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Optimal investment under multi-factor stochastic volatility

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  • Marcos Escobar
  • Sebastian Ferrando
  • Alexey Rubtsov

Abstract

We consider a model for multivariate intertemporal portfolio choice in complete and incomplete markets with a multi-factor stochastic covariance matrix of asset returns. The optimal investment strategies are derived in closed form. We estimate the model parameters and illustrate the optimal investment based on two stock indices: S&P500 and DAX. It is also shown that the model satisfies several stylized facts well known in the literature. We analyse the welfare losses due to suboptimal investment strategies and we find that investors who invest myopically, ignore derivative assets, model volatility by one factor and ignore stochastic covariance between asset returns can incur significant welfare losses.

Suggested Citation

  • Marcos Escobar & Sebastian Ferrando & Alexey Rubtsov, 2017. "Optimal investment under multi-factor stochastic volatility," Quantitative Finance, Taylor & Francis Journals, vol. 17(2), pages 241-260, February.
    • Handle: RePEc:taf:quantf:v:17:y:2017:i:2:p:241-260
    DOI: 10.1080/14697688.2016.1202440
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    Cited by:

    1. Ben-Zhang Yang & Xiaoping Lu & Guiyuan Ma & Song-Ping Zhu, 2020. "Robust Portfolio Optimization with Multi-Factor Stochastic Volatility," Journal of Optimization Theory and Applications, Springer, vol. 186(1), pages 264-298, July.
    2. Zhu, Yichen & Escobar-Anel, Marcos, 2022. "Polynomial affine approach to HARA utility maximization with applications to OrnsteinUhlenbeck 4/2 models," Applied Mathematics and Computation, Elsevier, vol. 418(C).
    3. Yichen Zhu & Marcos Escobar-Anel & Matt Davison, 2023. "A Polynomial-Affine Approximation for Dynamic Portfolio Choice," Computational Economics, Springer;Society for Computational Economics, vol. 62(3), pages 1177-1213, October.
    4. Escobar-Anel, Marcos & Rastegari, Javad & Stentoft, Lars, 2020. "Affine multivariate GARCH models," Journal of Banking & Finance, Elsevier, vol. 118(C).
    5. Junhe Chen & Marcos Escobar-Anel, 2021. "Model uncertainty on commodity portfolios, the role of convenience yield," Annals of Finance, Springer, vol. 17(4), pages 501-528, December.
    6. Ben-Zhang Yang & Xiaoping Lu & Guiyuan Ma & Song-Ping Zhu, 2019. "Robust portfolio optimization with multi-factor stochastic volatility," Papers 1910.06872, arXiv.org, revised Jun 2020.
    7. Wang, Hang & Hu, Zhijun, 2020. "Optimal consumption and portfolio decision with stochastic covariance in incomplete markets," Chaos, Solitons & Fractals, Elsevier, vol. 138(C).
    8. Marcos Escobar-Anel & Harold A. Moreno-Franco, 2019. "Dynamic portfolio strategies under a fully correlated jump-diffusion process," Annals of Finance, Springer, vol. 15(3), pages 421-453, September.
    9. Matt Davison & Marcos Escobar-Anel & Yichen Zhu, 2022. "Optimal market completion through financial derivatives with applications to volatility risk," Papers 2202.08148, arXiv.org.

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