Volatility vs. downside risk: optimally protecting against drawdowns and maintaining portfolio performance

Diana Barro (), Elio Canestrelli and Fabio Lanza
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Diana Barro: Department of Economics, University Of Venice C� Foscari
Fabio Lanza: Department of Economics, University Of Venice C� Foscari

No 2014:18, Working Papers from Department of Economics, University of Venice "Ca' Foscari"

Abstract: As a consequence of recent market conditions an increasing number of investors are realizing the importance of controlling tail risk to reduce drawdowns thus increasing possibilities of achieving long-term objectives. Recently, so called volatility control strategies and volatility target approaches to investment have gained a lot of interest as strategies able to mitigate tail risk and produce better risk-adjusted returns. Essentially these are rule-based backward looking strategies in which no optimization is considered. In this contribution we focus on the role of volatility in downside risk reduction and, in particular, in tail risk reduction. The first contribution of our paper is to provide a viable way to integrate a target volatility approach, into a multiperiod portfolio optimization model, through the introduction of a local volatility control approach. Our optimized volatility control is contrasted with existing rule-based target volatility strategies, in an out-of sample simulation on real data, to assess the improvement that can be obtained from the optimization process. A second contribution of this work is to study the interaction between volatility control and downside risk control. We show that combining the two tools we can enhance the possibility of achieving the desired performance objectives and, simultaneously, we reduce the cost of hedging. The multiperiod portfolio optimization problem is formulated in a stochastic programming framework that provides the necessary flexibility for dealing with different constraints and multiple sources of risk.

Keywords: Volatility; tail risk; stochastic programming; risk management. (search for similar items in EconPapers)
JEL-codes: C61 C63 D8 (search for similar items in EconPapers)
Pages: 28
Date: 2014
New Economics Papers: this item is included in nep-ore and nep-rmg
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