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The impact of heavy tails and comovements in downside-risk diversification

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Author Info
Jesus Gonzalo ()
Jose Olmo ()

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Abstract

This paper uncovers the factors influencing optimal asset allocation for downside-risk averse investors. These are comovements between assets, the product of marginal tail probabilities, and the tail index of the optimal portfolio. We measure these factors by using the Clayton copula to model comovements and extreme value theory to estimate shortfall probabilities. These techniques allow us to identify useless diversification strategies based on assets with different tail behaviour, and show that in case of financial distress the asset with heavier tail drives the return on the overall portfolio down. An application to financial indexes of UK and US shows that mean-variance and downside-risk averse investors construct different efficient portfolios.

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Paper provided by Universidad Carlos III, Departamento de Economía in its series Economics Working Papers with number we20070208.

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Date of creation: Feb 2007
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Handle: RePEc:cte:werepe:we20070208

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  1. Danielsson, Jon & Jorgensen, Bjorn N. & Sarma, Mandira & de Vries, Casper G., 2006. "Comparing downside risk measures for heavy tailed distributions," Economics Letters, Elsevier, vol. 92(2), pages 202-208, August. [Downloadable!] (restricted)
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  2. Bawa, Vijay S., 1975. "Optimal rules for ordering uncertain prospects," Journal of Financial Economics, Elsevier, vol. 2(1), pages 95-121, March. [Downloadable!] (restricted)
  3. Thomas Mikosch, 2005. "How to model multivariate extremes if one must?," Statistica Neerlandica, Netherlands Society for Statistics and Operations Research, vol. 59(3), pages 324-338. [Downloadable!] (restricted)
  4. Stephen A. Ross, . "Mutual Fund Separation in Financial Theory - The Separating Distributions," Rodney L. White Center for Financial Research Working Papers 1-76, Wharton School Rodney L. White Center for Financial Research.
  5. Andrew J. Patton, 2006. "Modelling Asymmetric Exchange Rate Dependence," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(2), pages 527-556, 05. [Downloadable!] (restricted)
  6. Arzac, Enrique R. & Bawa, Vijay S., 1977. "Portfolio choice and equilibrium in capital markets with safety-first investors," Journal of Financial Economics, Elsevier, vol. 4(3), pages 277-288, May. [Downloadable!] (restricted)
  7. Bawa, Vijay S, 1976. "Admissible Portfolios for All Individuals," Journal of Finance, American Finance Association, vol. 31(4), pages 1169-83, September. [Downloadable!] (restricted)
  8. Bawa, Vijay S. & Lindenberg, Eric B., 1977. "Capital market equilibrium in a mean-lower partial moment framework," Journal of Financial Economics, Elsevier, vol. 5(2), pages 189-200, November. [Downloadable!] (restricted)
  9. Yanqin Fan & Xiaohong Chen & Andrew Patton, 2004. "(IAM Series No 003) Simple Tests for Models of Dependence Between Multiple Financial Time Series, with Applications to U.S. Equity Returns and Exchange Rates," FMG Discussion Papers dp483, Financial Markets Group. [Downloadable!] (restricted)
  10. Andrew Ang & Joseph Chen & Yuhang Xing, 2006. "Downside Risk," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 19(4), pages 1191-1239. [Downloadable!] (restricted)
  11. Namwon Hyung & Casper G. de Vries, 2005. "Portfolio Diversification Effects of Downside Risk," Tinbergen Institute Discussion Papers 05-008/2, Tinbergen Institute. [Downloadable!]
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