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Portfolio Construction Based on Implied Correlation Information and Value at Risk

Author

Listed:
  • Jesus Rogel - Salazar

    (University of Hertfordshire)

  • Roberto Tella

    (Group Finance Treasury)

Abstract

Value at Risk (VaR) is a commonly used downside-risk measure giving the worst-case asset loss over a target horizon for a given confidence level. Implied correlation from VaR is an alternative form of the correlation coefficient calculated not only based on historic performance, but taking into account a forecast of the worst-loss. Given its importance, here we present a treatment that is accessible to undergraduate students in economics, finance and similar areas with the aim of familiarising the reader with this risk measure. With the use of three case studies we analyse the effect that implied correlation from VaR has on portfolios of increasing asset size. The VaR of each asset is calculated as well as a mean implied correlation, ρ, which is used to adjust the original portfolio’s invested fractions in order to view the shift in risk and return. We track comparative portfolios over a 50-day period to identify trends between portfolio type and risk encountered.

Suggested Citation

  • Jesus Rogel - Salazar & Roberto Tella, 2015. "Portfolio Construction Based on Implied Correlation Information and Value at Risk," EconoQuantum, Revista de Economia y Finanzas, Universidad de Guadalajara, Centro Universitario de Ciencias Economico Administrativas, Departamento de Metodos Cuantitativos y Maestria en Economia., vol. 12(1), pages 125-144, Enero-Jun.
    • Handle: RePEc:qua:journl:v:12:y:2015:i:1:p:125-144
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    More about this item

    Keywords

    Implied correlation; Value at Risk; VaR; Portfolio construction; Risk.;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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