Diss. ETH No.

16514

Optimal Portfolio Construction and Active Portfolio Management

Including Alternative Investments

A dissertation submitted to the SWISS FEDERAL INSTITUTE OF TECHNOLOGY ZURICH

for the degree of Doctor of Technical Sciences

presented by Simon Theodor Keel Dipl. Masch.-Ing. ETH born 26 January 1976 citizen of Rebstein, SG ISBN: 978-3-906483-10-8 accepted on the recommendation of Prof. Dr. H. P. Geering, IMRT PRESS c/o Measurement and Control Laboratory ETH Zentrum, ML examiner Prof. Dr. A. J. McNeil, coSonneggstr. 3 CH-8092 Zurich examiner Prof. Dr. D. B. Madan, co-examiner 2006

Acknowledgements

This research was carried out at the Measurement and Control Laboratory (IMRT) at the ETH Zurich, Switzerland from December 2002 to January 2006. The condence and support of my supervisor, Prof. Dr. H. P. Geering, is gratefully acknowledged. Furthermore, I would like to thank Prof. Dr. A. J. McNeil, ETH Zurich, and Prof. Dr. D. B. Madan, University of Maryland, for accepting to be my coexaminers. I am indebted to the members of the Financial Control Group at the IMRT, Dr. Gabriel Dondi and Dr. Florian Herzog, who supported me throughout my work. Their help and support during the whole thesis is greatly appreciated. I am particularly grateful to Dr. Lorenz Schumann for the challenging discussions, which were of invaluable help and always encouraging. I would also like to thank the entire sta of the Measurement and Control Laboratory, especially Mikael Bianchi. Finally, my thanks go to my parents who helped me in every possible way throughout my time at the ETH. Last but not least, I would like to express my sincerest gratitude to Sonja for all her wonderful support and encouragement.

Zurich, May 2006

Abstract

One aspect of nancial engineering is the development of portfolio management strategies. The research eld of optimal stochastic control is well suited for the derivation of these strategies in a dynamic environment. It is the aim of this work to explore and extend optimal portfolio construction techniques currently found in the literature. A special emphasis is given to alternative investments. In order to derive an optimal asset allocation strategy, a risk measure has to be introduced and the asset price dynamics have to be modeled. This results in dynamic optimal control problems, which are well studied in control engineering. However, the main emphasis of control engineering is given to deterministic models. Since the prices of nancial assets are predominantly driven by randomness, the concepts and techniques of control engineering have to be extended to the stochastic case. The rst step of the elaboration of an asset allocation strategy is the denition of the risk measure. However, not all risk measures are well suited for the derivation of optimal asset allocation strategies. Therefore, the terms coherent and convex risk measures are discussed in detail. For the modeling of asset prices, the statistical properties of asset returns have to be taken into account. Several distributions are investigated which are better suited than the typically found normal distribution. Since the literature is mainly concerned with the univariate case, special consideration is given to the multivariate case. It is found that the distribution called generalized hyperbolic and some of its limiting cases yield much more realistic models of asset returns than the normal distribution. In addition to parametric distributions, semi-parametric models including elliptical copulas are analyzed. Particularly, the event of concurrent extreme losses of dierent nancial assets is considered.

This work includes an in-depth study of alternative investments. Special

consideration is given to their statistical properties. Hedge funds make use of dynamic asset allocation

strategies and may have a large investment universe. Therefore, hedge funds need
special attention with respect to risk management. The specic structure and properties of hedge funds are elaborated and discussed. The process of investing in hedge funds is analyzed in detail. A wide range of dierent statistical properties among the dierent hedge funds styles is found. Therefore, a universal treatment of hedge fund returns as such is not possible. Following the analysis of the static and dynamic statistical properties of asset returns, optimal asset allocation strategies are derived. At rst, a framework of continuous-time stochastic dierential equations is considered. The stochastic dierential equations are driven by Brownian motion. Again, alternative investments are analyzed in particular. A closed-form solution of an investment strategy with common asset classes is derived. Furthermore, the optimal asset allocation is investigated for the case in which the asset price models contain unknown parameters or processes. It is shown that this problem can be transformed into one in which all parameters and processes are measurable. The properties of the Kalman lter are used for the derivation. The results of these theoretical investigations are tested in a detailed case study including alternative investments. Finally, the topic of active portfolio management is discussed. The importance of the benchmark for active portfolio management is highlighted. A deeper systematic treatment of active portfolio management has not been carried out because there exist neither a generally accepted terminology nor a unied framework for comparing dierent strategies. A specic active portfolio management problem is presented as well as a procedure for obtaining a solution for a single-period and a multi-period formulation. The single-period solution is backtested with historical data. The very last part of this work considers the use of Levy processes for the construction of optimal portfolios. The multivariate Levy measures of the generalized hyperbolic Levy process and its limiting cases are presented and derived for one limiting case. The work concludes with the presentation of optimal portfolio strategies derived with Levy processes.

Zusammenfassung

Portfolio

Management

ist

ein

wichtiger

Aspekt

des

Fachgebietes

Financial

Engineering. Die optimale, stochastische Regelung bietet die hierfur notwendigen mathematischen Grundlagen. Ziel dieser Arbeit ist es, die momentan in der Literatur vorhandenen Techniken fur die Portfolio Konstruktion zu erweitern. Im speziellen werden alternative Anlagen untersucht. Um optimale Portfolio Management

Strategien herzuleiten, muss vorab ein Risikomass bestimmt und die Dynamik der Preise der Anlagemoglichkeiten modelliert werden. Hieraus ergeben sich optimale Regelungsprobleme, welche im entsprechenden Fachgebiet bereits grundlich erforscht wurden. Leider sind aber viele Resultate nur fur den deterministischen Fall gefunden worden. Da aber bei Finanzproblemen die betrachteten Systeme

hauptsachlich vom Zufall getrieben werden, mussen die Konzepte auf den stochastischen Fall erweitert werden. Der erste Schritt fur die Entwicklung einer Portfolio Management Strategie ist die Einfuhrung eines Risikomasses. Es sind jedoch nicht alle Risikomasse

gleichermassen geeignet. Koharente und konvexe Risikomasse besitzen fur die betrachteten Problemstellungen geeignete Eigenschaften. Die Modelle fur die Renditen von Wertpapieren sollen deren statistische Eigenschaften in realistischer Weise berucksichtigen. Hierfur werden mehrere Distributionen untersucht, welche die haug angetroene Normalverteilung ersetzen. Da in Studien oft nur der eindimensionale Fall behandelt gelegt. wird, Die wird besonderes welche Augenmerk unter dem auf den

mehrdimensionalen

Fall

Distribution,

Namen

Generalized Hyperbolic in der Literatur zu nden ist, kann die betrachteten Renditen sehr viel realistischer beschreiben als die Normalverteilung. Dies gilt auch fur einige Grenzfalle der Generalized Hyperbolic Verteilung. Zusatzlich werden elliptische Copulas untersucht.

Diese Arbeit enthalt eine ausfuhrliche Untersuchung von alternativen Anlagen. Im speziellen werden deren statistische Eigenschaften untersucht. Hedge Funds verfolgen in der Regel dynamische Anlagestrategien, was im Risikomanagement berucksichtigt werden muss. Hierfur werden die spezischen Eigenschaften von Hedge Funds untersucht und der Anlageprozess analysiert. Die Eigenschaften von Hegde Funds variieren enorm fur die verschiedenen Hedge Fund Stile. Deshalb konnen keine universellen Aussagen uber die statischen und dynamischen Eigenschaften von Hedge Funds gemacht werden. Der erste Teil der Arbeit konzentriert sich auf die statische und die dynamische Modellierung von Anlagemoglichkeiten. Im zweiten Teil werden aufgrund der erarbeiteten Modelle optimale Anlagestrategien entwickelt. Als erstes werden Modelle betrachtet, welche auf stochastischen Dierentialgleichungen fussen. Als Zufallsprozesse in diesen werden Brownsche Bewegungen eingefuhrt. Auch alternative Anlagen werden als ein solches System modelliert und eine optimale Anlagestrategie in geschlossener Form hergeleitet. Zusatzlich werden Modelle betrachtet, welche fur den Investor unbekannte Parameter und Prozesse enthalten. Um dieses Problem zu losen, wird ein Kalman Filter eingesetzt, die Resultate werden in einem Anwendungsbeispiel getestet. Der letzte Teil dieser Arbeit beschaftigt sich mit aktivem Portfolio Management. Die zentrale Bedeutung des Benchmarks fur das aktive Portfolio Management wird diskutiert. Da das aktive Portfolio Management kein eigentliches Forschungsgebiet darstellt, ist jedoch nur eine oberachliche Abhandlung moglich. Nichtsdestotrotz wird ein spezisches aktives Portfolio Management Problem diskutiert und werden zwei mogliche Losungsansatze prasentiert. Einer dieser Losungsansatze wird mittels historischer Daten veriziert. Der letzte Abschnitt dieser Arbeit beschaftigt sich mit Levy Prozessen im Zusammenhang mit Portfolio Konstruktion. Die multivariate Levy Dichte fur einen Grenzfall des Generalized Hyperbolic Levy Prozesses wird hergeleitet. Die Arbeit wird mit der Betrachtung von Levy Prozessen fur die Berechnung von optimalen Portfolios abgeschlossen.

Contents

1 Introduction ......................................................... 1 1.1 Financial Engineering .............................................. 2 1.2 Structure of the Thesis ............................................. 4 2 Financial Assets and Risk Management .............................. 11 2.1 Financial Assets ................................................... 11 2.2 TheAssetAllocationProcess........................................ 12 2.3 Risk Management and Risk Measures................................. 14 2.3.1 The Concept of Utility ........................................ 15 2.3.2 Financial Risk................................................ 16 3 Modeling of Financial Assets and Financial Optimization ............ 21 3.1 Statistical Properties of Asset Returns ................................ 23 3.1.1 Stylized Facts ................................................ 24 3.1.2 Univariate Properties.......................................... 25 3.1.3 Methodology and Results for the Univariate Case . . . . . . . . . . . . . . . . . 29 3.1.4 Multivariate Properties and Dependence ......................... 31 3.1.5 Results for the Multivariate Case ............................... 37 3.2 Dynamic Models of Financial Assets.................................. 42 3.3 Financial Optimization Techniques ................................... 44 4 Alternative Investments ............................................. 47 4.1 Introduction ...................................................... 47 4.1.1 Hedge Fund Fee Structure ..................................... 50 4.1.2 Hedge Fund Terminology ...................................... 51

VIII Contents

4.1.3 Hedge Fund Styles ............................................ 51 4.1.4 FundsofHedgeFunds......................................... 53 4.1.5 Hedge Fund Performance ...................................... 54 4.2 Systematic Risks of Hedge Funds and Risk Management . . . . . . . . . . . . . . . . 57 4.2.1 Systematic Risks of Hedge Funds ............................... 59 4.2.2 Risk Management for Hedge Funds.............................. 61 4.2.3 Non-linearities in Hedge Fund Returns........................... 64 4.3 Statistical Properties of Hedge Funds ................................. 65 4.3.1 Univariate Properties of Hedge Fund Returns..................... 66 4.3.2 Multivariate and Dependence Properties of Hedge Fund Returns . . . . 68 4.4 Hedge Fund Investing .............................................. 70 5 Optimal Portfolio Construction with Brownian Motions ............. 77 5.1 The Full Information Case .......................................... 78 5.1.1 The Model................................................... 80 5.1.2 Optimal Asset Allocation ...................................... 83 5.1.3 Case Study with Alternative Investments ........................ 86 5.2 The Partial Information Case........................................ 94 5.2.1 The Model................................................... 96 5.2.2 EstimationoftheUnobservableFactors.......................... 98 5.2.3 Portfolio Dynamics and Problem Transformation . . . . . . . . . . . . . . . . . . 100 5.2.4 Optimal Asset Allocation ...................................... 101 5.2.5 Case Study with a Balanced Fund............................... 106 6 Active Portfolio Management ........................................ 115 6.1 Sector Rotation Example ........................................... 118 6.2 PortfolioManagementwithLevyProcesses............................ 122 7 Conclusions and Outlook ............................................ 129 A Probability and Statistics ............................................ 133 A.1 Moments of Random Variables....................................... 133 A.2 Probability Distributions............................................ 133 A.2.1 Normal Mean-Variance Mixture Distributions . . . . . . . . . . . . . . . . . . . . . 133

Contents IX

A.2.2UnivariateProbabilityDistributions............................. 134 A.2.3MultivariateProbabilityDistributions ........................... 136 A.2.4 Bessel Functions and Modied Bessel Functions . . . . . . . . . . . . . . . . . . . 139 B GARCH Models for Dynamic Volatility ............................. 141 B.1 Univariate GARCH Processes ....................................... 141 B.2MultivariateGARCHProcesses...................................... 142 C Proofs ............................................................... 145 C.1 Tail Dependence within a t Copula ................................... 145 C.2 Transformation from Partial to Full Information ....................... 146 C.3 Levy Density of the Multivariate VG Levy Process ..................... 149 D Additional Data for the Sector Rotation Case Study ................. 151 References .............................................................. 153 Curriculum Vitae ....................................................... 165

List of Figures

2.1 3.1 3.2 3.3 3.4 4.1 4.2 4.3 4.4 4.5

Asset allocation process ............................................ 13 Classes of distributions in nance .................................... 23 Density estimates for the daily Dow Jones returns. ..................... 28 Logarithmic density estimates for the daily Dow Jones returns. . . . . . . . . . . 28 The model predictive control concept in nance........................ 45 Assets under management by the hedge fund industry................... 49 Serial correlation of the Tremont convertible arbitrage index. . . . . . . . . . . . . 62 Dynamic standard deviation of the Tremont long/short equity index. . . . . . 63 Non-linearities of hedge fund returns.................................. 64 Kernel regression of lagged S&P 500 returns vs. Tremont xed income

arbitrage returns................................................... 65 4.6 Density estimates for the monthly Tremont convertible arbitrage index

returns. .......................................................... 67 4.7 4.8 4.9 5.1 5.2 93 5.3 5.4 5.5 Correlation of Tremont Hedge Fund Indices with stocks and bonds.. . . . . . . 72 Hedge fund portfolio construction.................................... 73 The hedge fund selection process .................................... 74 Asset allocation strategy under full information for = 10. ............ 92 Asset allocation strategy performance under full information for = 10.. Estimations of the short rate and the unobservable factors and . ...... 111 Asset allocation strategy under partial information for = 10. ......... 112 Asset allocation strategy performance under partial information for =

10. ......................................................... 113

XII List of Figures

6.1 An MPC approach for the sector rotation problem...................... 120 6.2 Performance of the sector rotation asset allocation strategy. . . . . . . . . . . . . . 122

List of Tables

2.1 Financial assets ................................................... 11 2.2 Financial risks .................................................... 17 3.1 Distributions for daily Dow Jones returns. ............................ 29 3.2 Distributionsforequityindexreturns................................. 30 3.3 Distributions for commodity returns. ................................. 31 3.4 Distributions for bond total return index returns. ...................... 31 3.5 Multivariate distributions for equity indices returns. . . . . . . . . . . . . . . . . . . . . 37 3.6 Multivariate distributions for commodity returns. . . . . . . . . . . . . . . . . . . . . . . 38 3.7 Multivariate distributions for a typical portfolio. ....................... 39 3.8 Copula estimations for asset returns. ................................. 40 3.9 Tail dependence coecients of weekly world equity indices returns. . . . . . . . 41 3.10 Tail dependence coecients in a typical portfolio. ...................... 42 4.1 Hedge fund styles.................................................. 52 4.2 Common risk factors of hedge funds.................................. 60 4.3 4.4 4.5 Distributions for monthly Tremont hedge fund indices returns. . . . . . . . . . . . 66 Tail dependence coecients for Tremont hedge fund styles. . . . . . . . . . . . . . . 68 Tail dependence coecients for Tremont hedge fund styles with common

riskfactors........................................................ 69 4.6 5.1 Multivariate distribution models for a portfolio including hedge funds. . . . . 70 Typical values for the estimated parameters. .......................... 92

5.2 Key gures for the asset allocation strategy under full information . . . . . . . 94 5.3 Key gures for the asset allocation strategy under partial information. . . . . 113

XIV List of Tables

D.1 Factorsforthesectorrotationcasestudy.............................. 151

List of Symbols and Notation

Excess return Factor exposure 1 Skewness 2 Kurtosis I Identity matrix P Probability measure F Sigma algebra Ft Filtration N Normal (Gaussian) distribution Expected return (dx) Levy measure (t) Estimation error Sample space Volatility (t) Instantaneous covariance matrix per unit time 1{A} Identicator function of the set A C Copula function c Density of a copula

C C

Ga t

Gaussian copula t copula

Risk measure L0 Set of all almost surely nite random variables L

1 n

Set of n-dimensional integrable functions P Asset price

XVI List of Tables

r Risk-free interest rate u Control vector, asset allocation strategy V Investors wealth, value of a portfolio W Brownian motion x Observable factor y Unobservable factor AIC Akaike Information Criterion ARCH Autoregressive conditional heteroskedasticity BIS Bank for International Settlements CCC Constant conditional correlation CRRA Constant relative risk aversion CVaR Conditional Value at Risk DCC Dynamic conditional correlation EMH E?cient market hypothesis GARCH Generalized ARCH GH Generalized Hyperbolic distribution GIG Generalized Inverse Gaussian HJB Hamilton-Jacobi-Bellman i.i.d. independent, identically distributed ML Maximum loss MM Method of Moments NIG Normal Inverse Gaussian distribution s-t Skewed t distribution SDE Stochastic di?erential equation SP Shortfall probability TARCH Threshold GARCH VaR Value at Risk

Introduction

Copy from one, its plagiarism; copy from two, its research. Wilson Mizner

This work explores the possibilities and limits of the use of control engineering methods and techniques in nance. This chapter presents the motivation and goals of this work and the conceptual strategies involved. The application of control engineering methods and techniques to nancial problems is called nancial engineering. It makes use of engineering tools, i.e., it obtains quantitative results for models and problems developed in research elds such as economics, mathematics, and econometrics. The results in economics and mathematical nance are often of a theoretical or qualitative nature and cannot be used quantitatively as such. The results from the area of econometrics give an indication as to which models are quantitatively applicable. As in engineering problems, the problems considered in this work are solved in two stages: rst, modeling of the problem and then computation of its optimal solution. Therefore, the aim of the thesis is to apply improved nancial models to optimal portfolio construction problems. In the modeling part of the thesis, the goal is to improve the asset models used most often today. These are discussed in detail in Chapter 3. An important point to be noted is that modeling and optimization are not independent of each other. In general, the more complicated the underlying model is, the more involved the necessary optimization becomes. The models considered in this work are always chosen with the caveat of the existence of a solution for the resulting optimization problem. As in many other research areas, we face the tradeo between complexity and solvability of the problems posed. In the optimization part, we consider two important topics: reasonable objective functions, i.e., risk measures, and multi-period optimization problems. Various objective functions for investors are explored and their implications for the problems posed are discussed. In

2 1 Introduction

addition, we analyze the advantages and drawbacks of the use of multi-period optimization techniques for investment problems. We obtain a multi-period optimization when it is possible to change the portfolio composition before the end of the problem. However, applying the multi-period optimal solution is not the same as applying optimal single-period solutions sequentially, in general.

