Dependence and Risk Management

Simulating realistic correlation matrices for financial applications

The major part of observed correlation matrices in financial applications exhibits the Perron-Frobenius property, namely a dominant eigenvector with only positive entries. We present a simulation algorithm for random correlation matrices satisfying this property, which can be augmented to take into account a realistic eigenvalue structure. From the construction principle applied in our algorithm, and the fact that it is able to generate all such correlation matrices, we are further able to compute explicitly the proportion of Perron-Frobenius correlation matrices in the set of all correlation matrices in a fixed dimension.

 

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