Constructing Bayesian tangency portfolios under short-selling restrictions

Olha Bodnar, Taras Bodnar and Vilhelm Niklasson

Finance Research Letters, 2024, vol. 62, issue PA

Abstract: We address the challenge of constructing tangency portfolios in the context of short-selling restrictions. Utilizing Bayesian techniques, we reparameterize the asset return model, enabling direct determination of priors for the tangency portfolio weights. This facilitates the integration of non-negative weight constraints into an investor’s prior beliefs, resulting in a posterior distribution focused exclusively on non-negative values. Portfolio weight estimators are subsequently derived via the Markov Chain Monte Carlo (MCMC) methodology. Our novel Bayesian approach is empirically illustrated using the most significant stocks in the S&P 500 index. The method showcases promising results in terms of risk-adjusted returns and interpretability.

Keywords: Bayesian inference; Tangency portfolio; MCMC; Parameter uncertainty (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:62:y:2024:i:pa:s1544612324000953

DOI: 10.1016/j.frl.2024.105065

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