1.1 Financial Engineering

Financial engineering is dened as the use of mathematical nance and modeling to make pricing, hedging, trading, and portfolio management decisions. We mainly consider portfolio management decisions. By denition, a portfolio is a collection of investments held by an institution or an individual. Holding a portfolio with dierent investments instead of a single one is reducing the investors risk and is called diversication. In order to have a model of the portfolio return, we have to model the individual assets as well as their dependencies. Based on these models, we compute the portfolio return and its characteristics. A portfolio optimization is only possible once we have a model of the portfolio return. The investment decisions are derived from the portfolio optimization. We therefore aim to control the nancial risk that an investor takes. This raises the question of how to dene nancial risk, which is still an open issue in theory and in practice. Many dierent risk measures have been proposed so far, but no risk measure is well suited for all problems arising in the area of nancial engineering. This topic is discussed in Chapter 2. Control engineering in technical problems plays a similar role as nancial engineering does in nance problems. The use of feedback control strategies, i.e., making use of new information arriving in time is standard in technical problems, but not for nancial problems. This topic is a subject of heated debates among scholars and practitioners. The dispute is about the ecient market hypothesis (EMH), proposed in Samuelson (1965) and Fama (1965, 1970a). The ecient market hypothesis states that security prices fully reect all the information available. There are several forms of the ecient market hypothesis, where the strongest formulation states that all investors have the same information available and behave in the same economic optimal fashion, i.e., investors are rational. From this form, some relaxed forms of the EMH have been derived. According to the EMH, only a buy-and-hold investment strategy can be optimal. However, we doubt that only buy-and-hold investment strategies are optimal under all circum

1.1 Financial Engineering

stances. Among the most important reasons for this statement are: the market behavior is non-stationary, the market has some kind of inertia, not all investors have the same information, and since investors are not always rational, the techniques underlying the investment strategies dier, they provide advantages or

disadvantages to investors. We will now discuss these points in more detail. Economies go through phases, such as the well-known bull and bear market phases. In addition, we observe long periods of time during which we cannot distinguish a market direction, i.e., when the market sustains its level. We may speak of dierent regimes in the market. As a matter of fact, optimal investment strategies in these regimes cannot be the same. Therefore, since a buy-and-hold strategy would just average over the dierent regimes, it cannot be optimal in either regime. Investors with a buy-and-hold investment strategy have to leave the portfolio unchanged for a considerable amount of time. Only then the optimization of the buyand-hold investment strategy makes sense. For most investors, this is not a feasible strategy since they are constrained by liabilities and consumption.

It is a fact that when markets are in a stress situation, the dependence properties of assets usually change. Assets which reasonably could be considered independent may drop at the same time. This pattern has been observable in every crash that has occurred so far. These facts and many other (empirical) facts show that asset prices are dynamic in their nature and that their properties change over time. The reader is referred to Campbell, Lo and MacKinlay (1997) for more details on this topic. As a matter of fact, nancial return series are not independent. This property can easily be veried by examining the serial correlation of squared returns. Therefore, investment decisions taken in the past may no longer be optimal when the market has altered its behavior. The fact that not every investor has the same information available is obvious. The research area of behavioral nance provides strong evidence that for economic and nancial theories, the assumption of rational investors is rather bold. We stress the fact the quantitative models used by investors dier tremendously in their degree of sophistication. This leads to further advantages and disadvantages among them. In terms of market paradigms, we agree with the adaptive market hypothesis (AMH) of which the properties are described in Lo (2004). They agree with the statements made so far in this chapter. One implication of the AMH is that a relation between risk and reward exists, but it is

4 1 Introduction

unlikely to be stable over time. A second one is that arbitrage opportunities arise from time to time. See Cvitanic, Lazrak, Martellini and Zapatero (2004) for a denition of arbitrage. A third implication is that investment strategies which perform well in certain environments may perform poorly in other environments. A fourth implication is that innovation is the key to survival, which is the only objective that matters. The main conclusion of this section is that a portfolio has to be actively managed. The most important reasons, as mentioned, are upcoming liabilities and

consumption, changing market behavior, and the advances in research which lead to new tools and methods. Up to this point, we have not discussed the case of arbitrageurs who seem to persistently outperform the market. The money inows to the hedge fund industry may be considered as evidence, as they have steadily increased over the last years. If there are any legal arbitrage opportunities, they tend to diminish after a reasonable time once they are discovered by others. Therefore, arbitrageurs usually do not provide details about the arbitrage possibilities they have identied and how they are exploiting them. As a consequence, any systematic treatment of this subject is impossible. It is not the purpose of this work to identify arbitrage possibilities but rather to show that quantitative methods can produce added value in a portfolio.

1.2 Structure of the Thesis

Chapter 2: Financial Assets and Risk Management In Chapter 2, the nancial assets considered are introduced. They are categorized into traditional and alternative investments. The traditional assets are cash, xedincome investments, equity (stocks), real estate, and foreign exchange. The alternative investments are hedge funds, managed futures, private equity, physical assets (e.g., commodities), and securitized products (e.g., mortgages). A detailed description of the asset allocation process is given. The main levels of the asset allocation process are the strategic asset allocation, the investment analysis, the tactical asset allocation, and the monitoring of the portfolio. We introduce the concepts of risk, risk management, and utility functions. A sound understanding of risk is necessary in order to successfully elaborate a dynamic asset allocation strategy. Therefore, risk measures and their properties are analyzed in detail.

1.2 Structure of the Thesis

An overview of nancial risks and their classication are presented and the literature on the good properties of risk measures is reviewed. Risk measures with favorable properties in terms of risk management are introduced as coherent and convex risk measures. Finally, the topic of dynamic risk measures is briey discussed.

Chapter 3: Modeling of Financial Assets and Financial Optimization Chapter 3 starts with a brief historical survey of important asset price models proposed so far. The main part of the chapter is devoted to the investigation of the statistical properties of asset returns. The stylized facts of asset return distributions are listed. First, the unconditional properties of univariate asset returns are analyzed. The models proposed in the literature are reviewed. Three main classes of distributions are considered. These are the elliptical distributions, the stable distributions, and the normal mean-variance mixture distributions. In particular, distributions of the generalized hyperbolic (GH) type are investigated. We nd that the GH class of distributions ts univariate returns very well. The distributions of the GH class account for the stylized facts which are observed with real-world data. In addition, the GH class contains many important distributions in form of special and limiting cases. Having investigated the univariate case, the next part of the chapter is devoted to the multivariate case. The multivariate version of the GH distribution also oers the best ts in most of the cases considered. Apart from the fully parametric distributions, we investigate the concept of copulas. A copula is a function which ties together univariate distributions to a fully multivariate distribution. Copulas allow for constructing a dependence structure among totally dierent kinds of marginal distributions. We choose non-parametric models for the margins and only consider elliptical copulas in detail. In particular, the Gaussian and the t copula are investigated. We nd that the t copula ts the data considerably better than the Gaussian copula. It is a well-documented fact that correlation is not always sucient for describing the dependence among asset returns. Therefore, we present some alternative dependence measures commonly found in the literature. We are particularly interested in the measure called tail dependence. Tail dependence describes the limiting proportion of exceeding one margin over a certain threshold, given that the other margin has already exceeded that threshold. Tail dependence is a copula property and independent of the margins. We

6 1 Introduction

nd considerable tail dependence among popular asset classes. However, stocks and bonds oer good diversication properties with respect to concurrent extreme losses. After having analyzed the static properties of asset returns in detail, dynamic properties and models of asset returns are briey reviewed. In particular, factor models and various forms of GARCH models, which are frequently found in the literature, are discussed. The section concludes with an overview of optimization techniques in nance. The most common dynamic optimization technique in nance is stochastic dynamic programming. The model predictive control approach for solving stochastic control problems is briey described. The main advantage of model predictive control is that constraints on the decision variables can be taken into account. Chapter 4: Alternative Investments In Chapter 4, the topic of alternative investment is discussed. Only the case of hedge funds is considered in detail. First, a brief history and an overview of the current state of the hedge fund industry are given. The investment vehicle hedge fund is formally dened. The special fee structure of hedge funds and its implications for investors are discussed. It is found that high watermarks as well as a considerable amount of the investors own money in the fund are favorable for protecting the investors interests. The terms alpha and beta are introduced which are often found in the realm of hedge funds. A survey of dierent hedge fund styles found in the literature is presented. The advantages and disadvantages of funds of hedge funds are discussed. We nd the most severe disadvantage of funds of hedge funds to be the double layer of fees. The performance of hedge funds is reviewed and the inherent problems of the performance measurement are highlighted. Because of several biases in the available hedge fund databases, an accurate assessment of the performance of hedge funds is dicult. The most common biases such as survivorship bias, selection bias, and backll bias, are discussed in detail. The literature on the quantications of these biases is reviewed. All reviewed publications on this topic nd considerable biases in common hedge fund databases. It is also found that the most popular riskadjusted performance measure for hedge funds is the Sharpe ratio, although the deciencies of the Sharpe ratio are notorious. Systematic risks are an important input for the risk management of hedge funds. Therefore, the role of the idiosyncratic risk for hedge funds is analyzed. It is observed that

1.2 Structure of the Thesis

the variance of a hedge fund portfolio is decreased by combining an increasing number of hedge funds. In contrast to variance, the kurtosis is increased when the number of hedge funds in the portfolio is increased. This is a very unfavorable behavior. However, by combining a suciently large number of hedge funds, only the systematic part of risk is expected to remain. The systematic risk is described by a factor model. The most common systematic risk factors for hedge funds are summarized. These risk factors also include non-linear dependencies with respect to traditional asset classes. Sometimes, option-like pay-o structures to traditional assets are found for hedge funds. The risk management of hedge funds demands far more sophisticated methods than traditional assets do. This is due to the fact that the statistical properties of hedge funds are quite dierent from those of traditional assets. In particular, the topic of tail risk has to be considered carefully. Some returns of hedge fund styles show serial correlation and volatility clustering eects. Market frictions such as illiquidity are the reason for the serial correlations in hedge fund returns. Volatility clustering may be caused by a higher risk-taking of the hedge fund manager because of incurred losses. As for traditional assets, the univariate and multivariate statistical properties of hedge fund returns are analyzed. We nd that the results vary considerably among the dierent hedge fund styles. As in the case of traditional assets, the GH distribution is found to be well suited for describing hedge fund returns. Concerning dependence, the t copula gives far better ts than the Gaussian copula. Finally, the process of hedge fund investing is described. The approaches for constructing a fund of hedge funds portfolio as well as the embedding of hedge funds in the traditional portfolio are discussed. We nd that the correlation properties of some hedge fund styles with respect to traditional assets such stocks and bonds are not stable over time. Chapter 5: Optimal Portfolio Construction with Brownian Motions In Chapter 5, dynamic asset allocation strategies are developed for asset prices modeled as continuous-time stochastic dierential equations (SDEs) driven by Brownian motion. The main advantage of using the continuous-time framework is that to a high degree the optimal control problem can be solved analytically. In some cases, even closed-form solutions may be derived. This gives more insights into the mechanics of an optimal asset alloca

8 1 Introduction

tion strategy than a numerical approximation could. However, the modeling properties are rather limited for continuous-time stochastic processes with Brownian motion. The use of factors for explaining expected returns of assets is common in nance. Two dierent types of problems are considered. We consider the case in which all factors which are explaining the return of assets are known, i.e., measurable. The second case considers the situation where not all of the factors explaining returns are observable. This problem is called optimal asset allocation under partial information. The optimal asset allocation strategies are derived with a stochastic dynamic programming approach. This is done by solving the Hamilton-Jacobi-Bellman (HJB) equation. The HJB equation is a nonlinear partial dierential equation, which is very hard to solve if the control variable is constrained. For problems in higher dimensions, it is virtually impossible to nd solutions for the constrained case. This fact and the limited possibilities for modeling asset returns are the main disadvantages of modeling assets in a continuous-time stochastic dierential framework with Brownian motion. The portfolio dynamics can be derived once the dynamics of the considered assets are dened. The portfolio is modeled to be self-nancing, i.e., there are no external in-or outows of money. Two types of investors are considered who are characterized by their corresponding utility functions. On the one hand, we are considering the popular case of constant relative risk aversion (CRRA). On the other hand, we are considering the case of constant absolute risk aversion (CARA). The problems are solved by using Bellmans optimality principle. For the partial information case we show that the separation theorem is no longer valid, i.e., we cannot separate the estimation from the optimization. This means that we cannot simply estimate the unobservable quantities and then treat them as if they were known exactly.

The general solutions are analyzed in two case studies, one for the full information case and one for the partial information case. The former is simpler to analyze than the latter. The model used for the full information case study is simpler than the one for partial information. However, the full information problem possesses a closedform solution. This is not the case for the partial information problem. In both case studies, the opportunity set of the investor consists of a bank account, stocks, bonds, and an alternative investment. The resulting dynamic trading strategies are backtested with historical data, for which the parameters are adapted in every step. In both cases, the resulting risk-adjusted returns

1.2 Structure of the Thesis

are higher for the actively managed portfolio than for the passive investments. It is found that the partial information approach is superior to the full information approach in the chosen investment framework.

Chapter 6: Active Portfolio Management Chapter 6 discusses the role of active portfolio management as well as

implementation examples. First, a formal denition of active portfolio management is given and the importance of the denition of the benchmark is highlighted. The key components of active portfolio management are found to be the investment universe and the investment strategy. A crude classication of active portfolio management strategies is given. We dierentiate between security selection and market timing. However, there is neither a generally accepted terminology nor a unied framework to compare dierent strategies. Therefore, a deeper systematic treatment of this topic is not possible. A case study concerning the sector rotation problem is presented and implemented with historical data. The S&P 500 index with its ten sector indices is considered. The active portfolio management strategy is presumed to beat the S&P 500 by over-and under-weighting the single sectors. Two implementation possibilities are presented, i.e., a multi-period and a single-period environment. The actual implementation of the strategy with historical data is done with the single-period strategy. The conditional value at risk (CVaR) is used as risk measure. In both settings, GARCH models for modeling dynamic volatility are used. The tendimensional return vector of the sector indices is assumed to have a multivariate normal inverse Gaussian distribution. An adaptive factor model is used to predict the returns of the dierent sectors. The implementation of the mean-CVaR optimization in an out-of-sample manner is run for the period from 1999 to 2005. The results are promising; we observe an alpha of 5% and an information ratio 0.96. Finally, the use of Levy processes for optimal portfolio construction is discussed. For the description of asset returns in Chapter 3, we have found that the generalized hyperbolic (GH) distribution and its limiting cases are well suited. Because the GH distribution is innitely divisible, we may construct a Levy process whose increments have a GH distribution. Therefore, we can construct dynamic models in continuous time which take the statistical properties of asset returns well into account. The limiting cases of the GH distribution such as the normal inverse Gaussian (NIG) and the variance gamma (VG)

10 1 Introduction

distribution are also well suited for optimal portfolio construction. The necessary L evy densities are given for describing the corresponding Levy processes. The study of Levy processes is one of the most promising research areas in mathematical nance because of the ne properties of Levy processes.

Financial Assets and Risk Management

Being a language, mathematics may be used not only to inform but also, among other things, to seduce. Benot Mandelbrot

2.1 Financial Assets

A nancial investment, contrary to a real investment which involves tangible assets such as land or factories, is an allocation of money with contracts whose values are supposed to increase over time. Therefore, a security is a contract to receive prospective benets under stated conditions like stocks or bonds. The two main attributes that distinguish securities are time and risk. Usually, the interest rate or rate of return is dened as the gain or loss of the investment divided by the initial value of the investment. An investment always contains some sort of risk. Therefore, the higher an investor considers the risk of a security, the higher the rate of return or premium the investor demands, see Sharpe, Alexander and Bailey (1998) for details. We divide nancial assets in two main categories, i.e., traditional and alternative investments. Table 2.1 summarizes the considered assets. The main traditional assets are
Traditional Table Alternative 2.1. Financial assets Cash Hedge Funds Fixed-Income Managed Futures Equity (stocks) Private Equity Real Estate Physical Assets (Commodities, Art, Wine, ...) Foreign Exchange Securitized Products (Mortgages, Loans, ...)

