Fat Tails and the Effect on Optimal Asset Allocations

Andre Lucas and Pieter Klaassen

Chapter 14 in Bank Strategies and Challenges in the New Europe, 2001, pp 272-288 from Palgrave Macmillan

Abstract: Abstract In investment management problems one often uses scenarios to determine optimal strategies and to quantify the uncertainty associated with these strategies. Such scenarios are mostly based on the assumption of normality for variables like asset returns, inflation rates and interest rates. Financial economic time series often display leptokurtic behaviour, implying that the assumption of normality may be inappropriate. In this chapter we use a simple asset allocation problem with one shortfall constraint in order to uncover the main consequences of non-normal distributions on optimal asset allocations. It is found that the probability of shortfall plays a crucial role in determining the effect of fat tails on optimal asset allocations. Depending on this probability, the presence of fat tails may lead to either more aggressive or more prudent asset mixes. We also examine the effect of misspecification of the degree of leptokurtosis. Using distributions with an incorrect tail behaviour may lead to portfolios with a minimum return that is up to 418 basis points below the minimum return imposed in the model. In value-at-risk calculations, this implies that the true value-at-risk may deviate by more than 4 per cent (as a fraction of the invested notional) from what an incorrectly specified model suggests.

Keywords: Asset Return; Scenario Generator; Asset Allocation; Investment Manager; Precision Matrix (search for similar items in EconPapers)
Date: 2001
References: Add references at CitEc
Citations:

There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:pal:palchp:978-0-333-99276-0_14

Ordering information: This item can be ordered from
http://www.palgrave.com/9780333992760

DOI: 10.1057/9780333992760_14

Access Statistics for this chapter

More chapters in Palgrave Macmillan Books from Palgrave Macmillan
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().