The importance of dynamic risk constraints for limited liability operators

John Armstrong (), Damiano Brigo and Alex S. L. Tse ()
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John Armstrong: King’s College London
Alex S. L. Tse: University College London

Annals of Operations Research, 2024, vol. 336, issue 1, No 28, 898 pages

Abstract: Abstract Previous literature shows that prevalent risk measures such as value at risk or expected shortfall are ineffective to curb excessive risk-taking by a tail-risk-seeking trader with S-shaped utility function in the context of portfolio optimisation. However, these conclusions hold only when the constraints are static in the sense that the risk measure is just applied to the terminal portfolio value. In this paper, we consider a portfolio optimisation problem featuring S-shaped utility and a dynamic risk constraint which is imposed throughout the entire trading horizon. Provided that the risk control policy is sufficiently strict relative to the Sharpe ratio of the asset, the trader’s portfolio strategies and the resulting maximal expected utility can be effectively constrained by a dynamic risk measure. Finally, we argue that dynamic risk constraints might still be ineffective if the trader has access to a derivatives market.

Keywords: Dynamic risk constraints; Limited liability operators; S-shaped utility; Portfolio optimisation (search for similar items in EconPapers)
JEL-codes: D81 G11 G13 (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1007/s10479-023-05295-5

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