12 2 Financial Assets and Risk Management

cash, xed-income securities, and stocks. We assume that cash is stored in some kind of bank account, the interest rate on this account is often referred to as risk-free interest rate. We briey describe xed-income securities. For short-term borrowing, governments and corporations issue securities with a year or less to maturity. This market, where governments and corporations manage their short-term cash needs, is called money market. Two important money market interest rates are the London Interbank Oered Rate (LIBOR) and the interest rate on Treasury Bills. Treasury Bills, in the U.S., are issued by the New York Federal Reserve Bank in weekly auctions. The large banks in London are willing to lend money to each other at the LIBOR rate. The long-term borrowing needs of corporations and governments are met by issuing bonds. A bond contract provides periodic coupon payments and redemption value at maturity to the bondholder. Bonds are either traded over-the-counter or in secondary bond markets. For more details on xed-income securities, the reader may refer to Fabozzi (2005). Stocks are issued by corporations, which convey rights to the owner. The stock owners elect the board of directors and have claims on the earnings of the company. The stock holders are compensated with cash dividends, whose amount is determined by the board of directors. When we refer to stocks, we mean public stocks. Public trading of stocks (shares) is regulated by the government. The process of arranging the public sale of stocks of a private rm is called initial public oering (IPO). In this context, privately held stocks are referred to as private equity. Real estate investments are also usually found in institutional portfolios, either direct or indirect via investment trusts. Since the end of the Bretton-Woods agreement for xed exchange rates in 1973, foreign exchange or derivatives on foreign exchange rates are also found in portfolios. This is usually the case for international investors who want to hedge against currency risks. As alternative investments we consider hedge funds, managed futures, private equity, physical assets (e.g. commodities), and securitized products (e.g. mortgages). Alternative investments are discussed in detail in Chapter 4.

2.2 The Asset Allocation Process

Obviously, the asset allocation process refers to the process of investing money in dierent nancial assets. There is no generally accepted methodology for this problem. However,

2.2 The Asset Allocation Process

there are many keywords describing dierent stages of the asset allocation process, e.g., strategic and tactical asset allocation. We consider the asset allocation process as an iterative process since a continuous monitoring of the portfolio characteristics is essential. We consider the assets of Table 2.1 as investment opportunities. Note that the iterative nature of the asset allocation process implies active portfolio management.
Strategic Asset Allocation ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c450001 0100000c484c696e6f021000006d6e74725247422058595a2007ce000200090006003100 00616373704d5346540000000049454320735247420000000000000000000000000000f 6d6000100000000d32d4850202000000000000000000000000000000000000000000000 00000000000000000000000000000000000000000000000000116370727400000150000 0003364657363000001840000006c77747074000001f000000014626b70740000020400 0000147258595a00000218000000146758595a0000022c000000146258595a000002400 0000014646d6e640000025400000070646d6464000002c400000088767565640000034c 0000008676696577000003d4000000246c756d69000003f8000000146d6561730000040 c0000002474656368000004300000000c725452430000043c0000080c67545243000004 3c0000080c625452430000043c0000080c7465787400000000436f707972696768742028 63292031393938204865776c6574742d5061636b61726420436f6d70616e79000064657 3630000000000000012735247422049454336313936362d322e31000000000000000000 000012735247422049454336313936362d322e310000000000000000000000000000000 00000000000000000000000

Investmen t Analysis

Tactical Asset Allocation

Monitoring

Fig. 2.1. Asset allocation process

In Figure 2.1, the asset allocation process is shown graphically. The asset allocation process starts with the strategic asset allocation. The strategic asset allocation is the most important part of a successful investment strategy. It denes the investment objectives, the way risk is measured, gives the set of investment opportunities, and sets the constraints on the single investment positions. The strategic asset allocation should be based on a long-term focus. Therefore, the outermost feedback loop in Figure 2.1, representing the process of the strategy reassessment, has a much lower frequency than the other loops. The next stage is the investment analysis. It may be regarded as a lter for the next step of the asset allocation process. The main task is the further containment of the investment universe. This step includes the fundamental analysis of countries, sectors,

14 2 Financial Assets and Risk Management

companies, commodities, hedge fund managers, etc. If the investment opportunities do not comply with the investment philosophy or are unfavorable in some kind of fashion, they are excluded from the investment universe. As the investment strategy, the investment analysis has to be reviewed at a reasonable frequency. This is symbolized by the middle feedback loop in Figure 2.1. After the investment analysis, the denitive investment universe is dened and the actual portfolio construction can be conducted. This part of the asset allocation process is called tactical asset allocation. It has to comply with the constraints and rules of the strategic asset allocation. If the strategic asset allocation and the investment analysis are carried out accordingly, the tactical asset allocation solely consist of the statistical modeling and the mathematical optimization problem. Investment analysis and tactical asset allocation are often combined in the same step. The portfolio construction may be altered at a predened frequency, usually dened in the strategic asset allocation. This is the innermost feedback loop in Figure 2.1. It has the highest frequency of the three feedback loops.

The last step of the asset allocation process is the monitoring of the portfolio and its single positions. The new information about the evolvement of the prices of the dierent assets is incorporated in the optimization problem, i.e., the model parameters are updated. In addition, the performance in comparison to the benchmark is analyzed. If the risk tolerance is violated, the portfolio composition has to be altered. If the expected, additional gains by changing the portfolio positions are lower than the transaction costs, the portfolio should be left unchanged.

2.3 Risk Management and Risk Measures

There are many examples where improper risk management led to huge losses. Some examples are Metallgesellschaft in 1993, Barings Bank in 1995, and Long Term Capital Management (LTCM) in 1998. In each case, catastrophic losses occurred. These cases highlight the importance of proper risk management. Obviously, we rst need an understanding of risk before the topics of risk management and risk measures can be addressed. The main problem is that there is no universal denition of risk and neither are there generally accepted denitions for risk in specic environments. There is a close relation between risk and uncertainty. Because of the above

2.3 Risk Management and Risk Measures

mentioned points we do not state a rigorous denition of risk. For our purposes we may dene risk as follows: Denition 2.1 (Risk). Risk is the exposure to some uncertain future event. The probabilities of the dierent outcomes of this future event are assumed to be known or estimable. The mathematical tool to describe problems including uncertainty is probability theory. The term exposure in Denition 2.1 states that a certain system only contains the risks of the uncertain events it is exposed to. In a nancial context, these uncertain events are often called risk factors. Therefore, only events which have a dependence on the considered system may inuence its risk. In a nancial model with risk factors, the return of an asset only depends on the considered risk factors. It is common to model stocks with two risk factors. The rst factor represents market risk, the second risk factor is the idiosyncratic risk of the company. We are only considering risks involved in the realm of investing. Mathematically speaking, risk is a random variable, mapping the future states of the world into monetary gains or losses. The key for every successful investment strategy is a sound risk management. From this statement the question arises what good risk management is. The two main components of nancial risk management are the modeling of the assets and the denition of the risk measure. Once these two elements are dened, risk management becomes a formal, logical process. The rst key factor, i.e., the modeling of the assets, is the subject of Chapter 3. The topic of risk measures is discussed in the following. 2.3.1 The Concept of Utility In economics, the concept of utility has been introduced centuries ago. Utility is a measure of the happiness or satisfaction gained from goods or services in an economic context. For nancial problems, the argument of utility function usually is money (consumption). The rst systematic description of risk for nancial problems is the concept of risk aversion. It is introduced in Morgenstern and Neumann (1944) which contains an axiomatic extension of the ordinal concept of utility to uncertain payos. We therefore consider the concept of risk aversion as the rst form of a risk measure. For a risk averse investor, a utility function U must fulll certain properties:

1 16 2 Financial Assets and Risk Management

A utility function must be an increasing continuous function: U > 0. 0 < 0. A utility function must be concave: U The rst property makes sure that an investor prefers always more wealth to less wealth. The second property captures the principle of risk aversion. Some commonly used utility functions include

1the exponential function (a> 0): U(x)= eax . 2the logarithmic function: U(x) = ln(x). 3the power functions (b< 1 and b b (x)b

2.3 Risk Management and Risk Measures

In the realm of nancial markets, risk describes the uncertainty of the future outcome of a current decision or situation. This is put in a more formal manner by introducing the random variable X, dened on a probability space (, F, P), which denotes the prot or loss of a nancial position. Therefore, X is a real-valued function on the set of possible scenarios. By L0 we denote the set of all random variables X : R, which are almost surely nite. A quantitative measure of risk is given by a mapping from the set L0 to the real line. Formally, the denition of a quantitative risk measure is given as: = 0): U(x)= . Denition 2.2 (Risk measure). 0 A risk measure is a function : a): R. ax bx2 . L 4. the quadratic functions (x< 2b U(x)= All The Bank for International Settlements (BIS) is an of risk aversion. This is of these utility functions capture the principle international organization accomplishedcooperation thecentral banks and international nancial institutions.the fostering the whenever of utility function is concave. We will not get into Its details of utility nancialfor more details the reader is2.2. classication of theory, risks is summarized in Table referred to Luenberger (1998), Cvitanic and Market Risk (2004), and Panjer (1998). Since we are usually not Zapatero interested in the absolute values of utility functions but rather in its shape, Pratt and Credit Risk Arrow have independently developed measures for risk aversion. Let U(x) be a utility Operational Risk function, then the Arrow-Pratt measures for absolute and relative risk aversion are
failed dened as follows: internal processes, people and systems, or from external events. Liquidity Risk " "( (x) The risk that positions cannot be liquidated quickly enough atUcritical times. U " x) Model Risk the Arrow-Pratt measure of absolute risk aversion: a(x)= U"" (x) . The the Arrow-Pratt risk of using of relative risk aversion: b(x)= x. U" (x) measure inaccurate or wrong models for risk budgeting. The risk of direct or indirect loss resulting from inadequate or The risk associated with the uncertainty of the default of debtors. Table 2.2. Financial risks The risk associated with the uncertainty of the value of traded assets
1

The main

Event Risk The risk of extreme event. Reputational Risk critique on utility theory is that humans are not always The risk of losing ones reputation as investment manager.

rational. We do not

discuss this topic since we do not derive economic or nancial models based on this assumption. Here, we investigate the performance of rational investment strategies. In this work, the main emphasis will be on dealing with market risk. 2.3.2 Financial Risk Single Period Risk Measures The actual return of every security is always uncertain and therefore full information The systematic treatment of risk measures was introduced in the seminal paper of of the underlying risks in a portfolio means knowing the exact distribution of the Artzner, Delbaen, Eber and Heath (1998), where the properties of good risk measures portfolio return. In addition, one wants to know how the portfolio return distribution is are described by some axioms. A risk measure fullling these axioms is called a aected by altering the positions in the portfolio. This is very dicult when dealing in coherent risk measure. Let the two random variables X and Y denote the prot or loss a complex stochastic environment. Even for single securities it may be hard to nd a of two assets. The axioms for a coherent risk measure are (r denotes the risk-free suitable distribution, e.g., for illiquid securities. Therefore, dierent risk-measures as rate of interest): r a single quantity have been )established. ) Subadditivity: VX, Y : (X + Y : (X)+ (Y These risk measures are characteristic Positive-homogeneity: VX : c 0: (cX)= quantities of a probability density function. c(X)

1 18 2 Financial Assets and Risk Management

Translation invariance: VX : c R : (X + cr)= (X) c Monotonicity: VX, Y : X : Y : (X) (Y )

The subadditivity property ensures that diversication reduces risk. The positivehomogeneity property, together with subadditivity, implies that the risk measure is convex. measure which is translation invariant and monotone is called monetary. A risk Ziemba and Rockafellar (2000) and Follmer and Schied (2002) introduce the concept of convex monetary risk measures. This concept is a generalization of the more restrictive concept of coherent risk measures. The axioms for convex monetary

r risk measures are

Convexity: VX, Y : (cX + (1 c)Y ) : c(X) + (1 c)(Y ),c [0, 1] 1 Translation invariance: VX : c R : (X + cr)= (X) c Monotonicity: VX, Y : X : Y : (X) (Y )

2.3 Risk Management and Risk Measures

into account. The method of partial moments overcomes the problem of symmetry. As an example, the partial variance for a given threshold a is formally PV(a)= E[X |X<a].
2

Value at Risk (VaR) Value at risk is, besides variance, the most-used quantitative analysis tool in risk management today. The reason for this is because the BIS has introduced VaR as standard risk measure for banks in the new Basel Capital Accord (Basel II). It is intuitively understood and characterized by a condence level and the time period considered. This leads to the following formal expression VaR() = inf{x R|P (X x) },

where Xofdenotes the is no loss of generalityposition. The VaR-quantity is the In most the cases it return of a nancial to assume that a given monetary maximum satises (0) = 0. In Ziemba and Rockafellar (2000), modied risk risk measure loss over the next time period that will not be exceeded with probability . The are described as convex that it does not state what the outcome is once measures major drawback of VaR is monetary risk measures including the properties an extreme event has happened, i.e., it contains no information measures are (0) = 0 and for X< 0: (X) > 0. Some examples of single period risk about the tail of the distribution. Furthermore, VaR is not a coherent measure because it is not Maximum Loss (ML) subadditive, i.e., diversication does not necessarily reduce risk, see Embrechts (2004) for an illustrative example. is intuitive and needs no further explanation. The maximum loss risk measure Note that the maximum loss is unbounded and therefore useless when the return Conditional Value at Risk (CVaR) distribution is neither truncated nor discrete. Sucient historical data has to be A possible, coherent extension to VaR is the conditional value at risk (CVaR). CVaR available for the use of this risk measure. is also known as expected shortfall (ES) and is dened as Shortfall Probability (SP) CVaR()= E[X|X : VaR()]. A shortfall is the event when the return of a portfolio drops below a given threshold. A portfolio manager may not be allowed to drop below a certain Again, a condence level is specied and the returns a characterized for a given performance level; therefore the manager is interested in minimizing the time period. CVaR is below this level. Formally speaking: below the VaR occurs. probability to perform the expected loss once a return Informally, CVaR states how bad SP(a)= P (X : a). has the appealing property that is bad?. CVaR it is coherent in a single-period setting. Method of Moments (MM) Note that, from a regulatory point of view, coherent risk measures should be the Since the introduction of mean-variance portfolio theory, moments of return preferred choice. From therisk measures. The variance is still the most widely more distributions are used as point of view of an investment manager it is used comfortable to work withrisk. This has obvious measures in order to moresign of the measure to quantify convex monetary risk disadvantages, e.g., the accurately model the investment problem. return is not taken

20 2 Financial Assets and Risk Management

Dynamic Risk Measures The area of dynamic risk measures is still immature and there is no generally accepted standard. A dynamic risk measure is necessarily a stochastic process. One of the rst publications on this subject is Cvitanic and Karatzas (1999). Formal treatments are found in Balbas, Garrido and Mayoral (2002), Riedel (2004), and Boda and Filar (2005). In these publications, coherent risk measures within a dynamic environment are presented. The axioms for the dynamic case resemble those of the static case. In Cheridito, Delbaen and Kupper (2004), dynamic risk measures are investigated for processes which are right-continuous with left limits. The connection between Bellmans principle and dynamic risk measures is also found in these publications. Riedel (2004) introduces the concept of dynamic consistency, which is an important concept in connection with active portfolio management. A dynamically consistent risk measure rules out contradictory investment decisions over time. Therefore, if two portfolios have the same risk tomorrow in every scenario, then these portfolios should have the same risk today. Note that CVaR needs not to be time consistent in a dynamic environment, as shown in Boda and Filar (2005). For more details on the subject of dynamic risk measures, the reader is referred to the publications mentioned above.

Modeling of Financial Assets and Financial Optimization

Young man, in mathematics you dont understand things, you just get used to them. John von Neumann

The choice of asset models is an important success factor of a quantitative investment strategy. The more realistic the asset prices are modeled, the better the investment strategy performs. In addition, the more accurately the asset returns are reect by the chosen distribution, the better the actual risk exposure can be calculated. Therefore, we are interested in distributions which can take the stylized facts of asset returns into account. Obviously, we do not want to underestimate the taken risks. However, the overestimation of risk is also unfavorable because this reduces the risk capacity and therefore results in lower returns. We are interested in models for the nancial assets discussed in Chapter 2. We provide a short overview of the economic and nancial models developed so far. We attribute the rst analytic and systematic treatment to Harry Markowitz. In his seminal publication, Markowitz (1952) models asset returns as multivariate random variables. Asset returns are modeled as multivariate Gaussian random variables and the investors utility function is quadratic. Therefore, it is often referred to as mean-variance model. The reader is referred to Panjer (1998) for more details on the mean-variance model. Sharpe, Lintner, and Mossin have, based on the assumptions of Markowitz, derived the capital asset pricing model (CAPM), see Sharpe (1964). The CAPM is one of the rst factor models. The importance of the CAPM stems also from its terminology, i.e., the use of the Greek letters and , which are widely used in portfolio management contexts today. The reader is referred to Sharpe et al. (1998) for more details on the CAPM.

