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

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  • Gonzalo, J.
  • Olmo, J.

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 Department of Economics, City University London in its series Working Papers with number 07/02.

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Date of creation: 2007
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Handle: RePEc:cty:dpaper:07/02

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Postal: Department of Economics, Social Sciences Building, City University London, Whiskin Street, London, EC1R 0JD, United Kingdom,
Phone: +44 (0)20 7040 8500
Web page: http://www.city.ac.uk
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  2. Andrew Patton, 2004. "Modelling Asymmetric Exchange Rate Dependence," Working Papers wp04-04, Warwick Business School, Finance Group.
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  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.
  9. Bawa, Vijay S, 1976. "Admissible Portfolios for All Individuals," Journal of Finance, American Finance Association, vol. 31(4), pages 1169-83, September.
  10. 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.
  11. Jon Danielsson & Bjørn N. Jorgensen & Mandira Sarma & C. G. de Vries, 2005. "Comparing downside risk measures for heavy tailed distribution," LSE Research Online Documents on Economics 24671, London School of Economics and Political Science, LSE Library.
  12. Juri, Alessandro & Wuthrich, Mario V., 2002. "Copula convergence theorems for tail events," Insurance: Mathematics and Economics, Elsevier, vol. 30(3), pages 405-420, June.
  13. Harlow, W. V. & Rao, Ramesh K. S., 1989. "Asset Pricing in a Generalized Mean-Lower Partial Moment Framework: Theory and Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 285-311, September.
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