) CORTEZ’S STATEMENT TO USE THE WORK OF BOTH FIRMS TO DETERMINE A COVARIANCE ESTIMATE IS MOST LIKELY AN EXAMPLE OF

4.) Cortez’s statement to use the work of both firms to determine a covariance estimate is

most likely an example of:

A.

a prudence trap.

B.

a shrinkage estimate.

C.

nonstationarity.

Answer =B

Cortez’s statement to calculate a weighted average for the covariance estimate is an

example of shrinkage estimation. Shrinkage estimation involves taking a weighted

average of a historical estimate of a parameter and some other parameter estimate, in

which the weights reflect the analyst’s relative belief in the estimates. A shrinkage

estimator of the covariance matrix is a weighted average of the historical covariance

matrix and an alternative estimator of the covariance matrix.

“Capital Market Expectations,” by John P. Calverley, Alan M. Meder, Brian D. Singer,

and Renato Staub

Sections 2.2.3, 2.2.8, 3.1.1.2