Journal of Risk

Risk.net

The most general methodology for creating a valid correlation matrix for risk management and option pricing purposes

Riccardo Rebonato and Peter Jäckel

ABSTRACT

Ad hoc correlation matrices, those calculated from incomplete data, and those taken from news services sometimes do not comply with the requirement of symmetry and positive-semidefiniteness. While it is easy to amend the symmetry requirement by manual intervention, it is not always straightforward to see how to adjust the given correlation matrix so that it can be used for factor analysis or simulation purposes. In this paper, two methods are described that can be used to best match an invalid correlation matrix given the constraint of positive-semidefiniteness.

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