22 3 Modeling of Financial Assets and Financial Optimization

A further milestone in nancial modeling is the arbitrage pricing theory (APT) of Ross (1976). The APT framework is essentially a multifactor model which rules out arbitrage possibilities. Fama and French (1993) was one of the rst publications, giving empirical evidence that factors explain average returns of stocks and bonds. Treynor and Black (1973) pioneered the area of systematic active portfolio management. Their ideas have been rened in Black and Litterman (1991, 1992) by introducing uncertainty about the model parameters. Besides the single-period models mentioned above, there is the branch of continuous-time nance. The breakthroughs of continuous-time nance are the seminal publications of Black and Scholes (1973) and Merton (1973b). These papers consider the problem of pricing contingent claims. The continuous-time extension of the CAPM is found in Merton (1973a). The models of Black, Scholes, and Merton are based on Brownian motion which implies that returns are normally distributed. The concept of risk-neutral valuation was introduced by Cox and Ross (1976). Short-rate models are frequently used for modeling xed-income securities, see Vasicek (1977) for an example. Concerning the modeling of the whole term structure, the pioneering work of Ho and Lee (1986) considers the discrete-time case. The continuous-time case is studied in Heath, Jarrow and Morton (1992). Besides the just mentioned economic and nancial models, a major advance in volatility modeling is called autoregressive conditional heteroskedasticity (ARCH), introduced by Engle (1982). This topic is discussed in Section 3.2. The drawbacks of the continuous-time models of Black, Scholes, and Merton are that returns are normally distributed. This deciency is overcome by replacing the Brownian motion with a Levy process. A Levy process is a continuous-time process with independent and stationary increments, based on a more general distribution than the normal distribution. However, in order to dene such a stochastic process with independent and stationary increments, the distribution has to be innitely divisible. Levy processes take the stylized facts of asset returns much better into account than Brownian motion. The reader is referred to Schoutens (2003) for details on Levy processes in nance. Of course, this short overview is far from complete. It should serve the reader as an overview of the models and methods used in this work.

3.1 Statistical Properties of Asset Returns

3.1 Statistical Properties of Asset Returns

In Chapter 2, the rate of return is dened as the monetary gain or loss of the investment divided by the initial value of the investment. This concept is called arithmetic return, sometimes also denoted as simple return. The return of an asset may also be dened as the continuous-compounded or log-return. The numerical dierences between simple and log-returns are usually small for high frequencies of data. Both concepts have their advantages and disadvantages in terms of portfolio and time aggregation. If not stated otherwise, we usually work with the log-return. The reader is referred to Tsay (2001) for details. In order to describe asset returns, the distribution of the asset returns has to be specied. The distribution can either be parametric, semi-parametric, or nonparametric. Whilst the fully parametric models are most vulnerable to modeling errors, their mathematical use for further calculations is far richer. For instance, portfolio optimizations are by far easier with parametric models than with semi-or non-parametric models. Figure 3.1 gives an overview of important parametric models in nance. ffd8ffe000104a46494600010201012c01 2c0000ffe20c584943435f50524f46494c45 00010100000c484c696e6f021000006d6e 74725247422058595a2007ce0002000900 0600310000616373704d5346540000000 049454320735247420000000000000000 000000000000f6d6000100000000d32d48 502020000000000000000000000000000 000000000000000000000000000000000 000000000000000000000000000000000 011637072740000015000000033646573 Normal Mean63000001840000006c77747074000001f0 00000014626b707400000204000000147 258595a00000218000000146758595a00 00022c000000146258595a00000240000 00014646d6e640000025400000070646d Fig. 3.1. Classes of distributions in nance 6464000002c4000000887675656400000 34c0000008676696577000003d4000000 246c756d69000003f8000000146d656173 Elliptical distributions 0000040c0000002474656368000004300 are often reasonably good models for nancial return data 000000c725452430000043c0000080c675 and have very pleasing properties. For instance, taking linear combinations of 452430000043c0000080c6254524300000 elliptical random vectors 43c0000080c7465787400000000436f707 same type. The results in an elliptical random vector of the 972696768742028632920313939382048 marginal and conditional distributions of elliptical distributions are again elliptical. 65776c6574742d5061636b61726420436f 6d70616e7900006465736300000000000 Popular elliptical distributions are the normal and the t distribution. For more details 00012735247422049454336313936362d 322e31000000000000000000000012735 on elliptical distributions, the reader is referred to McNeil, Frey and Embrechts 247422049454336313936362d322e3100 (2005). 000000000000000000000000000000000 0000000000000000000

24 3 Modeling of Financial Assets and Financial Optimization

Stable distributions were introduced by Paul Levy in 1925. Note that stable distributions are also called -stable, stable Paretian, or Levy stable distributions. The sum of two independent random variables having the same stable distribution is again a random variable with the same stable distribution. Note that, in general, there exists no closed form formula for the density of the the stable distribution. This makes the maximum likelihood estimation computationally tedious because

numerical approximations have to be used. Stable distributions have innite variance, in general, which is also an unpleasant property. A normal mean-variance mixture distribution is a generalization of the normal distribution. The generalization stems from a positive mixing variable, introducing randomness into the mean vector and the covariance matrix of a multivariate normal random variable. Let U be a random variable on [0, ), R and , R two arbitrary vectors. The random variable X| U = u N ( + u, u) is said to have a normal mean-variance mixture distribution. This distribution is elliptical for = 0 and is called normal variance mixture in this case. The most important normal mean-variance mixture distribution we consider in this context is the generalized hyperbolic distribution (GH). The mixing variable for the GH distribution is the generalized inverse Gaussian (GIG) random variable. The reader is referred to Appendix A for the technical details on normal mean-variance mixture distribution. Having described the important classes of distributions found in Figure 3.1, the role of the normal distribution, denoted by N , becomes apparent. It is the only distribution which is found in every of the three classes. Therefore, the normal distribution is usually considered as benchmark for the modeling of nancial assets. In the sequel of this chapter, the univariate and the multivariate properties of asset returns are explored. The data in this chapter is obtained from the Datastream database of Thomson Financial. The datasets range from 1990 to 2005.
n nn

a covariance matrix,

3.1.1 Stylized Facts There are many publications on the subject of the stylized facts of asset returns. Since theses stylized facts are observed empirically, they are now more or less accepted. We list the most important stylized facts.

3 3.1 Statistical Properties of Asset Returns

Equity returns show little or no serial correlation although they are not independent. Equity returns are fat-tailed and skewed. E Squared or absolute equity returns are serially correlated. S Volatility is time-varying and appears in clusters.

26 3 Modeling of Financial Assets and Financial Optimization

Standard

references

for

continuous

distributions

are

Johnson,

Kotz

and

Balakrishnan (1995a, 1995b). Many distributions are not considered because of their unpleasant properties. The Laplace and the exponential distribution have not been considered because of their shape, the Cauchy distribution has not been considered because its mean is not dened. We consider the log-normal, gamma, generalized For high frequency data and their properties see Cont (2001) and the references inverse Gaussian, chi-square, Weibull, beta, and F distributions as candidates for therein. A standard reference on high frequency nance is Dacorogna, Gencay, price distributions, but not for return distributions. Muller, Olsen and Pictet (2001). For more details on the stylized facts of asset returns There are many to McNeil et al. (2005), Ziemba and kurtosis values of asset the reader is referredpublications treating skewness (2003), Campbell et al. (1997), returns. All of them report that real-world return series are leptokurtic and skewed. and Campbell and Viceira (2002). Therefore, we are interested in distributions which are skewed, have fat tails, or both. A possible extension of the normal distribution is its skewed version, introduced by 3.1.2 Univariate Properties Azzalini (1985). The estimation in its original form is inconvenient, we therefore use We explore the (unconditional) univariate properties of asset returns. Therefore, we the methods described in Pewsey (2000). The results for the skewed normal consider the set of univariate distributions. skewed normal point is thedoes not distribution are rather disappointing since the The starting distribution normal distribution, fat tails.is the most popular in portfolio construction since state, as a account for which Therefore, it is not investigated any further. We may Markowitz (1952). For nance inthe inclusion normality assumption is found in most is more rule of thumb, that general, the of heavy-tails in return distributions models. The rst appearance of the normal distribution in nance dates back to Bachelier important than the skewness aspect. A fat-tailed extension of the normal distribution is the t distribution. The t (1900). Another reason for the popularity of the normal distribution is because of the use distribution converges to the normal distribution as the parameter tends to innity, of Brownian motion in nance. Although Brownian motion has been mathematically see (A.2) for details. Therefore, a large value of indicates that the considered rigorously introduced in 1923 by Norbert Wiener, the Brownian motion rst shows up random variable may also be considered normal. A further extension would be the in nance in Osborne (1959). A lot of continuous-time nance results have emerged skewed t distribution. We use the method of Fernandez and Steel (1998) to extend from Samuelson (1969) and Merton (1969). The central limit theorem makes the the t distribution to be skewed, see (A.1) for details. The skewness is measured by normal distribution the most important distribution in probability. Some similar the parameter (0, ). We have no skewness for = 1 which results in the phenomenon may also be observed for equity returns. The lower the frequency of ordinary t distribution. The skewed t distribution obviously has the properties of the returns, the more the distribution of the returns resembles a normal distribution. being leptokurtic and skewed. Note that Hansen (1994) also introduces a skewed This means that we may reasonably model yearly returns as normal. However, daily version of the t distribution. returns cannot be assumed normal, statistically. The generalized hyperbolic (GH) distribution is introduced by Barndor-Nielsen (1977), although not in a nancial context. Eberlein and Keller (1995) use the GH disOne of the rst published doubts about the normality assumption of asset returns tribution to describe nancial return data and also suggest a hyperbolic Levy are Mandelbrot (1963) and Fama (1965). Since then, many more publications on this motion. The GH distribution is a very exible distribution and is well suited for subject have appeared. Motivated by the fact that nancial returns are skewed and describing return data. It contains many important special and limiting cases. Among leptokurtic (fat-tailed), we want to investigate suitable extensions of the normal these are the hyperbolic, normal inverse Gaussian (NIG), a version of the skewed t, distribution. Figure variance gamma, t, and the normal distribution. assumption proposed so far. 3.1 shows promising extensions of the normality All these distributions are proposed as nancial return models

3.1 Statistical Properties of Asset Returns

in the literature. For more details on the GH distribution in nance see McNeil et al. (2005), Knight and Satchell (2000), Prause (1999), Raible (2000), Rydberg (1998), and Barndor-Nielsen and Shepard (2001). The density functions of the GH family are found in Appendix A.2.3. In his publication, Mandelbrot (1963) nds that the stable distribution is well suited for describing asset returns. As their name suggests, these distributions have the pleasing property of being stable. That is, the sum of two independent random variables characterized by the same stable distribution is itself characterized by the same stable distribution. Besides this appealing property, the problem with the stable distribution is that it has innite second and higher moments. This is in contrast with empirical observations which have nite second moments. Madan and Seneta (1987) introduce the variance gamma distribution. A nancial application of the variance gamma distribution is found in Madan and Seneta (1990). Note that Eberlein and von Hammerstein (2004) show that the variance gamma distribution is a limiting case of the generalized hyperbolic distribution. Carr, Gemna, Madan and Yor (2002) give a generalization of the variance gamma distribution, called CGMY. The CGMY distribution is innitely divisible and therefore also suited for building a corresponding Levy process. Geman (2002) shows that the GH-and CGMY distribution are well suited for describing asset returns. We distinguish between two main classes to model asset returns more realistically. These classes are the GH class and the class of stable distributions. We investigate further models of the GH class. The reasons for this are manifold. One important reason is that, using multivariate distributions of the GH class, the distribution of the portfolio is easily calculated. Another reason is that for the stable distribution, there exists, in general, no closed-form of its density. Therefore, the GH distribution is much more convenient to work with. The most important reason is that various empirical studies, e.g., Akgiray and Booth (1988), rule out innite variance of asset returns and therefore also stable distributions. We investigate the following univariate distributions: normal, t, normal inverse Gaussian (NIG), skewed t, and generalized hyperbolic (GH). Apart from these parametric distributions we also consider kernel density estimates. The

corresponding kernels are always chosen to be Gaussian, the bandwidth is optimized with the leave-one-out method,

28 3 Modeling of Financial Assets and Financial Optimization

ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c48 4c696e6f021000006d6e74725247422058595a2007ce00020009000600310000616373704d534654000 0000049454320735247420000000000000000000000000000f6d6000100000000d32d4850202000000 70 0000000000000000000000000000000000000000000000000000000000000000000000000000000000 00000001163707274000001500000003364657363000001840000006c77747074000001f0000000146 26b707400000204000000147258595a00000218000000146758595a0000022c000000146258595a000 60 0024000000014646d6e640000025400000070646d6464000002c400000088767565640000034c00000 08676696577000003d4000000246c756d69000003f8000000146d6561730000040c000000247465636 50 8000004300000000c725452430000043c0000080c675452430000043c0000080c625452430000043c0 000080c7465787400000000436f70797269676874202863292031393938204865776c6574742d50616 36b61726420436f6d70616e790000646573630000000000000012735247422049454336313936362d3 22e31000000000000000000000012735247422049454336313936362d322e310000000000000000000 00000000000000000000000000000000000

d e n si ty
40 30 20 10 0

return Fig. 3.2. Density estimates for the daily Dow Jones returns.

see Hardle (1992) for details. Figure 3.2 shows the density estimates for the daily Dow Jones log-returns from 1990 to 2005. The GH distribution gives the best parametric t in terms of the log-likelihood value. In this case, the deciency of the normal distribution is that it does not account for the fat tails and the thin middle.
ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c48 4c696e6f021000006d6e74725247422058595a2007ce00020009000600310000616373704d53465400 00000049454320735247420000000000000000000000000000f6d6000100000000d32d48502020000 000000000000000000000000000000000000000000000000000000000000000000000000000000000 0 00000000001163707274000001500000003364657363000001840000006c77747074000001f000000 014626b707400000204000000147258595a00000218000000146758595a0000022c00000014625859 5a0000024000000014646d6e640000025400000070646d6464000002c400000088767565640000034 c0000008676696577000003d4000000246c756d69000003f8000000146d6561730000040c000000247 5 4656368000004300000000c725452430000043c0000080c675452430000043c0000080c62545243000 0043c0000080c7465787400000000436f70797269676874202863292031393938204865776c6574742 d5061636b61726420436f6d70616e7900006465736300000000000000127352474220494543363139 36362d322e31000000000000000000000012735247422049454336313936362d322e3100000000000 10 0000000000000000000000000000000000000000000

lo g( d e n si ty )

15

20

return Fig. 3.3. Logarithmic density estimates for the daily Dow Jones returns.

3.1 Statistical Properties of Asset Returns

In order to analyze the tails, the logarithmic density estimates are plotted in Figure 3.3. Obviously, the normal distribution ts very poorly in the tails, therefore considerably underestimating the events of extreme losses.

3.1.3 Methodology and Results for the Univariate Case The distributions are tted to the return time series by a maximum likelihood approach. For the model selection part, we use the method of information criteria. In this work, we use the concept of Akaike (1974). An alternative approach is suggested in Schwarz (1978), which is more restrictive with respect to higher order models. Accordingly, we chose the distribution with the lowest information criterion as the best model. By y we denote the geometric returns of the price data. The parameters of the distribution are assembled in the vector , the estimated parameters are denoted by . The log-likelihood value of the estimation is denoted by l(|y). The Akaike information criterion is dened as AIC = 2l(|y)+2q, (3.1) where q is the number of parameters of the distribution. The distribution which minimizes the Akaike information criterion is considered as the best model. As an example, we give the detailed results for the Dow Jones Industrials index. The results from the maximum likelihood estimation for a daily frequency are shown in Table 3.1, the best results are shown in bold numbers. Note that the normal distribution gives the worst t for daily returns. Having inspected Figure 3.2 this result is expected.

Table 3.1. Distributions for daily Dow Jones returns. Distribution AIC value log-likelihood value GH -25496.33 12753.17 NIG -25482.79 12745.39 t -25468.92 12737.46 Skewed t -25467.84 12737.92 Normal -24914.26 12459.13

In Table 3.1, the GH density has the highest log-likelihood value and therefore ts the data best. If the number of parameters is taken into account, i.e., we use the AIC criterion for model selection, the GH distribution still is the best model in this particular case.

Equity index monthly min(AIC) ?1 30 3 Modeling of Financial Assets and Financial Optimization ?2 weekly min(AIC) ?1 ? Table 3.2 reports the results for dierent2 equity indices with data from 1990 to daily min(AIC) ?1 ? 2005. The GH, NIG, and the skewed t (s-t) t 2the data best in terms of the maximum S&P 500 likelihood value. In addition, the skewness NIG -0.36 the kurtosis 2 are given. The 1 and 3.43 NIG -0.41 normal distribution is the best model for monthly Nikkei 225 return data. This result 5.83 is supported by the values of 1 and 2 forGH -0.10 the monthly Nikkei 225 returns. The 6.89 Dow Jones considered stock indices, in general, have fat tails and are skewed to the left. This is s-t -0.27 3.71 seen from the values of 1, which are all negative, and from the values of 2, which s-t -0.40 6.34 are all larger than three. For daily returns, the GH and the NIG distribution are the GH -0.23 7.69 best models in terms of the AIC value. In terms of the maximum likelihood value, the Nasdaq GH -0.53 GH distribution ts best. 4.22 NIG -0.45 Table 3.2. Distributions for equity index returns. 6.35 GH -0.02 8.74 FTSE 100 NIG -0.38 3.75 NIG -0.33 5.97 NIG -0.09 6.14 CAC 40 s-t -0.46 3.50 t -0.23 4.70 NIG -0.09 5.83 DAX 30 s-t -0.76 4.33 NIG -0.47 5.86 NIG -0.21 6.87 SMI s-t -0.71 5.47 NIG -0.69 7.34 GH -0.25 8.21 Nikkei 225 N -0.13 3.43 t 0.02 4.71 GH 0.20 6.35 S&P Global 1200 s-t -0.41 3.57 NIG -0.46 4.81 NIG -0.19 6.96

Commodity (index) monthly min(AIC) ?1 ?2 weekly min(AIC) ?1 ?2 daily min(AIC) ?1 ?2 Gold

6.46 t 0.31 8.39 GH -0.08 14.34 Oil (West Texas Int.) 3.1 Statistical Properties of Asset Returns t 0.07 3.85 Table 3.3. Distributions for commodity returns. s-t -0.45 8.72 GH -1.47 29.40 Platinum (London) t -0.1 3.75 t -0.02 6.78 NIG -0.24 11.19 Moodys Commodities Index N 0.30 3.64 t 0.12 FI index4.00 GH 0.04 monthly min(AIC) ?1 11.82 ?2 GSweekly min(AIC) ?1 considered so far. For monthly returnsCommodities Index of less than seven years, the with a maturity t 0.14 ?2 3.56 1 normal distribution is the best model indaily min(AIC)t?-0.59 value. We observe that the terms of the AIC ?2 8.67 US Govt. 1-3 the return distribution deviates from longer the maturity of the bond index, the moreyears-1.02 GH N 0.008 19.95 3.18 the normal distribution. The NIG distribution is particularly well suited for describing GS Energy Index t -0.04 t 0.26 3.88 daily bond index returns. Besides the normal and the NIG distribution, the skewed t NIG 0.063.80 t -0.04 7.05 distribution gives the best ts. 7.43 US Govt. 3-5 years GH -0.16 N -0.26 6.42 3.32 NIG -0.28 Table 3.4. Distributions for bond total return index returns. 3.66 NIG -0.22 5.67 US Govt. 5-7 years N -0.26 3.32 s-t -0.39 3.78 NIG -0.29 5.17 US Govt. 7-10 years s-t -0.38 3.71 Table 3.3 reports the results for some commodities. The results for the daily s-t -0.45 3.88 returns are similar to the ones in Table 3.2, the GH and the NIG distribution are the NIG -0.36 5.23 best models. For monthly and weekly returns, the t distribution is often the best US Govt. >10 years choice. Note that the t distribution is fat-taileds-t -0.49 whereas the GH distribution has semi3.83 s-t -0.41 heavy tails, see Prause (1999) for details. Commodity returns, in contrary to equity 3.84 index returns, may be significantly skewedNIG -0.33 right. The high values of the to the 4.67 US returns have fatter tails than the equity kurtosis give evidence that commodityGovt. all mat. s-t -0.40 3.56 indices in Table 3.2 and the bond indices in Table 3.4. Daily returns on oil are s-t -0.42 3.73 signicantly more non-normal than the returns on gold, indicated by the NIG -0.32 4.88 corresponding values of the skewness and kurtosis.

