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Reducing estimation risk in optimal portfolio selection when short sales are allowed

Author

Listed:
  • Gordon J. Alexander

    (University of Minnesota, Minneapolis, MN, USA)

  • Alexandre M. Baptista

    (The George Washington University, Washington, DC, USA)

  • Shu Yan

    (University of South Carolina, Columbia, SC, USA)

Abstract

The issue of estimation risk is of particular interest to the decision-making processes of portfolio managers who use long-short investment strategies. Accordingly, our paper explores the question of whether a VaR constraint reduces estimation risk when short sales are allowed. We find that such a constraint notably decreases errors in estimates of the expected return, standard deviation, and VaR of optimal portfolios. Furthermore, optimal portfolios in the presence of the constraint are substantially closer to the 'true' efficient frontier than those in its absence. Finally, we provide VaR bounds and confidence levels for the constraint that lead to the best out-of-sample performance. Copyright © 2008 John Wiley & Sons, Ltd.

Suggested Citation

  • Gordon J. Alexander & Alexandre M. Baptista & Shu Yan, 2009. "Reducing estimation risk in optimal portfolio selection when short sales are allowed," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 30(5), pages 281-305.
  • Handle: RePEc:wly:mgtdec:v:30:y:2009:i:5:p:281-305
    DOI: 10.1002/mde.1451
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    File URL: http://hdl.handle.net/10.1002/mde.1451
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    References listed on IDEAS

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    1. Gordon J. Alexander & Alexandre M. Baptista, 2004. "A Comparison of VaR and CVaR Constraints on Portfolio Selection with the Mean-Variance Model," Management Science, INFORMS, vol. 50(9), pages 1261-1273, September.
    2. Louis K.C. Chan & Jason Karceski & Josef Lakonishok, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," NBER Working Papers 7039, National Bureau of Economic Research, Inc.
    3. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1684, August.
    4. Alexander, Gordon J. & Baptista, Alexandre M., 2002. "Economic implications of using a mean-VaR model for portfolio selection: A comparison with mean-variance analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1159-1193, July.
    5. Haim Levy, 2004. "Prospect Theory and Mean-Variance Analysis," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 1015-1041.
    6. Merton, Robert C., 1972. "An Analytic Derivation of the Efficient Portfolio Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 7(04), pages 1851-1872, September.
    7. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
    8. Pritsker, Matthew, 2006. "The hidden dangers of historical simulation," Journal of Banking & Finance, Elsevier, vol. 30(2), pages 561-582, February.
    9. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
    10. Chan, Louis K C & Karceski, Jason & Lakonishok, Josef, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 937-974.
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    Cited by:

    1. Chiang, I-Hsuan Ethan, 2015. "Modern portfolio management with conditioning information," Journal of Empirical Finance, Elsevier, vol. 33(C), pages 114-134.
    2. Robert Durand & John Gould & Ross Maller, 2011. "On the performance of the minimum VaR portfolio," The European Journal of Finance, Taylor & Francis Journals, vol. 17(7), pages 553-576.
    3. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2012. "When more is less: Using multiple constraints to reduce tail risk," Journal of Banking & Finance, Elsevier, vol. 36(10), pages 2693-2716.

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