Downside Risk Efficiency Under Market Distress
AbstractIn moments of financial distress downside risk measures like lower partial moments are more appropriate than the standard variance to characterize risk. The goal of this paper is to study how to choose optimal portfolios in these periods. In order to do this we extend the definition of lower partial moments to this environment, derive the corresponding mean-risk dominance set and define the concept of stochastic dominance under distress. The paper shows the close connection between the mean-risk dominance set and the stochastic dominance frontier in these situations. The advantage of using stochastic dominance is that we can readily compare investors' preferences over investment portfolios in a meaningful way regardless their degree of risk aversion. We do this by proposing a hypothesis test. Our novel family of test statistics for testing stochastic dominance under distress makes allowance for testing orders of dominance higher than one, for general forms of dependence between portfolios and can be extended to residuals of regression models. These results are illustrated in an empirical application for data from US stocks. We show that mean- variance strategies are stochastically dominated by meanrisk efficient portfolios in episodes of financial distress.
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Bibliographic InfoPaper provided by Universidad Carlos III, Departamento de Economía in its series Economics Working Papers with number we094423.
Date of creation: Jun 2009
Date of revision:
Downside risk; Lower partial moments; Market distress; Mean-risk models; Mean-variance models; Stochastic dominance;
Other versions of this item:
- Gonzalo, Jesús & Olmo, José, . "Downside Risk Efficiency Under Market Distress," Open Access publications from Universidad Carlos III de Madrid info:hdl:10016/4870, Universidad Carlos III de Madrid.
- C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
- C2 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables
- G1 - Financial Economics - - General Financial Markets
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