The Impact of Heavy Tails and Comovements in Downside-Risk Diversification

Jesus Gonzalo () and Jose Olmo

No 07/02, City University Economics Discussion Papers from Department of Economics, City University, London

Abstract: This paper uncovers the factors influencing optimal asset allocation for downside-risk averse investors. These are comovements between assets, the product of marginal tail probabilities, and the tail index of the optimal portfolio. We measure these factors by using the Clayton copula to model comovements and extreme value theory to estimate shortfall probabilities. These techniques allow us to identify useless diversification strategies based on assets with different tail behaviour, and show that in case of financial distress the asset with heavier tail drives the return on the overall portfolio down. An application to financial indexes of UK and US shows that mean-variance and downside-risk averse investors construct different efficient portfolios.

Keywords: Comovements; Copulas; Downside-risk diversification; Expected shortfall; Heavy tails; Lower partial moments; Shortfall probability (search for similar items in EconPapers)
JEL-codes: C1 C2 G1 (search for similar items in EconPapers)
Date: 2007-02
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Related works:
Working Paper: The impact of heavy tails and comovements in downside-risk diversification (2007)
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Persistent link: http://EconPapers.repec.org/RePEc:cty:dpaper:0702

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