Table 3.4 reports the results for xed income indices. We consider US Government Bond indices with dierent maturities. The indices are total return indices and are calculated by Thomson Financial. These data sets seem to have thinner tails than the asset returns

32 3 Modeling of Financial Assets and Financial Optimization

combination of the components of a multivariate random variable or a random vector, respectively. As a consequence, the dependencies among the dierent components signicantly inuence the properties of the portfolio distribution. The dependence concept used most commonly is correlation, i.e., the linear dependence of multivariate random variables. If we are considering the meanvariance framework, correlation suces since the correlation matrix of a multivariate normal distribution fully describes its dependence. A standard reference on dependence is Joe (1997). It is documented that correlation is a questionable dependence measure when distributions are not elliptical, see Embrechts, McNeil and Straumann (2002) and Embrechts, Lindskog and McNeil (2003) for more details. Therefore, we investigate for dependence measures beyond correlation. Most of the distributions introduced in the previous section have a multivariate version, see Appendix A.2.3. However, instead of introducing a multivariate distribution function, there exists another approach to construct a multivariate distribution: a copula is a function which ties together univariate distributions to a fully multivariate distribution. Therefore, copulas provide a wide range of possible dependence structures. Copulas allow for constructing a dependence structure among totally dierent kinds of margins. This is not possible with multivariate distributions whose margins usually are of the same type.

Copulas In the area of nance, risk management and diversication play central roles. Obviously, reasonable risk management is not possible without a sound knowledge of the dependenciesof brevity, we only analyzed this knowledge, properties of some For the sake of the risky assets. Without the univariate good diversication cannot be achieved. The copula results for allows assetsseparate the modeling of the selected equities. However, the approach other us to in these classes are similar. univariate margins andthat the GH class with comprehensive introductory paper for Summarizing, we nd their dependencies. A its limiting cases oers a fairly good copulas in modeling univariate distributions for assetRiboulet and Roncalli (2000). We choice for nance is Bouye, Durrleman, Nikeghbali, returns. briey review the most important concepts of copulas used in this context. The reader is referred to the literature for details. A standard reference on copulas is 3.1.4 Multivariate Properties and Dependence Nelsen (1998), more recent publications are Mari and Kotz (2004) and McNeil et al. A portfolio, by denition, consists of more than one asset. Therefore, asset returns (2005). must be modeled as multivariate random variables. The previous section

investigated the (unconditional) marginal distributions of dierent kinds of assets. A portfolio is the linear

3.1 Statistical Properties of Asset Returns

A copula is a function C that links the univariate margins with the cumulative distribution functions Fi of the random variables X1,X2, ..., Xn to a full multivariate
n F . Therefore, 1 distribution an n-copula is a function C from [0, 1] to [0, 1] with the properties

C is grounded and n-increasing. C has margins Cn which satisfy Cn(u)= C(1, ..., 1, u, 1, ..., 1) = u, Vu [0, 1].

34 3 Modeling of Financial Assets and Financial Optimization

copula which is often found in nancial studies. Other popular Archimedean copulas are the Frank and the Clayton copula. See Schmidt, Hrycej and Stutzle (2003) for the GH copula. As mentioned in the previous section, the multivariate normal distribution is still the most popular distribution when modeling asset returns. This makes the Gaussian copula the most used copula in nance. The multivariate normal or Gaussian copula Sklar proved in 1959 that the copula C is unique for a multivariate distribution is given by 1 1 Ga C R (u1,...,un)= cR(c (u1),...,c (un)), function F with continuous margins. Its importance stems from the fact that marginal distributions and the standard normal distribution and cR the n-dimensional normal where c denotes their dependence can be separated. distribution with correlation matrix R. The corresponding density is (i = c Theorem 3.1 (Sklars Theorem).
1

(ui))

T 1 2 1 1 c(u1,...,un)= (R In) e, Let F be an n-dimensional distribution function with continuous margins F1,...,Fn. ? det(R) where In denotes the n-dimensional Then, F has a unique copula representation identity matrix. Another copula frequently found in nancial applications is the

multivariate t copula,

F (x1,...,xn)= C(F1(x1),...,Fn(xn)).
1 1 t R, C (u1,...,un)= tR, (t(u1),...,t(un)),

Proof. See Nelsen (1998).

With theR, denotes the Sklars theorem we may also distribution with degrees of where t assumptions of standardized multivariate t state that freedom and shape matrix R. Additionally, 1 denotes 1 the standard univariate t t C(u1,...,un)= F (F1 (u1),...,F n (un)). distribution with degrees of freedom. The corresponding density is
+n 2 +1 fR, (1,...,n) ? ( )[? ( )]n1 (1 + i ) The modeling process within the copula framework has two levels. The 2rst level n +1 n t (u1,...,u 1 cR,22 i=1 n)= = , (3.3) f1, (i) ? +n det(R)[?( )] (1 + T R1) 2 i=1 consists of modeling the marginal distributions. The second level consists of 2 n

modeling the dependence of the margins, i.e, of choosing the appropriate copula. In where i =t (ui) and fR, denotes the density of a tn(, 0,R) distributed random vari1 both levels we may either use parametric or non-parametric models. The marginal able, see Appendix A.2.3. The properties of the t copula and related copulas are densities of the random variables Xi are denoted by fi. The density f of the extensively studied in Demarta and McNeil (2005). Malevergne and Sornette (2003) multivariate distribution function F is given by nf(x1,...,xn)= investigate elliptical copulas for nancial assets. They consider the Gaussian and the n fi(xi), (3.2) c(F1(x1),...,Fn(xn)) t copula and nd that it may be dangerous to blindlyi=1 assume a Gaussian copula. Breymann, Dias and Embrechts (2003) and Dias and Embrechts (2004) analyze where c is the density of the copula given by elliptical as well as Archimedean copulas for their use in modeling of nancial data. c(u1 copula. n C(u1,...,un) We will investigate the normal and the t ,...,u1)= .The normal copula is considered u un because of its importance in nance. The t copula is investigated because it is a We extension of the normal copula, course, there copula is a limiting case of naturalonly consider elliptical copulas. Ofi.e., the normalare other classes of copulas such as Archimedean copulas, extreme value copulas, or Marshall-Olkin copulas the t copula. Furthermore, Malevergne and Sornette (2003) and Dias and Embrechts which nd very promising results for the t copula also (2004)are not further investigated. Elliptical copulas are simply the copulas of elliptic in comparisonArchimedean copulas are also popular in nance. The Gumbel copula is distributions. to Archimedean copulas. an Archimedean

3.1 Statistical Properties of Asset Returns

Finally, we examine the statistical inference of copulas. For the non-parametric case we may use the concept of empirical copulas, see Bouye et al. (2000) for details. For non-parametric margins we may either use empirical distributions or kernel regression techniques. For details on the method of kernel regression see Hardle (1992). The two main concepts for statistical inference are maximum likelihood and method of moments. We will use the maximum likelihood approach since, in general, it is more accurate than the method of moments. Suppose we have sample of size N, denoted by X . By we denote parameters of the model, c denotes the parameters of the copula, and i corresponds to the parameters of the i-th margin. From (3.2) we immediately obtain the log-likelihood function l() as N l(|X )= n L((ti)(ti) )) L (ti) [ log c(F1(x|1),...,Fi=1 j=1 )|c+ log (fj(x|j))]. (3.4) 1 nj n(x|n

If we have a parametric model for the margins and for the copula, (3.4) has to be maximized with respect to all of the elements in . However, one could also, in a rst step, estimate the parameters of the margins. After having estimated the parameters i (i =1,...,n) of the margins, the parameters of the copula are estimated separately. This procedure could also be applied to a non-parametric estimation of the margins. In this case we call the procedure a pseudo-maximum-likelihood estimation or inference functions for margins method (IFM). In both ways, the second term in (3.4) does not aect the estimation of the copula parameters. Therefore it is often omitted in the literature. By using the IFM method, the inference of the marginal properties and the dependence properties are separated.

Dependence Measures We give a brief overview of measures of dependence. For more details on the topic dependence measures, the reader is referred to McNeil et al. (2005), Embrechts et al. (2003), and Embrechts et al. (2002). In the following, we make use the concept of concordance. Informally speaking, the concordance of two random variables is the property that large and small outcomes of two random processes occur together. Let (x,x) be two 12 12 and (x,x) observations of a random vector (X1,X2) of continuous random variables. We
(ti)(tj )(ti)(tj ) 12 and (x,x) are say that (x,x)12 1122 (ti)(tj )(ti)(tj )concordant if (x x)(x x) > 0, and discordant if (x1 x1 )(x2 x2 ) < 0. (ti)(ti)(tj )(tj ) (ti)(ti)(tj )(tj )

36 3 Modeling of Financial Assets and Financial Optimization

Correlation The most used dependence measure in practice is the correlation. Note that zero correlation is a necessary but not a sucient condition for independence. Kendalls tau Kendalls tau is dened as the dierence between the probability of concordance minus the probability of discordance. Note that Kendalls tau is a copula property and therefore independent of the margins, see Nelsen (1998) for details. Spearmans rho Spearmans rho is dened to be proportional to the probability of concordance minus the probability of discordance. As Kendalls tau, Spearmans rho is a copula property and therefore independent of the margins, see Nelsen (1998) for details. Tail Dependence The concept of tail dependence describes the dependence for extreme values. Loosely speaking, tail dependence describes the limiting proportion of exceeding one margin over a certain threshold given that the other margin has already exceeded that threshold. We dierentiate between lower and upper tail dependence. For elliptical distributions, these two measures are the same. In a nancial context we are mainly interested in the lower tail dependence since this means concurrent extreme losses.

Denition 3.2 (Lower Tail Dependence).

If, for a bivariate copula C, the limit l = limu+0 u exists, then C has lower tail dependence for l (0, 1] and no lower tail dependence for l =0. As Kendalls tau and Spearmans rho, tail dependence is a copula property and therefore independent of the margins. The Gaussian copula has no tail dependence. This is the main deciency of the Gaussian copula since we know from the empirical properties of asset returns that asset prices may have concurrent extreme losses. The tail R, dependence of a bivariate t copula C t is

C(u,u)

) =2 t+1, (3.5) ( + 1)(1 )( 1+ where is the o-diagonal element of R and t+1 denotes the t distribution with +1
degrees of freedom. For a proof see Embrechts et al. (2002). Note that we can compute the tail dependence coecients in any dimension of the t copula in an analogous way. For the proof see Appendix C.1.

3.1 Statistical Properties of Asset Returns

(ti)(ti)(i)(j)(ti)(ti) N 12Let 1212 i=1 {(x,x)}

denote a sample of size N and R,Rthe rank of xand x,

respectively. Empirically, the tail dependencies can be calculated as

n 1 l = L 1(i)(i) . k} k {R? k,R? 12 i=1

The parameter k has to be dened. It reasonable the set k = n, where describes the percentage of the area under the distribution that is considered as tail. 3.1.5 Results for the Multivariate Case
Table 3.5. Multivariate distributions for equity indices returns.

Distribution We t the considered multivariate models to various typical combinations of assets

by maximum likelihood and analyze the montlog-l multivariate properties of the asset returns.
hly AIC First, we analyze the results of dierent multivariate distributions of asset returns. In weelog-l a second step, we elaborate the tail dependencies among several asset classes. kly AIC

Multivariate Parametric Distributions

dalog-l ily AIC

As in Section 3.1.3, we aim to select the Normal suitable model for asset returns. We most consider the multivariate versions of the normal, t, skewed t, NIG, and the GH 2835.5 distribution. The distribution functions are -5583 in Appendix A.2.3. Again, we make given use of the Akaike information criterion as 16274.8 in (3.1). We t the equity indices of dened Table 3.2 to the multivariate distributions -32462 mentioned above. The results are shown in Table 3.5; the best results are shown in bold numbers. The GH distribution gives the
106129

best t in terms of the log-likelihood value. Surprisingly, the multivariate t

-212170 t

distribution is the best model in terms of the AIC criterion, although it is not frequently chosen for the univariate case in Table 3.2. We nd that the normal
2866.7 -5643

distribution ts the data signicantly worse than the other distributions.

16607.6 -33125 108279 -216467 Skewed t 2871.5 -5637 16614.6 -33123 108285 -216464 NIG 2871.4

16612.3 -33119 38 3 Modeling of Financial Assets and Financial108286 Optimization mont hly -216467 wee Next, we t the commodities found in Table 3.5 to the parametric multivariate kly GH d distributions considered. Table 3.6 shows the results; the best results are shown in aily 2871.6 Distribution bold numbers. As for the equity indices returns, the multivariate t distribution oers a log-l -5635 AIC good t in terms of the AIC value. Thislog-l time, the choice of the multivariate t 16615.0 AIC distribution is less surprising since the t distribution is also frequently chosen in the log-l -33122 AIC univariate case. The best ts for the log-likelihood value are the multivariate skewed Normal 108291 2127.0 t and the GH distribution. -4200 -216474 11918.4 Table 3.6. Multivariate distributions for commodity returns. -23783 76832 -153609 t 2147.9 -4240 12332.0 -24608 80443 -160829 Skewed t 2149.7 -4231 12334.0 -24600 80447 -160825 NIG 2149.7 -4231 12319.1 -24570 80414 -160761 GH 2149.8 -4230 12333.9 -24598 80445 -160821

mont hly wee kly d aily Distribution

log-l AIC log-l AIC Normal 2351.4 Statistical Properties of Asset Returns 3.1 -4649 13147.2 Table 3.7. Multivariate distributions for a typical portfolio. -26241 84841 -169628 t 2376.6 -4697 13532.7 -27009 87751 -175447 Skewed t 2377.7 -4687 13536.4 -27005 87759 -175450 NIG 2377.4 -4687 13518.0 -26968 87724 -175381 GH 2377.7 -4685 13536.3 -27003 87758 -175447

We do not give the detailed results of the bond indices of Table 3.4. However, the results are similar to those obtained so far. Again, the multivariate t distribution oers the best t in terms of the AIC value. Although that the univariate distributions for monthly returns are reasonably modeled with the normal distribution, this is no longer the case for multivariate distributions. We interpret this nding as the lack of the multivariate normal distribution to model the dependence structure of bond index returns. In addition to the deciencies of the univariate normal distribution, the multivariate normal has further disadvantages because of its dependence structure. So far we have only considered multivariate distributions of asset returns belonging to the same asset class. We consider the portfolio of an US investor. The portfolio of this investor consists of the S&P 500, Nasdaq, S&P Global 1200, GS Commodities Index, GS Energy Index, and the DS US Government all maturities index. In this example, there are no foreign exchange or real estate assets in the portfolio. Neither are there any alternative investments. The results are shown in Table 3.7, the best results are shown in bold numbers. Again, the results are similar to the multivariate examples analyzed so far. The GH and the skewed t distribution oer good ts for the considered multivariate asset returns. The results for the portfolio substantiate the fact that assuming a normal

40 3 Modeling of Financial Assets and Financial Optimization

sity estimates are signicantly higher than for the empirical estimates. Therefore, we use kernel density estimates for the margins. Table 3.8 shows the result for the three considered cases. The rather low estimates for the degree of freedom parameter indicate that there is considerable tail dependence for the correlated assets. The higher the frequency of the data, the lower the degree of the freedom parameter of the t copula becomes. Therefore, a high frequency of return data implies more tail dependence. By comparing the loglikelihood values of the semidistributionTable portfolio construction asset returns with kernel estimations for the margins. for 3.8. Copula estimations for can underestimate the probability of extreme monthly Gaussian t
weekly Gaussian t Gaussian daily t Equity we have only analyzed For the sake of brevity,indices Commodities Portfolio some selected groups of equities. 2876 2889 (?=15) 2156 2163 (?=12) 2382 2395 (?=11) As expected, the GH16556 16710 (?=8) limiting cases oer a considerable improvement family and its 12296 12441 (?=11) 13497 13638 (?=9) 107891 80604 87425 108706 to the normal distribution. (?=6) 81263 (?=9) 88152 (?=7) log-likelihood

losses severely.

