Systemic Risk-Driven Portfolio Selection
Agostino Capponi, Alexey Rubtsov
Operations Research · 2022 · Volume 70 · Issue 3
Abstract
We consider an investor who trades off tail risk and expected growth of the investment. We measure tail risk through the portfolio’s expected losses conditioned on the occurrence of a systemic event: financial market loss being exactly at, or at least at, its value-at-risk (VaR) level and investor’s portfolio losses being above their conditional value-at-risk (CoVaR) level. We decompose the solution to the investment problem in terms of the Markowitz mean-variance portfolio and an adjustment for systemic risk. We show that VaR and CoVaR confidence levels control the relative sensitivity of the investor’s objective function to portfolio-market correlation and portfolio variance, respectively. Our empirical analysis demonstrates that the investor attains higher risk-adjusted returns, compared with well-known benchmark portfolio criteria, during times of market downturn. Portfolios that perform best under adverse market conditions are less diversified and invest on a few stocks that have low correlation with the market.
Keywords
Financial Engineering, systemic risk, portfolio selection, risk management, VaR, CoVaR, risk-adjusted returns
Enable JavaScript for citation tools and additional paper interactions.