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Endogenous Correlations in Mean-Variance Models

Article Quant Q&A · Author: phdstudent
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Summary

The document asks whether a mean-variance framework can make asset correlations depend on investor demand instead of treating the correlation matrix as fixed input. This matters because portfolio choices and market outcomes may influence one another: demand could affect returns, and shared attention or allocation behavior could shape relationships among assets.

The answer points to a paper on mutual funds' allocation of attention as an example in which excess returns respond endogenously to attention allocation. However, the excerpt does not describe the paper's equations, explain how correlations are derived, or show empirical results. It offers a potential direction for further study rather than a complete model or practical estimation recipe, so readers would need to consult the cited research to assess the mechanism and its applicability.

Key ideas

  • The question challenges the assumption that asset correlations are fixed exogenous inputs in mean-variance models.
  • The proposed endogenous relationship would connect investor asset demand with cross-asset dependence.
  • A paper on mutual funds' attention allocation is cited as a related model where excess returns respond to attention.
  • The excerpt does not explain the model's mathematics or provide evidence for its empirical performance.

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Portfolio constructionStatisticsEquities
Full text
# Mean-variance framework with endogenous correlations


# Mean-variance framework with endogenous correlations












In most mean-variance frameworks I have seen, once we clear markets in the model, it determines asset prices (and returns). However, all of these frameworks assume that the correlation matrix of the underlying assets is given exogenously. Is there any mean-variance type model with an endogenous correlation matrix? I.e. correlations that depend on the demand of each asset of each investor ?

## Answer by Cameron Pfiffer (score 1)

https://quant.stackexchange.com/a/71347

Yep, A Rational Theory of Mutual Funds' Attention Allocation has one such example of this, where excess returns are an endogenous response to attention allocation. One of my favorite papers of all time!

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