Portfolio Selection Under Systemic Risk

Weidong Lin, Jose Olmo and Abderrahim Taamouti

No 202208, Working Papers from University of Liverpool, Department of Economics

Abstract: This paper proposes a novel methodology to construct optimal portfolios that explicitly incorporates the occurrence of systemic events. Investors maximize a modified Sharpe ratio that is conditional on a systemic event, with the latter interpreted as a low market return environment. We solve the portfolio allocation problem analytically under the absence of short-selling restrictions and numerically when shortselling restrictions are imposed. This approach for obtaining an optimal portfolio allocation is made operational by embedding it in a multivariate dynamic setting using dynamic conditional correlation and copula models. We evaluate the outof-sample performance of our portfolio empirically on the US stock market over the period 2007 to 2020 using ex-post final wealth paths and systemic risk metric against mean-variance, equally-weighted, and global minimum variance portfolios. Our portfolio maximizing a modified Sharpe ratio outperforms all competitors under market distress and remains competitive in non-crisis periods.

Keywords: conditional volatility models; portfolio allocation; Sharpe ratio; systemic risk; conditional tail risk (search for similar items in EconPapers)
Pages: 59 pages
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:liv:livedp:202208

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