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I use the Random Matrix Theory to filter out the information from the correlation matrix that is associated with noise - Marcenko Pastur band. That is straight forward.

Then I follow Rosenow, Bernd, et al. "Portfolio optimization and the random magnet problem." EPL (Europhysics Letters) 59.4 (2002): 500. The procedure described in the paper

It says how to reconstruct the correlation matrix with filtered eigenvalues in the original basis.

My logic: I need to diagonalise a correlation matrix C, which is symmetric, the result is a sparse matrix with eigenvalues on the diagonal. The transformation matrix Q has columns of the respective eigenvectors.

computation $D=diag(t(Q)\%*\%empCor\%*\%Q)$ yields indeed the eigenvalues, where $t()$ is transpose. So that's ok.

As the paper says I denoise the eigenvalues by setting to zero all lower than the Marcenko-Pastur band and sort the diagonal in ascending order. I also sort the respective eigenvectors (although they dont specifically say) with it.

Now I understand I need to transform the to transform the new D_hat to basis of C: I would do C_hat= Q%%D_hat%%t(Q), but it always yields one negative eigenvalue of the new matrix, and hence the new correlation matrix is no longer positive(semi) definite. I cannot figure out why it happens, because the paper does not specify there needs to be any correction done.

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I figured the problem out, if anyone ever needs it. It is based on Brian Rowe's tawny package in R

1) Work with correlation, not covariance, matrix!

2) Get eigenvalues and eigenvectors (save those)

3) Replace all eigenvalues below upper Marcenko-Pastur band with their average

4) create a diagonal matrix with the new eigenvalues. Change into old basis

$C_{hat}=Q*D_{hat}*Q^{T}$

5) Apply scaling correction $DiagM=diag(C_{hat})*o*I$ where $*o*$ is the outer product and $I$ is the unit matrix. 6) Resulting denoised matrix is

$C_{hat}=\frac{C_{hat}}{\sqrt{DiagM \times DiagM^{T}}}$, where $\times$ is the elementwise product.

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The goal is to denoise the price return data matrix $\bf{X}$ (days in rows, assets in columns) by

  1. fitting the MP density to the eigenvalues of the asset $\times$ asset correlation matrix $\bf{R}$
  2. identify the noise cuttoff, $\lambda^+$, a parameter of the MP eigendensity
  3. regress (multivariate) all of the days $\times$ 1 vectors of principal component scores associated with the noise eigenvalues on all the original assets
  4. the residuals of this regression then become the new denoised asset data file $\bf{X}^*$
  5. then determine $\bf{R}^*$ from the denoised asset data matrix $\bf{X}^*$.

This $\bf{R}^*$ matrix is then used in e.g. Markowitzian modern portfolio theory for asset weight determination.

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  • $\begingroup$ Do you have any source, please? $\endgroup$ – Jan Sila Feb 25 '18 at 14:43
  • $\begingroup$ Eq 19 in arxiv.org/abs/physics/0609053 $\endgroup$ – 4k3x9d7r Feb 26 '18 at 17:18
  • $\begingroup$ It's Eq 20 in the Arxiv.org pdf. $\endgroup$ – 4k3x9d7r Feb 26 '18 at 17:24

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