Forecasting High-Dimensional Covariance Matrices of Asset Returns with Hybrid GARCH-LSTMs

TL;DR

This paper introduces a hybrid GARCH-LSTM model for high-dimensional covariance matrix forecasting of asset returns, demonstrating improved performance over traditional methods in portfolio optimization.

Contribution

It proposes a novel multivariate GARCH-based hybrid model combining neural networks for volatility and econometric models for correlation, addressing high-dimensional challenges.

Findings

Hybrid model outperforms equally weighted portfolios.

Adding GARCH parameters improves model accuracy.

One-hot encoding enhances neural network differentiation.

Abstract

Several academics have studied the ability of hybrid models mixing univariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models and neural networks to deliver better volatility predictions than purely econometric models. Despite presenting very promising results, the generalization of such models to the multivariate case has yet to be studied. Moreover, very few papers have examined the ability of neural networks to predict the covariance matrix of asset returns, and all use a rather small number of assets, thus not addressing what is known as the curse of dimensionality. The goal of this paper is to investigate the ability of hybrid models, mixing GARCH processes and neural networks, to forecast covariance matrices of asset returns. To do so, we propose a new model, based on multivariate GARCHs that decompose volatility and correlation predictions. The volatilities are here forecast using hybrid neural networks while correlations follow a traditional econometric process. After implementing the models in a minimum variance portfolio framework, our results are as follows. First, the addition of GARCH parameters as inputs is beneficial to the model proposed. Second, the use of one-hot-encoding to help the neural network differentiate between each stock improves the performance. Third, the new model proposed is very promising as it not only outperforms the equally weighted portfolio, but also by a significant margin its econometric counterpart that uses univariate GARCHs to predict the volatilities.