate high frequency unevenly sampled data, we extract the observation times in such a way

that the durations between observations are drawn from an exponential distribution with means

1

= 6 sec and

2

= 8 sec for the two assets respectively. Therefore, on each trading day the pro-

cesses are observed at a dierent discrete unevenly spaced grid {0 = t

l

1

t

l

2

t

l

n

l

2}

for any l = 1, 2.

For the realized covariance type estimators, we generate equally-spaced continuously-compounded

returns using the previous tick method. We consider 1, 5 and 10-min sampling intervals or opti-

mally sampled realized covariances. [Bandi et al., 2006] provide an approximate formula for opti-

mal sampling, which holds for uniform synchronous data. Given our general data setting, the op-

timal sampling frequency can be obtained by direct minimization of the true mean squared error.

In order to preserve the positive deniteness of the covariance matrices, we use a unique sampling

frequency for realized variances and covariances, given by the maximum among the three optimal

frequencies. For the Fourier and AO estimators, we employ all the available data set. In imple-

menting the Fourier estimator

12

N,n

1

,n

2

, the smallest wavelength that can be evaluated in order

to avoid aliasing eects is twice the smallest distance between two consecutive prices (Nyquist

frequency). Nevertheless, as pointed out in the univariate case by [Mancino and Sanfelici, 2008a]

and conrmed in the bivariate case in [Mancino and Sanfelici, 2008b], smaller values of N may

provide better variance/covariance measures. More specically, the optimal cutting frequencies

for the various volatility measures can be obtained independently by minimizing the true MSE.

7

Although the positivity result of Proposition 2.1 is ensured only when the same N is used for

all the entries of the covariance matrix, numerical experiments show that the use of dierent

cutting frequencies N for variances and covariances still preserves positive deniteness of the

covariance matrix, both in the sample and in the forecasting horizon.

4.1 Covariance estimation and forecast

As a rst application, we perform an in-sample analysis in order to shed light on the properties

of the dierent estimators in terms of dierent statistics of the covariance estimates, such as

bias, MSE and others. More precisely, we consider the following relative error statistics

= E

_

C

12

_

2

0

12

(t)dt

_

2

0

12

(t)dt

_

, std =

_

V ar

_

C

12

_

2

0

12

(t)dt

_

2

0

12

(t)dt

__

1/2

,

which can be interpreted as relative bias and standard deviation of an estimator

C

12

for the

covariance. The Fourier and RC

opt

estimators have been optimized by choosing the cutting

frequency N of the Fourier expansion and the sampling interval on the basis of their MSE. The

results are reported in Table 1. Within each table, entries are the values of , std, MSE and bias,

using 750 Monte Carlo replications which roughly correspond to three years. Rows correspond

to the dierent estimators. The sampling interval for the realized covariance-type estimators

is indicated as a superscript. The optimal sampling frequency for RC

opt

is obtained by direct

minimization of the true MSE and corresponds to 2.33 min.

When we consider covariance estimates, the most important eect to deal with is the Epps

eect. The presence of other microstructure eects represents a minor aspect in this respect. On

the contrary, it may in some sense even compensate the eects due to non-synchronicity, as we

can see from the smaller MSE of 1-minute realized covariance estimator with respect to 5-minute

estimator. We remark that the corresponding 1-minute estimator for variances is more aected

by the presence of noise, since it is not compensated by non-synchronicity. As any estimator

based on interpolated prices, the realized covariance-type estimators suer from the Epps eect

when trading is non-synchronous, but the lead-lag correction reduces such an eect, at least in

terms of bias to the disadvantage of a slightly larger MSE. Note that the lead/lag correction

contrasts the Epps eect, thus producing occasionally positive biases. On the other hand, the

presence of noise strongly aects the AO estimator. This is due to the Poisson trading scheme

with correlated noise. In fact, the AO remains unbiased under independent noise whenever

the probability of trades occurring at the same time is zero, which is not the case for Poisson

arrivals. The Fourier estimator provides good covariance measures, both in terms of bias and

MSE. Therefore, we can conclude that contrary to the AO estimator the Fourier covariance

estimator is not much aected by the presence of noise, so that it becomes a very interesting

alternative especially when microstructure eects are particularly relevant in the available data.

