Coherent Asset Allocations with Liquidity-Adjusted Value-at-Risk Method: Review of Theoretical Algorithms and Applications

This chapter reviews the method development aspects of Al Janabi (2012) theoretical foundations and optimization algorithms for the assessment of optimum and coherent (investable) portfolios. Specifically, the chapter reviews the implementation of a robust method for commodity portfolio selection and within a liquidity-adjusted value-at-risk (LVaR) framework. The proposed optimization algorithm demonstrates that better investable portfolios can be obtained than using the traditional Markowitz’s (1952) technique. The commodity risk techniques and empirical findings are interesting in terms of theory as well as practical applications and have important implications for asset management, particularly in light of the aftermaths of the recent financial crisis. In a nutshell the advantages of the method include: (1) developed optimization algorithms can aid in advancing portfolio management in commodities and financial markets by testing for investable portfolios subject to meaningful financial and operational constraints; (2) investable commodity portfolios cannot be achieved via Markowitz’s (1952) classical portfolio approach as the empirical results indicate that investable portfolios lie off the efficient frontier; (3) the proposed modeling technique can be used by portfolio managers for the assessment of appropriate asset allocations of different investable commodity portfolios under crisis market outlooks.