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Portfolio optimization under the generalized hyperbolic distribution: optimal allocation, performance and tail behavior

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  • John R. Birge
  • L. Chavez-Bedoya

Abstract

In this paper, we analyze the asset allocation problem under the generalized hyperbolic (GH) distribution of returns and exponential utility. We provide closed-form expressions to compute the optimal portfolio weights; and we introduce two new measures, associated with a more general mean-risk trade-off, that allow us to express the optimal solution as an affine combination of two efficient portfolios: one minimizing risk and the other maximizing mean given a particular level of risk. Also, we prove that optimal portfolio performance is not monotonic in tail behavior since it increases when tails become lighter or heavier with respect to a particular threshold; however, distributions with heavier tails produce more conservative allocations in terms of the weight given to the minimum-risk portfolio increments. Finally, the practical relevance of our paper show that tail behavior greatly affects portfolio construction and performance, and that including non-normality features of short-term asset returns, through a GH distribution, has the potential to significantly improve the investor's certainty equivalent excess return.

Suggested Citation

  • John R. Birge & L. Chavez-Bedoya, 2021. "Portfolio optimization under the generalized hyperbolic distribution: optimal allocation, performance and tail behavior," Quantitative Finance, Taylor & Francis Journals, vol. 21(2), pages 199-219, February.
  • Handle: RePEc:taf:quantf:v:21:y:2021:i:2:p:199-219
    DOI: 10.1080/14697688.2020.1762913
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