Before turning to asset allocation, we evaluate the forecasting power of the dierent esti-

mators. In the tradition of [Mincer and Zarnowitz, 1969], we regress the real daily integrated

covariance over the forecasting period on one-step-ahead forecasts obtained by means of each co-

variance measure. More precisely, following [Andersen and Bollerslev, 1998], we consider a larger

sample path of 1000 days and we split it into two parts: the rst one containing 20% of total

estimates is used as a burn-in period to t a univariate AR(1) model for the estimated covari-

ance time series and then the tted model is used to forecast integrated covariance on the next

8

Method std MSE bias

RC

1min

-0.07805275472999 0.22595032210904 0.00000085621669 -0.00032576060834

RC

5min

-0.01130593672881 0.39847063473932 0.00000280603760 -0.00001894057172

RC

10min

0.01355081842814 0.54479459409222 0.00000571706029 0.00008501424105

RCLL

1min

0.01338414896851 0.32281801149180 0.00000173043743 0.00009896376793

RCLL

5min

-0.00869870282055 0.62833287597643 0.00000696972045 0.00003089840943

RCLL

10min

-0.02385652069431 0.89431477251656 0.00001491460726 -0.00003947110061

RC

opt

-0.02732364713452 0.29983219944312 0.00000150028381 -0.00008496777460

AO 0.56243149971616 0.35295341500361 0.00000366031965 0.00176446312515

Fourier -0.06518255776964 0.17089219158470 0.00000049500437 -0.00026715723226

Table 1: Relative and absolute error statistics for the in-sample covariance estimates for dierent

estimators.

day. The choice of the AR(1) model comes from [At-Sahalia and Mancini, 2007], who consider

the univariate Heston data generating process. The total number of out-of-sample forecasts m

is equal to 800. Each time a new forecast is performed, the corresponding actual covariance

measure is moved from the forecasting horizon to the rst sample and the AR(1) parameters

are re-estimated in real time. For each time series of covariance forecasts, we project the real

daily integrated covariance on day [t, t +1] on a constant and the corresponding one-step-ahead

forecast

C

t

_

t+1

t

12

(s) ds =

0

+

1

C

t

+error

t

,

where t = 1, 2, . . . , m. Alternatively, we can regress simultaneously the real daily integrated

covariance over the forecasting period on various one-step-ahead forecasts obtained by means of

dierent covariance measures. The regression now takes the form

_

t+1

t

12

(s) ds =

0

+

C

t

+

C

t

+error

t

,

where

C and

C are dierent covariance forecasts on day [t, t +1]. The R

2

from these regressions

provides a direct assessment of the variability in the integrated covariance that is explained

by the particular estimates in the regressions. The R

2

can therefore be interpreted as a simple

gauge of the degree of predictability in the volatility process and hence of the potential economic

signicance of the volatility forecasts.

The results are reported in Tables 2, 3 and 4, using a Newey-West covariance matrix. We

remark that in this simulation the Fourier estimator is not optimal in the MSE sense, but

we set N

1

= 155, N

2

= 123, N = 271 from the previous experiment. When we consider a

single regressor, the R

2

is the highest for the Fourier estimator while RCLL

10min

explains less

than ve percent of the time series variability. Moreover, for the Fourier estimator we can not

reject the hypothesis that

0

= 0 and

1

= 1 using the corresponding t tests. In contrast, we

reject the hypothesis that

0

= 0 and

1

= 1 for all the other estimators except RC

5min

and

RCLL

1min

. When we include alternative forecasts besides Fourier estimator in the regression,

the R

2

improves very little relative to the R

2

based solely on Fourier. Moreover, the coecient

estimates for

FE

are generally close to unity, while for the other estimators are near zero except

