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Black-Litterman Asset Allocation under Hidden Truncation Distribution

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  • Jungjun Park
  • Andrew L. Nguyen

Abstract

In this paper, we study the Black-Litterman (BL) asset allocation model (Black and Litterman, 1990) under the hidden truncation skew-normal distribution (Arnold and Beaver, 2000). In particular, when returns are assumed to follow this skew normal distribution, we show that the posterior returns, after incorporating views, are also skew normal. By using Simaan three moments risk model (Simaan, 1993), we could then obtain the optimal portfolio. Empirical data show that the optimal portfolio obtained this way has less risk compared to an optimal portfolio of the classical BL model and that they become more negatively skewed as the expected returns of portfolios increase, which suggests that the investors trade a negative skewness for a higher expected return. We also observe a negative relation between portfolio volatility and portfolio skewness. This observation suggests that investors may be making a trade-off, opting for lower volatility in exchange for higher skewness, or vice versa. This trade-off indicates that stocks with significant price declines tend to exhibit increased volatility.

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  • Jungjun Park & Andrew L. Nguyen, 2023. "Black-Litterman Asset Allocation under Hidden Truncation Distribution," Papers 2310.12333, arXiv.org.
    • Handle: RePEc:arx:papers:2310.12333
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    References listed on IDEAS

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    1. Carmichael, Benoıˆt & Coën, Alain, 2013. "Asset pricing with skewed-normal return," Finance Research Letters, Elsevier, vol. 10(2), pages 50-57.
    2. Rama Cont & Romain Deguest & Giacomo Scandolo, 2010. "Robustness and sensitivity analysis of risk measurement procedures," Quantitative Finance, Taylor & Francis Journals, vol. 10(6), pages 593-606.
    3. Rama Cont & Romain Deguest & Giacomo Scandolo, 2010. "Robustness and sensitivity analysis of risk measurement procedures," Post-Print hal-00413729, HAL.
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