Multivariate Semi-Parametric Distributions In the previous section, we have analyzed the goodness-of-t of parametric distribution models. In this section, we consider semi-parametric models. The models are semi-parametric because we chose non-parametric distributions for the margins. These are tied together with a copula function in order to have a multivariate distribution function. We either choose the empirical distribution or the kernel density for the estimates of the margins. The main advantage of the empirical distribution is that it is trivial to compute. The main deciency of using empirical distributions is that the tails may not reect the true tails of the underlying distribution. One possibility to overcome this problem is to use kernel densities. Another possibility would be having parametric tails with models from extreme value theory and using the empirical distribution for the body of the distribution. We investigate the Gaussian copula and make comparisons with the t copula. The copulas are tted to the same groups of assets as in the previous section. We consider the equities studied in Table 3.5, the commodities of Table 3.6, and the portfolio of the US investor found in Table 3.7. Only the copula parameters are estimated. For the margins, either the empirical distribution or the kernel density is used, i.e., we only consider the left term in (3.4) for the maximum likelihood estimation. We nd that the log-likelihood values for kernel den

0.61 0.42 0.21 0.22 0.22 0.20 3.1 Statistical Properties of Asset Returns 0.08 DJI

the degree of diversication in extreme situations. An investor is especially

0.27 interested in good diversication once extreme losses occur. 1 0.21 0.21 the tail dependence among dierent asset 0.21 0.21 to the data and then calculating the tail 0.07 Nas

We investigate tting a t copula

classes. This is done by dependence coecients

accordingly, as in (3.5). We do not make any modeling assumptions about the margins. Therefore, the kernel density is used. Note that the results for the tail dependence do not dier signicantly when the empirical distribution is used instead 0.16 of the kernel density. At rst, we analyze0.18 global equity indices, i.e., S&P 500, Dow Jones, Nasdaq, FTSE 100, CAC 40, DAX 30, 0.08 and Nikkei 225. SMI,
FSE Table 3.9. Tail dependence coecients of weekly world equity indices returns. S&P 500 (S&P), Dow Jones (DJI), NASDAQ (Nas), FTSE 100 (FSE), CAC 40 (CAC), DAX 30 (DAX), SMI (SMI), Nikkei 225 (Nik) 1 0.30 0.26 0.27 0.08 CAC 0.14 0.17 1

parametric models with the parametric models, we nd that the semi-parametric models with the t-copula give the best t in every case. The results for the Gaussian copula are mixed. For monthly returns, the semi-parametric Gaussian model is
1 0.37 superior to the parametric models. This is not the case for weekly and daily data. 0.30 0.08 DAX univariate

The previous section showed that

margins, in general, cannot

reasonably assumed to be normal. This section indicates that the Gaussian copula is usually not suitable for describing multivariate asset returns as well. The interpretation of the results in Table 3.8 is that the Gaussian copula cannot account
1 for tail dependence, although the low values of indicate signicant tail dependence. 0.08 As the multivariate normal distribution, the Gaussian copula underestimates extreme 0.30 SMI

losses in a portfolio because it does not account for concurrent extreme losses of assets in a portfolio. Tail Dependencies In the previous section, several alternative dependence measures have been 1
0.08 introduced. Although these dependence measures are found in many scientic texts, Nik

they are hardly found in practice. Nevertheless, Spearmans rho and Kendalls tau can easily be calculated. In addition, the interpretation of these measures is rather simple and resembles the one of correlation. In contrast to Spearmans rho and Kendalls tau, the tail dependence is consider tail dependence important since it measures not easily calculated. However, we
1

42 3 Modeling of Financial Assets and Financial Optimization S&P5 small. The bond indices found in Table 3.4 are very tail dependent. We interpret this 0.39 result as the fact that the duration does not diversify with respect to extreme losses. 0.52 0.01 0.01 Again, we consider the portfolio of an US investor. Recall that this portfolio 0.02 consists of the S&P 500, Nasdaq, S&P Global 1200, GS Commodities Index, GS Nasd 1 0.03 0.01 0.01 0.01 Table 3.10. Tail dependence coecients in a typical portfolio. S&P 500 (S&P5), Nasdaq (Nasd), S&P Global S&PG 1200 (S&PG), GS Commodities Index (GSCI), GS Energy Index (GSEI), and the DS US Government all 1

Energy Index, and the DS US Government all maturities index. The results for this portfolio are shown in Table 3.10.

maturities index (USFI). 1 0.01 0.01 0.02 GSCI S&P DJI Nas FSE CAC DAX SMI Nik

1 0.70 0.01 GSEI

1 0.01 USFI

From Table 3.9 we observe strong tail dependence between the S&P 500 and the Dow Jones. Surprisingly, the S&P 500 and the Nasdaq are not as tail dependent as one would expect. The other numbers are 1 moderate except for the Nikkei, which makes the Nikkei very suitable for global diversication. If we chose a daily frequency for the returns, the tail dependencies become much higher. The tail dependence of the S&P 500 and the Dow Jones for daily returns is 0.93. The Nikkei, for daily returns, has a tail dependence of approximately 0.2 with the other indices. The low tail dependence of the Nikkei with the other indices for daily data may be caused by asynchronous returns, see Audrino and Buhlmann (2003) for details. We analyze the tail dependencies of the commodities found in Table 3.3. The Goldman Sachs (GS) indices show considerable tail dependence with oil. The commodities index and the energy index have a high tail dependence coecient, indicating that energy prices are considerably inuenced by commodity prices. The other tail dependencies are rather

3.2 Dynamic Models of Financial Assets

The autoregressive moving average (ARMA) model is popular for nancial time series in discrete time. From the stylized facts of asset returns, we know that returns, in general, are not autoregressive. Therefore, we do not aim to model asset returns as ARMA processes. For more details on ARMA models, the reader is referred to Hamilton (1994). The stylized facts of asset returns show that squared returns are autocorrelated. In the introduction of this chapter we mentioned the concept of autoregressive conditional heteroskedasticity (ARCH). Often, we encounter processes of a

generalized ARCH type, abbreviated by GARCH. There exists a wide range of possible extensions of GARCH models such as threshold GARCH, denoted by TARCH, and many others. The TARCH model S&P5 Nasd S&PG GSCI GSEI USFI for modeling equity is particularly well suited returns. For more details on ARMA and GARCH models in nance the reader is referred to Alexander (2001), Tsay (2001), or McNeil et al. (2005). A good comparison of dierent volatility models is found in Sadorsky (2004). The univariate case for GARCH models is usually not sucient for interesting applications. Therefore, we are interested in multivariate models. Popular multivariate models are the vector GARCH model (VEC) and the BEKK model of Baba, Engle, Kroner, and Kraft. In this work we will make use of the constant conditional correlation We observe that the S&P 500 correlation (DCC) GARCH have The CCC model (CCC) and the dynamic conditionaland the S&P Global 1200 model.considerable tail dependence, indicating the global importance model was introduced However, and was proposed by Bollerslev (1990). The DCC of the US economy. in Engle the Nasdaq and the S&P Global (2002).have almost no tail dependence. The large the Sheppard (2001) and Engle 1200 In these models, as for the copula model, tail dependence between the commodities index and the energy index has already been univariate models are separated from the dependence structure. Therefore, the mentioned. The series tail dependencies are very small. Therefore, thethen combined univariate time other are modeled by individual GARCH models and basic portfolio containing stocks and bonds makes The DCC losses less severe. The a good tradeo by a dynamic correlation matrix. extreme GARCH model oers US Government all maturities index has low tail dependence the estimationassets, parameters,very between model complexity and convenience of to all other of the making it see suitable for diversication. for details. We only consider GARCH models in a discreteEngle and Sheppard (2001) time context. For a continuous-time version see Kluppelberg, Lindner and Maller

3.2 Dynamic Modelsaof Financial Assets dependence of asset return prices (2004). Cointegration is popular model for the
and introduced by Engle and Granger (1987). However, it is not further investigated Havingcontext. in this investigated static asset return models in detail, the dynamic models of nancial assets used in this work are briey discussed. We do not give technical In general, continuous-time models are mathematically more profound than details about the models. They are either found in the literature or in the discrete-time models. Stochastic dierential equations, driven by Brownian motions, corresponding applications later on. In Section 3.1, the statistical properties of are the most popular continuous-time models. In this type of model, asset returns are nancial assets are studied. These properties are inherently static and unconditional. assumed to be (conditional) normally distributed. We have seen in this chapter that However, by inspection of the evolution of asset prices, it is natural to model them as this is not always appropriate. Brownian motion belongs to the family of Levy stochastic processes. processes which oers much

44 3 Modeling of Financial Assets and Financial Optimization

more degrees of freedom to model asset returns. A Levy process is a continuoustime stochastic process which is continuous in probability and has stationary, independent increments. Therefore, the increments of a Levy process have an innitely divisible distribution. In a Levy process framework, we may model asset return distributions as members of the GH family. This chapter indicates that this type of distribution is well suited for describing asset returns. Since the introduction of the APT by Ross (1976), factor models are popular for describing asset returns. This often results in a linear regression or in an ARMA model. Factor models represent the thought that asset returns are driven by underlying economic factors such as dividend yields, price-earnings ratios etc. In addition, the use of technical factors for forecasting asset returns is popular, e.g., the momentum. Therefore, we consider the use of factors for two reasons. The rst usage of factors is to elaborate the systematic risks of asset returns. By knowing the return drivers of an asset, the investor obtains valuable insights with respect to risk management. This is particularly interesting if an investor is inspecting a nancial product. The second purpose of factors is to predict asset returns. The biggest problem thereby is an in-sample overtting of the model which has no out-of sample prediction ability. To overcome this problem, model selection techniques are necessary. The reader is referred to Burnham and Anderson (1998) for more details on this topic.

3.3 Financial Optimization Techniques

As mentioned in the introduction, we attribute the rst systematic treatment of the portfolio selection problem to Markowitz (1952). It is still the most popular singleperiod nancial optimization although its deciencies are widely documented. We already know that the normal distribution is not a suitable model for describing univariate or multivariate asset returns. Further drawbacks of the mean-variance model are that the risk criterion is not coherent and that it is only a single period optimization. Some alternative risk measures to variance in a single-period context are semivariance (see, e.g., Markowitz (1959)), mean-absolute deviation (see Konno and Yamazaki (1991)), expected regret (see Dembo and King (1992)), and conditional value at risk (see Rockafellar and Uryasev (2000)). In these models, the actual optimization problem becomes either a linear or a quadratic program. These can be solved in very large dimensions.

3.3 Financial Optimization Techniques

The single period optimization lacks many important properties which are encountered in real-world investment processes. First of all, it does not account for transaction costs. Second, the possibility of altering the portfolio at dierent times in the future is not taken into account. In a single period optimization problem, the investment decisions are inherently static. The deciencies of single period optimizations can only be taken care of if a dynamic optimization approach is used. For deterministic systems as well as stochastic systems, Bellmans optimality principle and Pontryagins minimum principle are often used to nd optimal solutions, see Fleming and Rishel (1975) for details. Bellmans optimality principle is also called dynamic programming and is popular in nancial optimization. Some early publications on multi-stage portfolio selection problems are Samuelson (1969), Fama (1970b), and Dantzig and Infanger (1993). When the decision or control variables of the optimization problem are constrained, dynamic optimization problems become very hard to solve. A technique for overcoming this problem is called model predictive control (MPC). The use of MPC in deterministic problems is popular, see Bemporad and Morari (1999) for a survey. This is not the case for stochastic MPC for which many important results have only been found recently, the reader is referred to Herzog (2005) for details. ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010 100000c484c696e6f021000006d6e74725247422058595a2007ce00020009000600310000 616373704d5346540000000049454320735247420000000000000000000000000000f6d60 00100000000d32d485020200000000000000000000000000000000000000000000000000 000000000000000000000000000000000000000000000116370727400000150000000336 4657363000001840000006c77747074000001f000000014626b7074000002040000001472 58595a00000218000000146758595a0000022c000000146258595a000002400000001464 6d6e640000025400000070646d6464000002c400000088767565640000034c0000008676 696577000003d4000000246c756d69000003f8000000146d6561730000040c00000024746 Fig. 3.4. The model predictive control concept in nance 56368000004300000000c725452430000043c0000080c675452430000043c0000080c6254 52430000043c0000080c7465787400000000436f707972696768742028632920313939382 04865776c6574742d5061636b61726420436f6d70616e7900006465736300000000000000 12735247422049454336313936362d322e31000000000000000000000012735247422049 Figure 3.4 shows the MPC strategy conceptually. The crucial idea is that in each 454336313936362d322e3100000000000000000000000000000000000000000000000000 step, we solve the whole multi-stage optimization problem but then only apply the 0000 current decision variable. The future decision variables are calculated but are not actually implemented since the current decisions variable is recalculated in each decision step. We can either have a xed or a receding horizon. Besides dynamic programming, there exists a dierent approach to solving dynamic stochastic optimization problems, called stochastic programming. For introductory text

46 3 Modeling of Financial Assets and Financial Optimization

books on stochastic programming, the reader is referred to Louveaux and Birge (1997) and Kall and Wallace (1994). For applications of stochastic programming see Ziemba and Mulvey (2001) and Wallace and Ziemba (2005). Further case studies and details on the interplay between dynamic programming and stochastic programming are found in Herzog (2005). For a detailed case study of a stochastic programming approach for the asset and liability management of a Swiss pension fund see Dondi (2005). Finally, we give an important result concerning the interplay between the modeling and optimization of a portfolio. We consider the class of elliptical distributions such as the multivariate normal, t, and symmetric NIG distribution. Suppose we use an arbitrary positive-homogeneous, translation-invariant measure of risk to determine the risk-minimizing portfolio with a desired return. Then the portfolio weights are the same as if we used the variance as risk measure. The reader is referred to McNeil et al. (2005) for the proof. This means that, in an elliptical world, the mean-variance ecient portfolio is the same as the mean-VaR ecient portfolio. This section serves as a very brief introduction on the topic of nancial optimization. As a matter of fact it is far from complete. However, the literature on this topic is very rich. The reader is referred to Deng, Wang and Xia (2000) for nice overview on models and strategies in portfolio selection. The technical details on the optimization methods used in this work are provided in the applications.

Alternative Investments

We must believe in luck. For how else can we explain the success of those we dont like? Jean Cocteau

4.1 Introduction
The traditional portfolio consists of xed-income securities, stocks, real estate, and cash. In Chapter 2, further types of assets have been introduced, called alternative investments. Alternative assets give investors a further degree of freedom to manage the risk-return characteristics of their portfolios. We call hedge funds, managed futures, private equity, physical assets (e.g. commodities), and securitized products (e.g. mortgages) alternative investments. The statistical properties of some commodities have been studied in Chapter 3. The main emphasis of this chapter is on hedge funds. The inherent properties of hedge funds signicantly dier from those of private equity and securitized products. Therefore, the results of this chapter cannot be generalized to private equity investments and securitized products.

The rst hedge fund is usually credited to Alfred Winslow Jones in 1949. However, Ziemba (2003) nds that already John M. Keynes was using hedge fund techniques in an endowment portfolio in the 1920s. Since these early stages of hedge funds, the hedge fund industry has developed a wide range of dierent strategies to exploit market ineciencies. The legal environment for hedge funds diers from the legal environment of traditional investments. Hedge funds are usually not allowed to make public advertisements. Also, hedge funds are often domiciliated in o-shore regions, i.e., in regions which are favorable for tax and legal reasons. Popular o-shore locations are Caribbean islands such as the

48 4 Alternative Investments

British Virgin Islands or the Cayman Islands. Having discussed some issues about hedge funds, we nally give a formal denition of a hedge fund. Denition 4.1 (Hedge Fund). A Hedge Fund is a generally pooled private investment vehicle, often in the form of partnerships or limited companies. It is loosely regulated and not required to have a particular performance objective or fee structure. Hedge Funds are not widely available to the public and may have a limited number of investors. They do not prohibit the use of leverage, short selling, or the use of derivatives. From this denition, the dierences of hedge funds compared to mutual funds are obvious. Mutual funds are highly regulated, are neither allowed to use leverage, nor to sell short, or to hold derivatives, and have a given free structure. The dierences between hedge funds and mutual funds are discussed in Fung and Hsieh (1997, 1999). Often, high minimum investments are required for investing in hedge funds. In addition, lockup periods prevent investors from withdrawing money quickly. As of December 2005, the hedge fund industry consists of some 8000 funds and manages about US$ 1.1 trillion of assets, according to Hedge Fund Research, a provider of hedge fund data. By considering the evolution of the assets under management in Figure 4.1, we observe a steady growth of the industry. The assets under management have considerably increased since 2002. However, according to the Investment Company Institute, a mutual fund data provider, there are currently US$ 16.1 trillion invested in mutual funds worldwide. This makes hedge fund investments rather small in comparison to mutual fund investments. Seen under the caveat that hedge funds are not open to the public, the gure of US$ 1.1 trillion is still impressive. Because of fraud scandals and their loose regulation, hedge funds are often discussed, in the press as well as in politics. This means that investment managers may commit themselves to a considerable amount of reputational risk by including hedge funds in their portfolio. One of the biggest hedge fund disasters in history, as briey discussed next, has forced the management of nancial institutions to leave the company because of the huge losses incurred. The best known hedge fund disaster is the case of Long Term Capital Management (LTCM), which occurred in 1998. This major event is also observable in Figure 4.1. The literature on LTCM is vast, we only give a few references. A very detailed description of

