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Dynamic Correlation or Tail Dependence Hedging for Portfolio Selection

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  • Redouane Elkamhia

    (University of Iowa, Henry B. Tippie College of Business)

  • Denitsa Stefanova

    (VU University Amsterdam, and Duisenberg School of Finance)

Abstract

We solve for the optimal portfolio allocation in a setting where both conditional correlation and theclustering of extreme events are considered. We demonstrate that there is a substantial welfare loss indisregarding tail dependence, even when dynamic conditional correlation has been accounted for, andvice versa. Both effects have distinct portfolio implications and cannot substitute each other. We alsoisolate the hedging demands due to macroeconomic and market conditions that command importanteconomic gains. Our results are robust to the sample period, the choice of the dependence structure,and both varying levels of average correlation and tail dependence coefficients.

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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 11-028/2/DSF10.

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Date of creation: 11 Feb 2011
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Handle: RePEc:dgr:uvatin:20110028

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

Related research

Keywords: correlation hedging; dynamic portfolio allocation; Monte Carlo simulation; tail dependence;

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