Sharpe Ratio Maximization And Expected Utility When Asset Prices Have Jumps
We analyze portfolio strategies which are locally optimal, meaning that they maximize the Sharpe ratio in a general continuous time jump-diffusion framework. These portfolios are characterized explicitly and compared to utility based strategies. We show that in the presence of jumps, maximizing the Sharpe ratio is generally inconsistent with maximizing expected utility, in the sense that a utility maximizing individual will not choose a strategy which has a maximal Sharpe ratio. This result will hold unless markets are incomplete or jump risk has no risk premium. In case of an incomplete market we show that the optimal portfolio of a utility maximizing individual may "accidentally" have maximal Sharpe ratio. Furthermore, if there is no risk premium for jump risk, a utility maximizing investor may select a portfolio having a maximal Sharpe ratio, if jump risk can be hedged away. We note that uncritical use of the Sharpe ratio as a performance measure in a world where asset prices exhibit jumps may lead to unreasonable investments with positive probability of ruin.
Volume (Year): 10 (2007)
Issue (Month): 08 ()
|Contact details of provider:|| Web page: http://www.worldscinet.com/ijtaf/ijtaf.shtml |
|Order Information:|| Email: |
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Lars Peter Hansen & Ravi Jagannathan, 1990.
"Implications of security market data for models of dynamic economies,"
Discussion Paper / Institute for Empirical Macroeconomics
29, Federal Reserve Bank of Minneapolis.
- Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
- Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
- John H. Cochrane & Jesús Saá-Requejo, 1998.
"Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets,"
CRSP working papers
430, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- John H. Cochrane & Jesus Saa-Requejo, 2000. "Beyond Arbitrage: Good-Deal Asset Price Bounds in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 79-119, February.
- John H. Cochrane & Jesus Saa-Requejo, 1996. "Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets," NBER Working Papers 5489, National Bureau of Economic Research, Inc.
- Eckhard Platen, 2004. "Capital Asset Pricing for Markets with Intensity Based Jumps," Research Paper Series 143, Quantitative Finance Research Centre, University of Technology, Sydney.
- James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
- Morten Christensen & Eckhard Platen, 2004. "A General Benchmark Model for Stochastic Jump Sizes," Research Paper Series 139, Quantitative Finance Research Centre, University of Technology, Sydney.
- Schweizer, Martin, 1992. "Martingale densities for general asset prices," Journal of Mathematical Economics, Elsevier, vol. 21(4), pages 363-378.
- Martin Kulldorff & Ajay Khanna, 1999. "A generalization of the mutual fund theorem," Finance and Stochastics, Springer, vol. 3(2), pages 167-185.
- Merton, Robert C., 1971.
"Optimum consumption and portfolio rules in a continuous-time model,"
Journal of Economic Theory,
Elsevier, vol. 3(4), pages 373-413, December.
- R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
- Back, Kerry, 1991. "Asset pricing for general processes," Journal of Mathematical Economics, Elsevier, vol. 20(4), pages 371-395.
- Holger Kraft & Mogens Steffensen, 2005. "How to Invest Optimally in Corporate Bonds: A Reduced-Form Approach," FRU Working Papers 2005/07, University of Copenhagen. Department of Economics. Finance Research Unit.
- Nielsen, Lars Tyge & Vassalou, Maria, 2004. "Sharpe Ratios and Alphas in Continuous Time," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(01), pages 103-114, March.
When requesting a correction, please mention this item's handle: RePEc:wsi:ijtafx:v:10:y:2007:i:08:p:1339-1364. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Tai Tone Lim)
If references are entirely missing, you can add them using this form.