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Foster–Hart optimal portfolios

Abhinav Anand, Tiantian Li, Tetsuo Kurosaki and Young Shin Kim

Journal of Banking & Finance, 2016, vol. 68, issue C, 117-130

Abstract: We reinvestigate the classic portfolio optimization problem where the notion of portfolio risk is captured by the “Foster–Hart risk”—a new, bankruptcy-proof, reserve based measure of risk, extremely sensitive to left tail events (Foster and Hart, 2009). To include financial market frictions induced by market microstructure, we employ a general, ex-ante transaction cost function with fixed, linear and quadratic penalty terms in the objective function. We represent the US equity market by the Dow Jones Industrial Average (DJIA) index and study the performance of the Foster–Hart optimal DJIA portfolio. In order to capture the skewed and leptokurtotic nature of real life stock returns, we model the returns of the DJIA constituents as an ARMA–GARCH process with multivariate “normal tempered stable” innovations. We demonstrate that the Foster–Hart optimal portfolio’s performance is superior to those obtained under several techniques currently in use in academia and industry.

Keywords: ARMA–GARCH model; Normal tempered stable distribution; Foster–Hart risk; Value-at-Risk (VaR); Average Value-at-Risk (AVaR); Reward risk ratio (search for similar items in EconPapers)
JEL-codes: C13 C22 C52 C61 G11 (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1016/j.jbankfin.2016.03.011

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Handle: RePEc:eee:jbfina:v:68:y:2016:i:c:p:117-130