5min

for the realized covariance which diers signicantly from zero at the 5% level. Therefore,

we can conclude that the higher accuracy and lower variability of Fourier covariance estimates

9

Method R

2

F p

0

1

Fourier 0.210362 212.589597 0.000000 0.000251 0.996739

(0.000251) (0.068361)

RC

1min

0.186222 182.611691 0.000000 0.000004 1.091056

(0.000288) (0.080739)

RC

2min

0.159487 151.420599 0.000000 0.000646 0.872224

(0.000265) (0.070882)

RC

5min

0.158765 150.605610 0.000000 0.000653 0.839401

(0.000265) (0.068399)

RC

10min

0.107694 96.311707 0.000000 0.000654 0.842651

(0.000328) (0.085863)

RCLL

1min

0.155834 147.311660 0.000000 0.000824 0.781413

(0.000254) (0.064382)

RCLL

5min

0.067863 58.096974 0.000000 0.000705 0.811731

(0.000413) (0.106497)

RCLL

10min

0.041545 34.590271 0.000000 0.002408 0.364288

(0.000248) (0.061940)

AO 0.186796 183.303989 0.000000 -0.001162 0.888731

(0.000373) (0.065642)

Table 2: Regression of real integrated covariance on each covariance forecast over the forecasting

horizon. Standard deviations are listed in parenthesis.

translate into superior forecasts of future covariances and this explains the superior performance

of the Fourier forecasts.

4.2 Dynamic portfolio choice and economic gains

In this section, we consider the benet of using the Fourier estimator from the perspective of

the asset-allocation problem of Section 3.

Given any time series of daily variance/covariance estimates, we split our sample of 750

days into two parts: the rst one containing 30% of total estimates is used as a burn-in

period, while the second one is saved for out-of-sample purposes. The out-of-sample forecast is

based on univariate ARMA models. More precisely, following [At-Sahalia and Mancini, 2007],

the estimated series of 225 in-sample covariance matrices is used to t univariate AR(1) models

Method R

2

F p

0

FE

1min

5min

10min

RC 0.218 55.438 0.000 0.000064 0.762475 0.052218 0.322030 -0.098934

Std (0.000338) (0.162943) (0.199279) (0.143406) (0.145376)

T-statistics (0.188921) (4.679382) (0.262034) (2.245592) (-0.680538)

RCLL 0.212 53.448 0.000 0.000319 0.895311 0.147186 -0.052503 -0.017447

Std (0.000405) (0.119065) (0.118386) (0.177799) (0.089995)

T-statistics (0.788629) (7.519509) (1.243270) (-0.295294) (-0.193873)

Table 3: Regression of real integrated covariance on Fourier (FE) and RC/RCLL -type estimators

over the forecasting horizon. The rst panel refers to the realized covariance estimator with 1,

5, 10-min sampling, the second one to its lead/lag bias correction.

10

Method R

2

F p

0

FE

2min

AO

Others 0.2110 70.962 0.000 -0.000025 0.852102 0.030607 0.121691

Std (0.000434) (0.194413) (0.136529) (0.170537)

T-statistics (-0.056499) (4.382940) (0.224183) (0.713576)

Table 4: Regression of real integrated covariance on Fourier (FE), RC

2min

and AO estimators

over the forecasting horizon.

for each variance/covariance estimates separately. The total number of out-of-sample forecasts

m for each series is equal to 525. Each time a new forecast is performed, the corresponding

actual variance/covariance measure is moved from the forecasting horizon to the rst sample

and the AR(1) parameters are re-estimated in real time. Given sensible choices of R

f

,

p

and

t

,

each one-day-ahead variance/covariance forecast leads to the determination of a daily portfolio

weight w

t

. The time series of daily portfolio weights then leads to daily portfolio returns and

utility estimation.

