Random matrix theory for portfolio optimization: a stability approach

We apply random matrix theory (RMT) to an empirically measured financial correlation matrix, C, and show that this matrix contains a large amount of noise. In order to determine the sensitivity of the spectral properties of a random matrix to noise, we simulate a set of data and add different volumes of random noise. Having ascertained that the eigenspectrum is independent of the standard deviation of added noise, we use RMT to determine the noise percentage in a correlation matrix based on real data from S&P500. Eigenvalue and eigenvector analyses are applied and the experimental results for each of them are presented to identify qualitatively and quantitatively different spectral properties of the empirical correlation matrix to a random counterpart. Finally, we attempt to separate the noisy part from the non-noisy part of C. We apply an existing technique to cleaning C and then discuss its associated problems. We propose a technique of filtering C that has many advantages, from the stability point of view, over the existing method of cleaning. (C) 2003 Elsevier B.V. All rights reserved.