Projected Dynamic Conditional Correlations

Open Access       

Authors: Jordi Llorens-Terrazas and Christian Brownlees

International Journal of Forecasting, Vol. 39, No 4, 1761-1776, October, 2023

We propose a novel specification of the Dynamic Conditional Correlation (DCC) model based on an alternative normalization of the pseudo-correlation matrix called Projected DCC (Pro-DCC). Our modification consists in projecting, rather than rescaling, the pseudo-correlation matrix onto the set of correlation matrices in order to obtain a well defined conditional correlation matrix. A simulation study shows that projecting performs better than rescaling when the dimensionality of the correlation matrix is large. An empirical application to the constituents of the S&P 100 shows that the proposed methodology performs favorably to the standard DCC in an out-of-sample asset allocation exercise.