Hidden noise structure and random matrix models of stock correlations

Abstract

We find a novel correlation structure in the residual noise of stock market returns that is remarkably linked to the composition and stability of the top few significant factors driving the returns, and, moreover, indicates that the noise band is composed of multiple sub-bands that do not fully mix. Our findings allow us to construct effective generalized random matrix theory market models that are closely related to correlation and eigenvector clustering. We show how to use these models in a simulation that incorporates heavy tails. Finally, we demonstrate how a subtle purely stationary risk estimation bias can arise in the conventional cleaning prescription.

Keywords:

• Random matrix theory
• Clustering
• Stock return cross correlations
• PCA
• Residual risk bias
• Participation ratio
• TAQ

Acknowledgements

We would like to thank Marco Avellaneda and Jim Gatheral for their insightful comments and discussions.

Notes

†We have performed all the necessary tests (Bouchaud and Potters 2003) to ensure that the marginal 2 min mid-quote returns have no residual autocorrelations.