Computing the nearest correlation matrix--a problem from finance

Abstract

Given a symmetric matrix what is the nearest correlation matrix, that is, the nearest symmetric positive semidefinite matrix with unit diagonal? This problem arises in the finance industry, where the correlations are between stocks. For distance measured in two weighted Frobenius norms we characterize the solution using convex analysis. We show how the modified alternating projections method can be used to compute the solution for the more commonly used of the weighted Frobenius norms. In the finance application the original matrix has many zero or negative eigenvalues; we show that for a certain class of weights the nearest correlation matrix has correspondingly many zero eigenvalues and that this fact can be exploited in the computation.