4.1 Introduction ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f 50524f46494c4500010100000c484c696e6f021000006d6e747252 47422058595a2007ce00020009000600310000616373704d53465 40000000049454320735247420000000000000000000000000000 f6d6000100000000d32d485020200000000000000000000000000 00000000000000000000000000000000000000000000000000000 T 00000000000000001163707274000001500000003364657363000 ot 001840000006c77747074000001f000000014626b707400000204 al 000000147258595a00000218000000146758595a0000022c00000 A 0146258595a0000024000000014646d6e64000002540000007064 ss 6d6464000002c400000088767565640000034c000000867669657 et 7000003d4000000246c756d69000003f8000000146d6561730000 s 040c0000002474656368000004300000000c725452430000043c0 [$ 000080c675452430000043c0000080c625452430000043c000008 b 0c7465787400000000436f7079726967687420286329203139393 n] 8204865776c6574742d5061636b61726420436f6d70616e7900006 46573630000000000000012735247422049454336313936362d32 2e310000000000000000000000127352474220494543363139363 62d322e3100000000000000000000000000000000000000000000 0000000000year (Source: Hedge Fund Research) Fig. 4.1. Assets under management by the hedge fund industry.

the LTCM story is found in Lowenstein (2000). Jorion (2000) analyzes risk management aspects of the LTCM disaster. Because of the legal structure of hedge funds, investors take on more risk of fraud with hedge funds than with mutual funds. The legal environment of hedge funds is most probably subject to changes in the near future. Important issues are transparency and the obligation to register. As the emphasis of this work is not on the legal aspects of hedge funds, although it is an important issue, we will not discuss this topic any further. The reader is referred to Lhabitant (2002) or Cottier (1997) for details on legal and regional aspects. The question whether hedge funds as such are good or bad is a debate which has been ongoing for years. Opponents of hedge funds blame them for several reasons. One argument is that hedge funds are driving asset prices away from their equilibria because of speculation. Another is that hedge funds are causing nancial crises or at least making them worse once they occur. The opposite side claims making markets more ecient, eectively stabilizing markets. Fung and Hsieh (2000a) make an attempt to analyze the market impact of hedge funds. We do not cover this interesting topic in this work because it is less important for portfolio construction and risk management. It is not obvious whether hedge funds are a distinct asset class or not, i.e., a set of assets with stable and homogeneous characteristics. From a conceptual point of view, hedge funds are just a mix of dierent assets which are actively traded. This does not make hedge funds an asset class of its own. For regulatory and reporting reasons, however, institutional

50 4 Alternative Investments

investors often consider hedge funds as a distinct asset class. The investment process for hedge funds diers considerably from the case of traditional assets. Additionally, hedge funds have a dierent risk-return prole than most other assets. This makes them a distinct asset class for portfolio construction. The statistical properties of hedge fund returns demand more sophisticated models than traditional assets. This topic is discussed in more detail later in this chapter. Note that all nancial data used in the sequel of this chapter is obtained from the Datastream database of Thomson Financial. The hedge fund data is only available on a monthly basis. All data ranges from 1994 to 2005.

4.1.1 Hedge Fund Fee Structure Hedge funds usually charge a management fee and an incentive fee, whereas mutual funds only charge a management fee. In addition, there is a high watermark included in the fee structure of a hedge fund. This means that the manager will only receive incentive fees if the cumulative returns can make up for previous losses. The incentive fee rewards the hedge fund manager for high absolute returns. In addition, hedge fund managers usually have a considerable amount of their own money invested in the fund. This should motivate the manager to produce high riskadjusted returns. Kouwenberg and Ziemba (2004) nd that incentive fees increase the risk appetite of managers considerably. Only if the manager has a substantial amount of his own money in the fund, the risk taking is reduced. Kouwenberg and Ziemba (2004) also give empirical evidence that hedge funds with high incentive fees have signicantly lower mean returns (net of fees) and worse risk-adjusted performance. Liang (1999) nds that a high watermark is very eective in aligning the managers interest with the fund performance. Goetzmann, Ingersoll and Ross (2003) nd a closed-form expression for the value of a hedge fund manager contract. They state that the value of a hedge fund contract is increased with the variance of the portfolio under certain conditions and provide a discussion of the compensation structure of hedge funds. Hedge fund fee structures are also discussed in Ackermann, McEnally and Ravenscraft (1999). Brown, Goetzmann and Park (2001) nd that the risk choice of managers is motivated by industry benchmarks and not by high watermarks.

4.1 Introduction

Summarizing, the academic literature on performance fees of hedge funds suggests that high watermarks and a considerable amount of the fund managers own money in the fund are favorable for the investors interest.

4.1.2 Hedge Fund Terminology When dealing with alternative investments, we always nd the Greek letters and . The terminology stems from the capital asset pricing theory (CAPM), introduced by Sharpe (1964). In the CAPM, beta refers to the market risk. This concept has been generalized and is now often found in the literature as
nr(t)=

(t)+ L i(t)Fi(t)+ (t), (4.1)

i=1

where r(t) refers to the return of the hedge fund, (t) its intercept, Fi(t) an arbitrary factor, i(t) the factor loading, and (t) is a white noise process. Often, (t) and (t) are assumed to be constant. The estimation of the alpha and betas then reduces to a simple linear regression. One of the key questions in hedge fund research is actually the search of alpha and the detection of the betas. However, these goals are either dicult or impossible to achieve. In order to nd the managers real alpha and the actual betas, one has to know the hedge funds investment universe and the nancial products used therein. As hedge funds are, in general, reluctant to give the investor insights into these topics, the investor has to use a simplied, hypothetical investment universe of the hedge fund. By introducing the hypothetical investment universe we are speaking of systematic returns of hedge funds and not of the actual sources of returns. However, systematic risk is often found as the term sources of returns in the literature. But without an exact knowledge of the investment positions of a hedge fund over time, the determination of the return drivers of hedge funds is virtually impossible. Note that the estimation of alpha and its signicance also depends considerably on the underlying model, see Amenc, Curtis and Martellini (2003) for a detailed study.

4.1.3 Hedge Fund Styles There exists a huge variety of dierent styles by which hedge fund managers actively manage their portfolios. However, there is neither a generally accepted denition for hedge fund styles, nor is there a general classication of these. Nevertheless, many participants

52 4 Alternative Investments

in the industry made attempts to identify and classify hedge fund styles. In Table 4.1, a broad overview of common hedge fund styles is shown. Note that the directional style is often described as opportunistic.
Table 4.1. Hedge fund styles Directional Relative Value Event Driven Others Global Macro Long/Short Equity Dedicated Short Bias Emerging Markets Convertible Arbitrage Equity Market Neutral Fixed Income Relative Value Arbitrage Risk (Merger) Arbitrage Distressed Securities Regulations D Multi-Strategy Funds of Hedge Funds Equity Market Timing Equity non Hedge Multi-Strategy

4.1 Introduction

are returns on asset classes. Since hedge funds make use of dynamic trading strategies, the concept of Sharpe may not be applied to hedge funds as such. Not only do we not know what the exact investment universe of the hedge fund is; we also do not know how the investment positions change over time. Obviously, hedge fund mangers are reluctant to give this kind of information since it would reduce their edge. Because of their dynamic behavior, hedge funds returns may have a non-linear relationship to the returns of other asset classes. The classical style analysis is usually extended by more factors than just the returns on asset classes in order to account for the special properties of hedge funds. These additional factors are supposed to explain the trading style and the leverage decisions of hedge fund managers. alreadyfactorsby Alfred Winslowdetail later in this The long/short equity style was These used are discussed in Jones in 1949. It chapter. hedges market risk and derives its returns from equity selection skills. The return Fung and Hsieh (1997) state that managers having the same style will generate sources of the common directional style are the correct predictions the movements correlated returns. They use principal components and factor analysis to extract style of security prices. Leverage is sometimes used to increase returns. The relative value factors. By this, they circumvent the linear structure of classical style analysis by style seeks out relative pricing discrepancies between related instruments in equity introducing these new factors. Fung and Hsieh essentially nd ve dominant and xed income markets. An event driven manager invests in corporations involved investment styles. Brown and Goetzmann (2003) use a generalized least squares in special situations such as mergers and acquisitions. Multi-strategy funds do not procedure to identify dierent hedge fund styles. They nd eight dierent hedge fund have a pure style but rather have a mixture of several styles. Funds of hedge funds styles. However, from Table 4.1, we nd much more conceptual hedge fund styles, invest in several hedge funds and are therefore very dierent to the styles described which are obviously not all distinguishable by numerical analysis. These ndings so far. Funds of hedge funds will be discussed later in this section. A detailed show that there are probably more qualitative styles than quantitative styles. description of the dierent hedge styles is found in Cottier (1997), Lhabitant (2002, 2004), and Jaeger (2002). Another approach to analyze the styles of hedge funds is described in Lhabitant An important idea in the realm style analysis is to apply classical Investors are (2002). The maintopic in this kind of of hedge funds is style analysis. style analysis interested in which strategy a hedge fund is following substitutes; see Table 4.3 with the nine Tremont hedge fund indices as asset class in order to allocate their money66) for assess risk. The managers investment strategy also circumvents the (page or to the list of the Tremont hedge fund indices. This and the investment universe determine of hedge fund returns to traditionalof the classes.fund. Note that non-linear exposure the major part of the risk prole asset hedge hedge funds are classied by styles, however, this does not necessarily describe their strategy. The strategy, in contrary to the style, is described by the investors degree 4.1.4 Funds of Hedge Funds of freedom to invest in the hedge funds investment universe. Nevertheless, investors are interested whetheras hedge fund suggests, allocate money and whether this style Funds of hedge funds, a their name applies its reported style among several hedge is consistent over time. Bares, Gibson and Gyger (2004) nd that style consistency funds. In the sequel, we use the terminology fund of funds instead of fund of hedge can signicantly funds maysurvivaluse a top-down or a bottom-up approach to select funds. A fund of aect the either probability of a hedge fund. This corroborates the style analysis for hedge funds. dierent hedge funds. In the top-down approach, the style diversication is Style analysis In investment funds and traditional portfolios was pioneered by established rst. for a second step, hedge fund managers from the corresponding Sharpe (1992). This style analysis is basically a factor model with the constraint that style classes are chosen. The the factors

54 4 Alternative Investments

problem of the top-down approach is that there may not be suciently many good hedge fund managers for a particular style available. In the bottom-up approach, the hedge fund universe is screened for the best managers and then the fund of funds portfolio is constructed accordingly. This may result in a signicant exposure to a specic risk factor or group of risk factors, i.e., a clustering of risks. The importance of style diversication is also documented in Brown and Goetzmann (2003). The main advantages of fund of funds are the diversication of risk, the lower minimum investment requirement, and the access to closed funds. Fund of funds can, at least to some extent, reduce the idiosyncratic risk of hedge funds by diversication, making the hedge fund investment less risky. Due to minimum investment requirements for single hedge funds, it may be dicult for a single investor to hold a diversied hedge fund portfolio by himself. In addition, the managers of the fund of funds usually have a better understanding of the industry and a broader manager network than the investor. Because of the larger size of the fund of funds, the managers get more insight into the single hedge funds, sometimes even privileged access. Having described the advantages of fund of funds, one might wonder why someone would invest in single hedge funds at all. Unfortunately, there is also the ip side of the coin. We list some severe disadvantages of investing in fund of funds: the most important disadvantage is the second layer of fees. Brown, Goetzmann and Liang (2004) and Amin and Kat (2003) nd that the fees on fees in fund of some funds are too high and therefore oer the investor no added value. The second disadvantage lies in liquidity. Fund of funds usually oer better liquidity than the funds. This may lead to severe problems when too many investors want to withdraw their money at the same time. As a last disadvantage we mention the lack of control of the investor. If the investor disagrees with the inclusion of new hedge fund in the fund of funds, the only possibility for the investor is to sell all his shares in the fund of funds. 4.1.5 Hedge Fund Performance Besides the risk, the performance of an asset class is a crucial input for the strategic asset allocation. Measuring the performance of traditional asset classes is conceptually not dicult, because traditional investments are suciently regulated and are well studied. In addition, there are several de facto benchmarks. For equities, the MSCI World Index

4.1 Introduction

is often considered as benchmark for world wide equities. The S&P 500 index is often considered as benchmark for US equities. In contrast to the performance measurement for traditional assets, the

performance of hedge funds is very dicult to measure. The main reasons for this is that hedge funds are not obliged to report. Nevertheless, the hedge fund industry has launched several indices to meet investors demand for benchmarks. The basis for the calculation of these indices are hedge fund databases which include style and performance information. Since there is no generally accepted denition for hedge fund styles, the categorization of hedge fund performance gures is dicult. Therefore, the comparison of hedge fund indices among various hedge fund data providers leads to confusion because of the lack of standardization. For a list of various hedge fund data providers see Lhabitant (2002). Since hedge fund managers do not have to report, all hedge fund databases have the same problem of not being complete. Whether these databases are still representative for the whole industry is, again, a dicult question and is not addressed in this context. The reporting of hedge fund performance data is usually not audited. This leads to several biases in hedge fund databases; see Liang (2003) for a discussion on the importance of audited hedge fund data. We list the most important systematic biases which are present in hedge fund databases. Survivorship Bias In some databases, funds which do no longer report their performance gures are excluded from the database. Poor performance is one reason for hedge fund managers to stop reporting. However, if a manager closes the fund for new investors because the optimal size of assets under management has been reached, the manager may also stop reporting performance gures. Since the reasons for a manager to stop reporting are manifold, survivorship bias is hard to quantify. See Ibbotson and Chen (2005), Bares et al. (2004), Liang (2000), Fung and Hsieh (2000b), Ackermann et al. (1999) for estimations of the survivorship bias. However, the estimated numbers dier signicantly because of the already mentioned discrepancies in dierent hedge fund databases. Estimated numbers of survivorship bias range from 1.5% to 3%. Survivorship bias is considerably easier to estimate for mutual funds. Selection Bias Every database can only consist of a subset of all existing hedge funds. The rst type

56 4 Alternative Investments

of selection bias stems from the fact that hedge fund managers do not have to report. This is the same mechanism that also causes survivorship bias. The reasons for hedge fund managers to report have already been discussed in the topic of survivorship bias. The second type of selection bias arises from data vendors having additional selection criteria to add hedge funds to their databases. Backll (Instant History) Bias Hedge funds usually undergo an incubation period with seed money before they are oered to a broader audience. Once they are included in a database, their previous returns are included into the database as well. Obviously, only successful funds survive the incubation phase. Therefore, the database gives a too optimistic picture of the hedge fund universe. Fung and Hsieh (2000b) estimate the backll bias by 1.4% on major hedge fund databases. Ibbotson and Chen (2005) nd a backll bias of 4.8%. These biases are just an excerpt of the most important biases. Another bias is reporting bias. Reporting bias originates from hedge funds which report the performance manner not in an objective fashion but favorable for their track record. This may be the case when a hedge fund is invested in instruments which are hard to price, e.g., illiquid assets. These biases may also aect the statistical properties of hedge funds. Ackermann et al. (1999) show that survivorship bias can eect the rst two moments and the correlations of hedge fund returns. As mentioned, hedge fund indices are calculated from hedge fund databases. Since these databases are biased, hedge fund indices inhere these biases by construction. Amenc and Martellini (2003) discuss the problem of hedge fund indices and construct pure style indices using either a Kalman lter or a principal component approach. A detailed performance measurement for various dierent models is conducted. They nd a wide range of dierent alpha estimates for dierent models. This underlines the inherent problems of accurate performance measurement of hedge funds. Nevertheless, performance measurement remains an important topic for hedge funds. An interesting aspect of performance measurement is performance persistence. The investor is only interested in hedge funds which persistently deliver good performance. Gibson, Bares and Gyger (2003) nd short-term performance persistence but no signicant long-term persistence. See also Amin and Kat (2003), Agarwal and Naik (2000), and Locho (2002) for more details on performance persistence.

4.2 Systematic Risks of Hedge Funds and Risk Management

The actual performance of hedge funds should be measured by risk-adjusted performance measures. The most popular risk-adjusted performance measure for traditional investments in the Sharpe ratio, introduced by Sharpe (1966). Having its origins in the CAPM, the Sharpe ratio relies on variance as a risk measure, whose deciencies are well known. Nevertheless, the Sharpe ratio is also the most widely used risk adjusted performance measure for alternative investments, as found in Amenc, Martellini and Vaissie (2002). Because of the non-normality of at least some hedge fund styles, several further risk adjusted performance measures have been developed. These risk measures are usually based on the left-hand side of the distribution, therefore called downside risk measures. Popular risk measures based on downside risk are the Sortino, the Sterling, and the Burke ratio. Also popular are the return-on-VaR measure and the Omega performance measure. The reader is referred to Amenc, Malaise and Vaissie (2005) for details on these risk measures and how to use them in practice. Note that these measures are closely related to the ones used in active portfolio management, where the benchmark plays a central role. Obviously, the returns of the active portfolio are compared to the returns of the benchmark. The comparison between the active portfolio and the benchmark is usually done by considering the dierences between the corresponding returns. The mean of this dierence is the average outperformance and often called alpha. The standard deviation of the dierence is called tracking error. The ratio between alpha and tracking error is a revised Sharpe ratio, often called information ratio. The problem with all these riskadjusted performance measures is that the inherent risk measures are all not coherent. Therefore, extreme risks are not suciently taken into account. The considered performance measures cannot protect the portfolio against large losses in market stress. Therefore, a conditional risk measure such as CVaR should also be considered for risk-adjusted performance measures.

