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An Extreme Value Theory Approach To The Allocation Of Multiple Assets

Author

Listed:
  • BRENDAN O. BRADLEY

    (Department of Mathematics and Statistics, Boston University, 111 Cummington Street, Boston, MA 02215, USA)

  • MURAD S. TAQQU

    (Department of Mathematics and Statistics, Boston University, 111 Cummington Street, Boston, MA 02215, USA)

Abstract

We investigate the portfolio construction problem for risk-averse investors seeking to minimize quantile based measures of risk. Using dependence measures from extreme value theory, we find that most international equity markets are asymptotically independent. We also find that the few cases of asymptotic dependence occur mostly in markets which are in close geographic proximity. We then examine how extremal dependence affects the asset allocation problem. Following the structure variable approach, we focus on the portfolio and model its tail in a manner consistent with extreme value theory. We then develop a methodology for asset allocation where the goal is to guard against catastrophic losses. The methodology is tested through simulations and applied to portfolios made up of two or more international equity markets. We analyze in detail three typical types of markets, one where the assets are asymptotically independent and the ratio of marginal risks is not constant, the second where the assets are asymptotically independent but the ratio of marginal risks are approximately constant and the third where the assets are asymptotically dependent and the ratio of marginal risks is not constant. The results are compared with the optimal portfolio under the assumption of normally distributed returns. Surprisingly, we find that the assumption of normality incurs only a modest amount of extra risk for all but the largest losses. We make the software written in support of this work freely available and describe its use in the appendix.

Suggested Citation

  • Brendan O. Bradley & Murad S. Taqqu, 2004. "An Extreme Value Theory Approach To The Allocation Of Multiple Assets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 7(08), pages 1031-1068.
    • Handle: RePEc:wsi:ijtafx:v:07:y:2004:i:08:n:s0219024904002815
    DOI: 10.1142/S0219024904002815
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    References listed on IDEAS

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    1. Younes Bensalah, 2002. "Asset Allocation Using Extreme Value Theory," Staff Working Papers 02-2, Bank of Canada.
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    Cited by:

    1. Jin Zhang & Dietmar Maringer, 2010. "Asset Pair-Copula Selection with Downside Risk Minimization," Working Papers 037, COMISEF.
    2. Zhichao Zhang & Li Ding & Fan Zhang & Zhuang Zhang, 2015. "Optimal Currency Composition for China's Foreign Reserves: A Copula Approach," The World Economy, Wiley Blackwell, vol. 38(12), pages 1947-1965, December.
    3. Gonzalo Cortazar & Alejandro Bernales & Diether Beuermann, 2005. "Methodology and Implementation of Value-at-Risk Measures in Emerging Fixed-Income Markets with Infrequent Trading," Finance 0512030, University Library of Munich, Germany.

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