Tail Risk and Robust Portfolio Decisions

Xing Jin (), Dan Luo () and Xudong Zeng ()
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Xing Jin: Department of Mathematical Finance, Tianjin University of Finance and Economics, Tianjin 300222, China
Dan Luo: School of Finance, Shanghai University of Finance and Economics, Shanghai 200433, China; Shanghai Key Laboratory of Financial Information Technology, Shanghai 200433, China
Xudong Zeng: School of Finance, Shanghai University of Finance and Economics, Shanghai 200433, China; Institute of Scientific Computation and Financial Data Analysis, Shanghai University of Finance and Economics, Shanghai 200433, China

Management Science, 2021, vol. 67, issue 5, 3254-3275

Abstract: This paper formulates a portfolio choice problem in a multiasset incomplete market characterized by ambiguous jumps and arbitrary tail assumptions. We derive the optimal portfolio in closed form through a decomposition approach. We show that, due to fear of tail incidents, an investor diminishes portfolio diversification, and even more so under heavy-tailed jumps that intensify misspecification concerns. We then implement our model in international equity markets to quantify the impact of tail risk on portfolio selection, through comparisons between a normal and a slowly decaying jump size distribution. We find that, without jump ambiguity, constant relative risk aversion (CRRA) investors increase their jump exposures merely slightly and suffer negligible wealth losses from underestimating tail risk, given that the first two moments of the jump size distributions are preserved regardless of the tail properties. In stark contrast, sizable portfolio rebalancing and subsequent wealth losses are encountered in the presence of jump ambiguity.

Keywords: tail risk; jump ambiguity; robust decisions; portfolio selection (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (2)

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