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Model Risk in Portfolio Optimization

Author

Listed:
  • David Stefanovits

    () (RiskLab, Department of Mathematics, ETH Zurich, 8092 Zurich, Switzerland)

  • Urs Schubiger

    () (1741 Asset Management Ltd, Multergasse 1-3, 9000 St. Gallen, Switzerland)

  • Mario V. Wüthrich

    () (RiskLab, Department of Mathematics, ETH Zurich, 8092 Zurich, Switzerland
    Swiss Finance Institute SFI Professor, 8006 Zurich, Switzerland)

Abstract

We consider a one-period portfolio optimization problem under model uncertainty. For this purpose, we introduce a measure of model risk. We derive analytical results for this measure of model risk in the mean-variance problem assuming we have observations drawn from a normal variance mixture model. This model allows for heavy tails, tail dependence and leptokurtosis of marginals. The results show that mean-variance optimization is seriously compromised by model uncertainty, in particular, for non-Gaussian data and small sample sizes. To mitigate these shortcomings, we propose a method to adjust the sample covariance matrix in order to reduce model risk.

Suggested Citation

  • David Stefanovits & Urs Schubiger & Mario V. Wüthrich, 2014. "Model Risk in Portfolio Optimization," Risks, MDPI, Open Access Journal, vol. 2(3), pages 1-34, August.
  • Handle: RePEc:gam:jrisks:v:2:y:2014:i:3:p:315-348:d:38890
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    portfolio optimization; asset allocation; model risk; estimation uncertainty; covariance estimation;

    JEL classification:

    • C - Mathematical and Quantitative Methods
    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M2 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics
    • M4 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting
    • K2 - Law and Economics - - Regulation and Business Law

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