Rationalization of Investment Preference Criteria

Jacques Pézier
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Jacques Pézier: ICMA Centre, Henley Business School,University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: The majority of risk adjusted performance measures (RAPM) currently in use - e.g., Treynor ratio, (α/β)) ratio, Omega index, RoVaR, 'coherent' preference criteria, etc. - are incompat- ible with any sensible utility function and would be best avoided. We argue instead for the assessment of a maximum certainty equivalent excess return (CER*) criterion, or equivalent criteria, adapted to investment circumstances: alternative investments, return forecasts, and risk attitude. We explain the assessment of CER*s and give three applications: performance comparisons among traditional and alternative funds, optimal design of structured products, and explanation of the credit risk premium puzzle.

Keywords: Certainty equivalent return; risk-adjusted performance measure; risk aversion; HARA utility functions; coherent risk measures; spectral indices; Sharpe ratio; generalized Sharpe ratio; information ratio; Treynor ratio; Jensen alpha; skewness; kurtosis; volatility skew; optimal structured products; credit risk premium. (search for similar items in EconPapers)
JEL-codes: D80 D81 G10 G11 G13 (search for similar items in EconPapers)
Date: 2011-07
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