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Optimal portfolio allocation with volatility and co-jump risk that Markowitz would like

I. Oliva and R. Renò

Journal of Economic Dynamics and Control, 2018, vol. 94, issue C, 242-256

Abstract: We study a continuous time optimal portfolio allocation problem with volatility and co-jump risk, allowing prices, variances and covariances to jump simultaneously. Differently from the traditional approach, we deviate from affine models by specifying a flexible Wishart jump-diffusion for the co-precision (the inverse of the covariance matrix). The optimal portfolio weights that solve the dynamic programming problem are genuinely dynamic and proportional to the instantaneous co-precision, reconciling optimal dynamic allocation with the static Markowitz-type economic intuition. An application to the optimal allocation problem across hedge fund investment styles illustrates the importance of having jumps in volatility associated with jumps in price.

Keywords: Asset allocation; Stochastic volatility; Co-jumps; Wishart process; Dynamic programming; Hedge funds (search for similar items in EconPapers)
JEL-codes: C61 G11 (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1016/j.jedc.2018.05.004

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Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

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