We implement the criterion in (9) by setting R

f

equal to 0.03 (converted to daily values by

dividing by 250) and considering three targets

p

, namely 0.09, 0.12, 0.15. In order to concentrate

on volatility timing and abstract from issues related to expected stock return predictability, for

all times t we set the components of the vector

t

= E

t

[R

t+1

] equal to the sample means of the

returns on the risky assets over the forecasting horizon. For all times t, the conditional covariance

matrix is computed as an out-of-sample forecast based on the dierent variance/covariance

estimates.

We interpret the dierence U

C

U

Fourier

between the average utility computed on the basis

of the Fourier estimator and that based on alternative estimators

C, as the fee that the investor

would be willing to pay to switch from covariance forecasts based on estimator

C to covariance

forecasts based on the Fourier estimator. Table 5 contains the results for three levels of risk-

aversion and three target expected returns. Due to the presence of microstructure noise eects

which spoils the sum of squared high-frequency intra-day returns, besides the All-overlapping

estimator we consider the AO + RCLL

1min

estimator which is based on the AO estimator for

the covariances and on the 1-minute RCLL estimator for the variances. When the target is

0.09, the investor would pay between 0.52% (when = 2) of his portfolio return and 2.59%

(when = 10) per year to use the Fourier estimator versus the RC

1min

estimator. When the

target is 0.12, the investor would pay between 0.92% (when = 2) of his portfolio return

and 4.60% (when = 10). Finally, when the target is 0.15, the investor would pay between

1.44% (when = 2) of his portfolio return and 7.19% (when = 10). The same investor

would pay marginally less to abandon RC

5min

, according to the better in-sample properties

of this estimator for the whole covariance matrix which translate into more precise forecasts.

The remaining part of the table can be read similarly. Strikingly, the utility gain of the Fourier

estimator over the AO is very large, but this is due to the presence of microstructure eects. Even

when considering the AO + RCLL

1min

estimator, the Fourier estimator is superior, while only

a very small utility loss is encountered when considering the RCLL

1min

estimator. Notice that

the optimally sampled realized covariance estimator cannot achieve the same performance. In

particular, this evidence partially contradicts the conclusions of [De Pooter at al., 2008] about

the greater eects obtainable by a careful choice of the sampling interval rather than by bias

correction procedures.

11

Method

p

= 0.09

p

= 0.12

p

= 0.15

2 7 10 2 7 10 2 7 10

RC

1min

0.52 1.81 2.59 0.92 3.22 4.60 1.44 5.03 7.19

RC

5min

0.28 0.97 1.38 0.49 1.72 2.46 0.77 2.70 3.85

RC

10min

0.62 2.18 3.12 1.11 3.88 5.55 1.73 6.07 8.67

RCLL

1min

-0.30 -1.07 -1.52 -0.54 -1.90 -2.71 -0.85 -2.97 -4.24

RCLL

5min

1.50 5.26 7.52 2.68 9.37 13.38 4.18 14.64 20.91

RCLL

10min

1.76 6.14 8.78 3.12 10.93 15.61 4.88 17.08 24.40

RC

opt

0.004 0.01 0.02 0.007 0.02 0.04 0.01 0.04 0.06

AO 1.60 5.60 7.99 2.84 9.96 14.22 4.45 15.56 22.23

AO +RCLL

1min

0.38 1.33 1.89 0.67 2.36 3.37 1.05 3.69 5.26

Table 5: Annualized fees U

C

U

Fourier

that a mean-variance investor would be willing to pay

to switch from

C to Fourier estimates.

4.3 The statistical signicance of the economic gains

One way to assess the statistical signicance of the economic gains resulting from Table 5 is to

perform the following joint statistical test. For any target

p

and any estimator, one can dene

alternative covariance forecasts

C

t

and portfolio returns R

p(

C)

t+1

. Dene

a

C

t+1

= (R

p(Fourier)

t+1

R

p(Fourier)

)

2

(R

p(

C)

t+1

R

p(

C)

)

2

.

Assessing the statistical signicance of the economic gains of the Fourier estimate over alternative

forecasts can be conducted by testing whether the mean of a

C

t+1

is larger than (or equal to) zero

against the alternative that the mean is smaller than zero.

