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Second Order Risk

  • Peter G. Shepard
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    Managing a portfolio to a risk model can tilt the portfolio toward weaknesses of the model. As a result, the optimized portfolio acquires downside exposure to uncertainty in the model itself, what we call "second order risk." We propose a risk measure that accounts for this bias. Studies of real portfolios, in asset-by-asset and factor model contexts, demonstrate that second order risk contributes significantly to realized volatility, and that the proposed measure accurately forecasts the out-of-sample behavior of optimized portfolios.

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    File URL: http://arxiv.org/pdf/0908.2455
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    Paper provided by arXiv.org in its series Papers with number 0908.2455.

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    Date of creation: Aug 2009
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    Handle: RePEc:arx:papers:0908.2455
    Contact details of provider: Web page: http://arxiv.org/

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