Taming large events: portfolio selection for strongly fluctuating assets

Jean-Philippe Bouchaud, Didier Sornette, Christian Walter and Jean-Pierre Aguilar
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Jean-Philippe Bouchaud: Science & Finance, Capital Fund Management
Didier Sornette: UCLA
Jean-Pierre Aguilar: Science & Finance, Capital Fund Management

No 500044, Science & Finance (CFM) working paper archive from Science & Finance, Capital Fund Management

Abstract: We propose a method of optimization of asset allocation in the case where the stock price variations are supposed to have "fat" tails represented by power laws. Generalizing over previous works using stable Lévy distributions, we distinguish three distinct components of risk described by three different parts of the distributions of price variations: unexpected gains (to be kept), harmless noise inherent to financial activity, and unpleasant losses, which is the only component one would like to minimize. The independent treatment of the tails of distributions for positive and negative variations and the generalization to large events of the notion of covariance of two random variables provide explicit formulae for the optimal portfolio. The use of the probability of loss (or equivalently the Value-at-Risk), as the key quantity to study and minimize, provides a simple solution to the problem of optimization of asset allocations in the general case where the characteristic exponents are different for each asset.

JEL-codes: G10 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin and nep-rmg
Date: 1998-01
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Published in International Journal of Theoretical and Applied Finance 1, 25, (1998)

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Persistent link: http://EconPapers.repec.org/RePEc:sfi:sfiwpa:500044

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