The impact of heavy tails and comovements in downside-risk diversification
AbstractThis 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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Comovements; Copulas; Downside-risk diversification; Expected shortfall; Heavy tails; Lower partial moments; Shortfall probability;
Other versions of this item:
- Gonzalo, J. & Olmo, J., 2007. "The impact of heavy tails and comovements in downside-risk diversification," Working Papers 07/02, Department of Economics, City University London.
- Jesus Gonzalo & Jose Olmo, 2007. "The impact of heavy tails and comovements in downside-risk diversification," Economics Working Papers we20070208, Universidad Carlos III, Departamento de Economía.
- 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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