Applications of Gaussian Processes in Finance
Authors: Rajbir S. Nirwan, Nils Bertschinger
Keywords: Gaussian Processes, Latent Variable Model, Variational Bayes, Stan, Asset Pricing, Portfolio Allocation, Finance, CAPM
TL;DR: Covariance matrix estimation of financial assets with Gaussian Process Latent Variable Models
Abstract: Estimating covariances between financial assets plays an important role in risk management. In practice, when the sample size is small compared to the number of variables, the empirical estimate is known to be very unstable. Here, we propose a novel covariance estimator based on the Gaussian Process Latent Variable Model (GP-LVM). Our estimator can be considered as a non-linear extension of standard factor models with readily interpretable parameters reminiscent of market betas. Furthermore, our Bayesian treatment naturally shrinks the sample covariance matrix towards a more structured matrix given by the prior and thereby systematically reduces estimation errors. Finally, we discuss some financial applications of the GP-LVM model.