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Forward-looking robust portfolio selection

Author

Listed:
  • Sara Cecchetti

    () (Bank of Italy)

  • Laura Sigalotti

    () (Bank of Italy)

Abstract

In this paper we develop a portfolio optimization strategy based on the extraction of option-implied distributions and the application of robust asset allocation. We compute the option-implied probability density functions of the constituents of the Euro Stoxx 50 Index. To obtain the corresponding risk-adjusted densities, we estimate the risk aversion coefficient through a Berkowitz likelihood test. The correlation structure among the stocks is computed via an ad hoc technique, which provides a correction term for the historical correlations. We implement a robust portfolio construction, in order to incorporate the uncertainty about the estimation error for the expected returns in the optimization procedure.

Suggested Citation

  • Sara Cecchetti & Laura Sigalotti, 2013. "Forward-looking robust portfolio selection," Temi di discussione (Economic working papers) 913, Bank of Italy, Economic Research and International Relations Area.
  • Handle: RePEc:bdi:wptemi:td_913_13
    as

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    File URL: http://www.bancaditalia.it/pubblicazioni/temi-discussione/2013/2013-0913/en_tema_913.pdf
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    References listed on IDEAS

    as
    1. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
    2. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-651, October.
    3. Berkowitz, Jeremy, 2001. "Testing Density Forecasts, with Applications to Risk Management," Journal of Business & Economic Statistics, American Statistical Association, vol. 19(4), pages 465-474, October.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    5. Adrian Buss & Grigory Vilkov, 2012. "Measuring Equity Risk with Option-implied Correlations," Review of Financial Studies, Society for Financial Studies, vol. 25(10), pages 3113-3140.
    6. Robert R. Bliss & Nikolaos Panigirtzoglou, 2004. "Option-Implied Risk Aversion Estimates," Journal of Finance, American Finance Association, vol. 59(1), pages 407-446, February.
    7. Engle, Robert, 2002. "Dynamic Conditional Correlation: A Simple Class of Multivariate Generalized Autoregressive Conditional Heteroskedasticity Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 339-350, July.
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    Cited by:

    1. Michele Leonardo Bianchi & Gian Luca Tassinari, 2018. "Forward-looking portfolio selection with multivariate non-Gaussian models and the Esscher transform," Papers 1805.05584, arXiv.org, revised May 2018.

    More about this item

    Keywords

    portfolio allocation; robust optimization; implied correlation; stock options;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics

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