A LARGE DEVIATION APPROACH TO PORTFOLIO MANAGEMENT

Lucien Gardiol, R. Gibson (), P.-A. Bares (), R. Cont () and S. Gyger
Additional contact information
R. Gibson: Swiss Banking Institute, University of Zurich, 14 Platten strasse, 8032 Zurich, Switzerland
P.-A. Bares: Institut de Physique Théorique, École Polytechnique Fédérale de Lausanne, CH-1015 Lausanne, Switzerland
R. Cont: Institut de Physique Théorique, École Polytechnique Fédérale de Lausanne, CH-1015 Lausanne, Switzerland
S. Gyger: Institut de Physique Théorique, École Polytechnique Fédérale de Lausanne, CH-1015 Lausanne, Switzerland

International Journal of Theoretical and Applied Finance (IJTAF), 2000, vol. 03, issue 04, 617-639

Abstract: We propose a new framework to measure the risk of a single asset and of a portfolio of financial assets which takes the agent's investment horizon into account. The methodology is based on the moderate and large deviations theory in its simplest form. We show how it can be used to select optimal portfolios given investors' planning horizons and preferences for fatter right or left tails. For practical purposes, we introduce a new parameter, the "dilation exponent" α to characterize asset returns' distributions beyond the information contained in the mean-variance framework. We estimate α for Swiss individual stocks and for MSCI country and sector stock market indices. Finally, we show how to use the dilation exponent in conjunction with Sharpe's ratio for portfolio allocation purposes.

Keywords: Investment horizon; large deviation; portfolio selection; tail probabilities (search for similar items in EconPapers)
Date: 2000
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DOI: 10.1142/S0219024900000140

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