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Second Order Risk

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  • Peter G. Shepard

Abstract

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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  • Peter G. Shepard, 2009. "Second Order Risk," Papers 0908.2455, arXiv.org.
  • Handle: RePEc:arx:papers:0908.2455
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    File URL: http://arxiv.org/pdf/0908.2455
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Model uncertainty and portfolio management
      by Economic Logician in Economic Logic on 2009-10-29 19:38:00

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    Cited by:

    1. David Stefanovits & Urs Schubiger & Mario V. W├╝thrich, 2014. "Model Risk in Portfolio Optimization," Risks, MDPI, Open Access Journal, vol. 2(3), pages 1-34, August.

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