Following [Bandi et al., 2006], for any target return d = 0.09, 0.12, 0.15, we dene the vector

A

d

t+1

=

_

a

C

1

t+1

, a

C

2

t+1

, a

C

3

t+1

_

,

where the triple of estimators (

C

1

,

C

2

,

C

3

) is given by (RC

1min

, RC

5min

, RC

10min

), (RCLL

1min

,

RCLL

5min

, RCLL

10min

) and (RC

opt

, AO, AO+RCLL

1min

) respectively. We write the regression

model

A

d

t+1

=

d

1

3

+

t+1

,

where

d

is a scalar parameter. We perform the one-sided test H

0

:

d

0 against H

A

:

d

< 0.

The parameter

d

is estimated by GMM using a Bartlett HAC covariance matrix. The t-statistics

of all the tests imply rejection of the null and hence statistical signicance of the economic gains

at 5% level.

4.4 A small-sample Monte Carlo experiment

Another way to asses the superiority of the Fourier estimator over the others is based on the

work of [Diebold and Mariano, 1995] and consists in examining each a

C

t

time series separately in

a Monte Carlo experiment. By regressing on a constant, the null hypothesis is simply a test that

the mean of a

C

t

is zero. Therefore, a negative number is evidence in favor of better performance of

the Fourier estimator over

C. A similar approach is used also by [Engle and Colacito, 2006]. We

12

RC

1min

RC

5min

RC

10min

86 69 68

RCLL

1min

RCLL

5min

RCLL

10min

54 76 75

RC

2min

AO AO +RCLL

1min

76 99 86

Table 6: Number of times (out of 100 Monte Carlo trials) that the mean of a

C

t

has a signi-

cant negative value, i.e. the asset allocation based on the Fourier estimator has a statistically

signicant benet over the others.

explore the signicance of the proposed methods on a sample of 1000 days, with m = 800 out-

of-sample forecasts, and simulate a total of 100 samples. We allocate assets according to (8) and

run the one-sided Diebold-Mariano test in each Monte Carlo trial. In Table 6 we list the times

that the asset allocation based on the Fourier estimator has a statistically signicant benet over

the others at a 5% signicance level. We remark that in this automatic Monte Carlo experiment,

the Fourier and RC estimators have not been optimized with respect to MSE. On the contrary,

we arbitrarily x the sampling period for RC

opt

at 2 min and N

1

= 155, N

2

= 123, N = 271 for

the Fourier estimator for the two variances and the covariance respectively. The table reveals a

superiority of the Fourier procedure over all the other estimators, with a percentage of success

between 54% and 99%.

5 Conclusions

We have analyzed the gains oered by the Fourier estimator from the perspective of an asset-

allocation decision problem. The comparison is extended to realized covariance-type estimators,

to lead-lag bias corrections and to the All-Overlapping estimator.

We show that the Fourier estimator carefully extracts information from noisy high-frequency

asset price data and allows for non-negligible utility gains in portfolio management. Specically,

our simulations show that the gains yielded by the Fourier methodology are statistically signif-

icant and can be economically large, while only the realized covariance with one lead-lag bias

correction and suitable sampling frequency can be competitive.

Analyzing the in-sample and out-of-sample properties of dierent covariance measures,

we nd that the Fourier estimator provides more precise variance/covariance estimates which

translate into more precise forecasts.

References

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of quadratic variations. Working paper.

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yes, standard volatility models do provide accurate forecasts. International Economic Review,

39/4, 885905.

[Bandi et al., 2006] Bandi, F.M., Russel, J.R. and Y. Zhu (2006) Using high-frequency data in

dynamic portfolio choice. Econometric Reviews, forthcoming .

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[Barndor-Nielsen and al., 2008] Barndor-Nielsen, O.E., Hansen, P.R., Lunde, A. and Shep-

hard, N. (2008) Multivariate Realised kernels: consistent positive semi-denite estimators of

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correlations for asset allocation. Journal of Business & Economic Statistics, 24(2), 238253.

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