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Portfolio Diversification Effects of Downside Risk

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Author Info

  • Namwon Hyung

    ()
    (Seoul City University)

  • Casper G. de Vries

    ()
    (Faculty of Economics, Erasmus Universiteit Rotterdam)

Abstract

Risk managers use portfolios to diversify away the unpriced risk of individual securities. In this article we compare the benefits of portfolio diversification for downside risk in case returns are normally distributed with the case of fat-tailed distributed returns. The downside risk of a security is decomposed into a part which is attributable to the market risk, an idiosyncratic part, and a second independent factor. We show that the fat-tailed-based downside risk, measured as value-at-risk (VaR), should decline more rapidly than the normal-based VaR. This result is confirmed empirically. This discussion paper has resulted in a publication in the Journal of Financial Econometrics . (2005, 3(1), 107-125.)

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 05-008/2.

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Date of creation: 17 Jan 2005
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Handle: RePEc:dgr:uvatin:20050008

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Web page: http://www.tinbergen.nl

Related research

Keywords: Diversification; Value-at-Risk; Decomposition;

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Cited by:
  1. Zhou, Chen, 2010. "Dependence structure of risk factors and diversification effects," Insurance: Mathematics and Economics, Elsevier, vol. 46(3), pages 531-540, June.
  2. Marco Rocco, 2011. "Extreme value theory for finance: a survey," Questioni di Economia e Finanza (Occasional Papers) 99, Bank of Italy, Economic Research and International Relations Area.
  3. DiTraglia, Francis J. & Gerlach, Jeffrey R., 2013. "Portfolio selection: An extreme value approach," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 305-323.
  4. Moore, Kyle & Sun, Pengei & de Vries, Casper G. & Zhou, Chen, 2013. "The drivers of downside equity tail risk," MPRA Paper 45591, University Library of Munich, Germany.
  5. Chen Zou, 2009. "Dependence structure of risk factors and diversification effects," DNB Working Papers 219, Netherlands Central Bank, Research Department.
  6. Tee, Kai-Hong, 2009. "The effect of downside risk reduction on UK equity portfolios included with Managed Futures Funds," International Review of Financial Analysis, Elsevier, vol. 18(5), pages 303-310, December.
  7. Moore, Kyle & Sun, Pengfei & de Vries, Casper G. & Zhou, Chen, 2013. "The cross-section of tail risks in stock returns," MPRA Paper 45592, University Library of Munich, Germany.

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