4.2 Systematic Risks of Hedge Funds and Risk Management

We aim to discuss two closely related topics in this section. First, we discuss the topic of systematic risks of hedge funds. Second, important topics for the risk management of hedge funds are discussed. The connection between these two topics stem from the fact that the systematic risks determine an important part of the risk prole of a hedge fund or a fund of funds. It is always possible to analyze unconditional hedge fund returns, but

58 4 Alternative Investments

knowing the underlying risk exposures gives the investor more insight. Consequently, the knowledge of the risk exposures of all assets in a portfolio allows the investor to analyze the behavior of a combination of dierent assets. As for traditional assets, we dierentiate between systematic and idiosyncratic (nonsystematic) risks. Systematic risk is dened as the part of risk which is not diversiable. The other part of risk is called idiosyncratic risk. It is standard in nance to assume that the investor is only compensated for systematic risk and not for idiosyncratic risk. The most prominent model for this theory is the CAPM of Sharpe (1964). Whilst systematic risks for traditional assets, e.g., stocks, are well understood, this is not the case for hedge funds. From the classication of hedge fund styles, we know the conceptual return drivers of the corresponding funds. As mentioned, hedge funds usually give no details about their investment positions. However, this information would be needed in order to exactly identify the specic risks of a hedge fund. This problem worsens once we combine several hedge funds of dierent styles in a portfolio of hedge funds. Idiosyncratic risks of hedge funds are risks such as operational risk, model risk, or the risk of fraud. We do not discuss idiosyncratic risk of hedge funds in detail. It is a very dicult question how idiosyncratic risk of hedge funds is to be quantied. Therefore, due diligence is as important as a quantitative analysis when assessing idiosyncratic risk of hedge funds. Having introduced the concept of separating risk into systematic and idiosyncratic risk, we are interested whether this concept is also found empirically. A straightforward idea to measure the idiosyncratic risk of hedge funds would be to use the same approach as for stocks, i.e., to analyze the combination of dierent assets. Fung and Hsieh (2002) build randomly selected portfolios of hedge funds and analyze the variance for an ever larger number of hedge funds. They conrm that risks of hedge funds may be separated into an idiosyncratic and systematic part. However, it takes a lot of hedge funds (more than 120) for the idiosyncratic risk to nally diminish. Therefore, Fung and Hsieh suggest considering systematic risk style by style, which does make sense. Similar results for systematic risk are also found in Patel, Krishnan and Meziani (2002). However, there are also disadvantages when building portfolios of hedge funds. Lhabitant and Learned (2003) nd that the more funds are assembled into a portfolio, the higher the correlation with the equity market becomes. In addition, the kurtosis rises with the number of funds combined. Because of this nding, extreme losses cannot be reduced through diversication of idiosyncratic risks.

4.2 Systematic Risks of Hedge Funds and Risk Management

The contrary is the case, the higher kurtosis even indicates that extreme losses actually become worse through diversication. Lhabitant and Learned suggest not to have a too high number of funds combined (5-10), because the added value in the overall portfolio is successively decreased otherwise. By isolating the systematic risk through a combination of a large number of hedge funds, we can examine the properties of systematic hedge fund risk. We want to know whether an investor is exchanging idiosyncratic hedge fund risk for systematic exposure to traditional risks by diversifying among hedge funds. This is a very crucial question because the investor is certainly not interested in paying hedge fund managers fees for risk exposures already present in the original portfolio. We have already discussed the topic of the sources of returns of hedge funds. Recall that this terminology may lead to confusion. If we knew the sources of returns, the exact risk prole of the hedge fund in connection with the portfolio would be known. Unfortunately, this is not feasible because we virtually never have full information about the positions of a hedge fund. However, for portfolio construction, we are interested in the systematic risks of hedge funds and not in the actual underlying sources of returns. Of course, systematic risks do only reect an abstract part of the real sources of returns. Nevertheless, knowing the systematic returns of hedge funds allows the investor to more accurately identify the risk prole of the portfolio. This is of special importance when hedge funds are combined with dierent types of assets. 4.2.1 Systematic Risks of Hedge Funds We have argued previously in this chapter that hedge funds are conceptually not a distinct asset class but rather a dynamic combination of traditional assets and derivatives. However, by inspection of hedge fund returns, we observe that the statistical properties of hedge fund strategies are dierent from those of traditional assets. In addition, the legal environment of hedge funds is way dierent from the one of traditional assets. In contrast to mutual funds, the returns of hedge funds do not only depend on the investment universe of the fund. The returns of hedge funds do also depend on the dynamic trading strategy of the fund, which also includes the leverage decisions of the manager. Once the idiosyncratic risk of hedge funds is eliminated by constructing a fund of funds with suciently many hedge funds, only the systematic risk remains. We are interested

60 4 Alternative Investments

in the nature and the prole of systematic risk. One way to explore the systematic risks of hedge funds is to consider hedge fund indices. Conceptually, hedge fund indices are the same as a large fund of hedge funds. Therefore, the idiosyncratic part of risk in hedge fund indices is considered negligible. We are particularly interested if these systematic risks have an exposure to other risks. The literature on propositions of risk factors explaining systematic hedge fund risk is vast. We review some of the literature and give a collection of the most common risk factors. In particular see Chan, Getmansky, Haas and Lo (2005), Schneeweis and Spurgin (1998, 1999), Amenc, Bied and Martellini (2002), Agarwal and Naik (2004), and Jaeger (2003). Table 4.2 gives a summary of the risk factors found in these publications.
Table 4.2. Common risk factors of hedge funds

Equity markets Fixed income related Commodities Various US equity index World equity index Emerging markets index Value minus growth Small cap minus large cap Bank index Dividend yields Term spread Credit spread US government bond index US corporate bond index Treasury bills Treasury bills minus LIBOR High yield bond Oil Gold GS Com. Index ility Currency factor Momentum factors Moving averages of indices Lagged returns of equity indices Absolute returns of indices Option based r

4.2 Systematic Risks of Hedge Funds and Risk Management

4.2.2 Risk Management for Hedge Funds We have argued that mean-variance optimization cannot capture the statistical properties of traditional assets for portfolio construction. If hedge funds are included in the investment universe, the notorious weaknesses of the mean-variance approach become even more apparent. This is also widely documented in the literature, e.g., see Lhabitant (2004), Lo (2001), or Fung and Hsieh (1998). The main reason for this is that correlation is no longer sucient to measure diversication. Hedge funds have usually low correlations with traditional assets and a better Sharpe ratio than traditional assets, making them very favorable in terms of the meanvariance framework. This, however, leads to over-allocation of money to hedge funds in a mean-variance framework. The problem lies in the fact that hedge funds incur extreme losses when other assets have extreme losses as well. Therefore, when diversication is needed most, it essentially vanishes. Lo (2001) may be considered as a primer for the risk management for hedge funds. The problems of the use of classical risk management tools for hedge funds are highlighted. Additionally, the need for the special consideration of risk management for extreme events, i.e., tail risk, is stressed and illustrated in an example. Lo also discusses the problems of the use of value at risk in the realm of hedge funds. The ease of building an impressive track record with options is highlighted. This can be done by using derivative securities to mimic dynamic trading strategies. This economic extensively discussed in of the factors: Treasury bills stand We give the subject is interpretation for some Haugh and Lo (2001). An example of such a economic activity, the credit spread for the default premium,options. price for future strategy would be the shorting of out-of-the-money put the oil This strategy gives small positive returns mostbank index for the supply negative return for short-term business cycles, and the of the time. However, if a of liquidity for of this strategyOption-based risk factors are essentially non-linear dependence hedge funds. once in a while occurs, this loss is extreme. The additional danger with this typehedge fund returns it is hardlyof traditional assets. For more details on properties of of strategy is that to returns revealed from the hedge funds balance sheet, evenof Table 4.2 and their explanatory power, the reader is nd that to the the factors with full position transparency. Anson and Ho (2003) referred event driven strategies actually have this type of risk exposure to the equity market. literature. The risk this behavior, hedge funds fund returns are also found short-volatility Because of factors for explaining hedge are sometimes classied as as asset-based style factors in the literature. In the realm take these extreme events into factors strategies. Therefore, the investor has to of hedge funds, asset-based style special are rule-based replications risk of hedge funds. consideration when managing of hedge fund styles using traditional assets and derivatives. The reader is referred to Fung and Hsieh (2004) for asset-based style A major source of risks for hedge funds are the credit and liquidity risks. Illiquid factors for dierent hedge fund styles. The option-like pay-o structure to traditional assets are known to be hard to price, giving the hedge fund manager some degrees asset classes is documented in Agarwal and Naik (2004), Lhabitant (2004) and many of freedom for the reporting of the performance. Calculated or even manipulated other publications. For instance, Fung and Hsieh (2001) model trend-following prices are an explanation for the sometimes smooth and persistent hedge fund strategies as lookback straddles. returns, as reported in

62 4 Alternative Investments

Kat and Brooks (2001) and Agarwal and Naik (2000). Asness, Krail and Liew (2001) nd that hedge funds probably price their securities at a lag. One possibility for this are illiquid or otherwise hard to price assets. After eliminating the serial correlation in the considered return series, Asness et al. (2001) nd that the broad hedge fund universe and many subcategories no longer oer return and diversication benets. Kat and Brooks (2001) analyze the statistical properties of asset returns and their implications for investors. Among other ndings they nd that hedge fund returns are signicantly autocorrelated and that returns of hedge funds are smoothed. We know from the stylized facts of asset returns that returns do not have serial correlation. In an ecient market, serial correlation of asset returns is not possible. However, market frictions such as transaction costs, borrowing constraints, restrictions on trading, and costs of information do exist. These frictions all contribute to the possibility of serial correlation in asset returns, which cannot by exploited because of the presence of these frictions. If these frictions would not exist, traders would immediately make use of the serial correlation, which in turn would eliminate this phenomenon. Getmansky, Lo and Makarov (2004) suggest that the serial correlation of hedge fund returns is most probably caused by illiquid assets.
ffd8ffe000104a46494600010201012c012c0000ffe2 0c584943435f50524f46494c4500010100000c484c69 0.8 6e6f021000006d6e74725247422058595a2007ce000 20009000600310000616373704d534654000000004 S 0.6 945432073524742000000000000000000000000000 er 0f6d6000100000000d32d4850202000000000000000 ia 0.4 000000000000000000000000000000000000000000 l 000000000000000000000000000000000000001163 c 0.2 707274000001500000003364657363000001840000 or 006c77747074000001f000000014626b70740000020 re 04000000147258595a00000218000000146758595a0 la 000022c000000146258595a0000024000000014646d ti 0.2 6e640000025400000070646d6464000002c40000008 o 8767565640000034c0000008676696577000003d40 n 0.4 00000246c756d69000003f8000000146d6561730000 0 5 101520 040c0000002474656368000004300000000c7254524 Lag 30000043c0000080c675452430000043c0000080c62 5452430000043c0000080c7465787400000000436f7 Fig. 4.2. Serial correlation of the Tremont convertible arbitrage index. 0797269676874202863292031393938204865776c6 574742d5061636b61726420436f6d70616e79000064 657363000000000000001273524742204945433631 3936362d322e310000000000000000000000127352 47422049454336313936362d322e31000000000000 Tremont000000000000000000000000000000000000000000 (page hedge fund indices found in Table 4.3
1

Therefore, the

66) are

analyzed for serial correlation. Figure 4.2 shows the sample serial correlation of the Tremont convertible arbitrage index. The convertible arbitrage index shows signicant serial correlation for the rst two lags. Besides this hedge fund index, the event driven, the emerging market, the equity market neutral, and the xed-income arbitrage indices also show signicant serial

4.2 Systematic Risks of Hedge Funds and Risk Management

correlation. This indicates that many hedge fund managers have illiquid assets in their portfolios. From the stylized facts of traditional asset returns it is known that volatility appears in clusters. We are interested if this is also the case for hedge funds. We investigate for GARCH eects in the Tremont hedge fund indices of Table 4.3. The technical details for GARCH processes are found in Appendix B. There are highly signicant (99%) GARCH eects for the styles emerging markets, equity market neutral, global macro, and long/short equity. A possible explanation for this would be that the manager is increasing the risk tolerance because of incurred losses. A high watermark will compensate the manager with incentive fees only if the cumulative returns can make up for previous losses. This is comparable to the St. Petersburg concept of betting, see Weisman (2002) for details. Figure 4.3 shows the dynamic standard deviation of the Tremont long/short equity index, resulting from a GARCH model with t distributed innovations. Note that the results from Table 4.3 indicate that the t distribution is suitable for describing Tremont long/short equity index returns. We observe considerable volatility clustering in the year 2000. In addition, the hedge fund crisis of 1998 is clearly seen in Figure 4.3, where the
ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c484c696e6f021000006d6e74 725247422058595a2007ce00020009000600310000616373704d53465400000000494543207352474200000000000000000000 0.06 00000000f6d6000100000000d32d485020200000000000000000000000000000000000000000000000000000000000000000000 0000000000000000000000000001163707274000001500000003364657363000001840000006c77747074000001f00000001462 6b707400000204000000147258595a00000218000000146758595a0000022c000000146258595a0000024000000014646d6e64 0.05 0000025400000070646d6464000002c400000088767565640000034c0000008676696577000003d4000000246c756d69000003f 8000000146d6561730000040c0000002474656368000004300000000c725452430000043c0000080c675452430000043c000008 0c625452430000043c0000080c7465787400000000436f70797269676874202863292031393938204865776c6574742d5061636 0.04 b61726420436f6d70616e790000646573630000000000000012735247422049454336313936362d322e31000000000000000000 000012735247422049454336313936362d322e31000000000000000000000000000000000000000000000000000000 0.03 0.02 Jun94 Oct95 Mar97 Jul98 Dec99 Apr01 Sep02 Jan04 May05

St a n d ar d d e vi at io n

Fig. 4.3. Dynamic standard deviation of the Tremont long/short equity index.

volatility more than doubles in one month. Hedge fund styles play an important role for the risk management of hedge funds. The use of style information is manifold. As mentioned, Bares et al. (2004) nd that the survival probability of a hedge fund is signicantly aected by style consistency. Therefore, hedge funds should be constantly monitored whether they keep following their reported style or not. This can be either done be the approach suggested by Lhabitant (2002) or the approach found in Fung and Hsieh. Concerning styles, Brown and Goetzmann (2003)

64 4 Alternative Investments

discuss the importance of style diversication for risk management. Their nding makes the top-down portfolio construction superior to the bottom-up approach. Having mentioned the importance of style diversication, the reader has to be aware of the fact these results are only of indicative nature. Obviously, the style of a hedge fund only gives a very limited description of how the fund actually makes prot. However, what determines the risk-return prole of a hedge fund are the investment universe and the strategies implemented in these. The investment universe denes the opportunity sets of the hedge fund manager, the strategy denes the degrees of freedom therein. Therefore, styles are a classication scheme for hedge funds, hedge fund strategies describe the degrees of freedom of a manager. 4.2.3 Non-linearities in Hedge Fund Returns Since hedge funds use dynamic strategies, their exposure to traditional assets is unlikely to be linear. The returns of hedge fund styles in comparison to the equity market are analyzed. Therefore, the scatter plot of various hedge fund styles versus the the S&P 500 are considered. Mitchell and Pulvino (2001) nd that risk arbitrage has a similar return prole to the S&P 500 as the one of the short position of a naked put option on the S&P 500. This result is conrmed by performing a kernel regression on the S&P 500 returns versus the Tremont event driven index returns, as seen in Figure 4.4 (b).
0.04 0.05 ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c484c696e6f021000006d6e747252474220585 95a2007ce00020009000600310000616373704d5346540000000049454320735247420000000000000000000000000000f6d6000100000000d32d 0.02 48502020000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000011637072740000 0 01500000003364657363000001840000006c77747074000001f000000014626b707400000204000000147258595a00000218000000146758595a0 0 000022c000000146258595a0000024000000014646d6e640000025400000070646d6464000002c400000088767565640000034c00000086766965 0.05 0.02 77000003d4000000246c756d69000003f8000000146d6561730000040c0000002474656368000004300000000c725452430000043c0000080c675 0.1 452430000043c0000080c625452430000043c0000080c7465787400000000436f70797269676874202863292031393938204865776c6574742d50 0.04 61636b61726420436f6d70616e790000646573630000000000000012735247422049454336313936362d322e31000000000000000000000012735 0.1 0.2 247422049454336313936362d322e31000000000000000000000000000000000000000000000000000000 0.06

(a) (b) (c)

E m er gi n g M ar k et s 0.15 0.08 re 0.3 0.2 0.1 0 0.1 0.2 0.2 0.1 0 0.1 0.2 tu S&P500 returns S&P500 returns S&P500 returns Fig. 4.4. Non-linearities of hedge fund rn s returns. Kernel regressions of S&P 500 returns vs. dierent Tremont hedge fund indices returns.

The value of R2 for this regression is 77%, i.e., 77% of the variation of Tremont event driven index returns are explained by the kernel regression. Note that R denotes the
2

ffd8ffe00 ffd8ff ffd8ffe0001 0104a464 04a4649460 94600010 e00010 0010201012 201012c0 4a4649 c012c0000ff 12c0000ff e20c5849 460001 4.3 e20c584943 Properties of Hedge Funds Statistical 43435f505 020101 435f50524f4 24f46494c 2c012c 6494c45000 45000101 percentage of variation explained by the predictor 10100000c4 see Hamilton (1994) for variables, 00000c48 0000ffe 84c696e6f02 more details on linear regression. 4c696e6f0 20c584 1000006d6e 21000006 d6e74725 943435 7472524742 By performing a kernel regression on the S&P2058595a20 24742205 f50524 500 returns versus the Tremont 8595a200 07ce000200 emerging market index returns, as7ce00020 Figure 4.4 (a), the relationship is similar to seen in f46494 0900060031 00900060 c45000 0000616373 the event-driven case. In this case, 86% of101000 the variations may be explained by the 03100006 704d534654 16373704 regression function. It would be tempting 00c484 that the Tremont xed income d5346540 to state 0000000049 00000004 c696e6 4543207352 arbitrage index has the shape of94543207 call option, as shown in Figure 4.4 (c). a short 4742000000 f02100 35247420 2 0000000000 However, the R of this regression is only 1%, making this statement insignicant. 00000000 0006d6 0000000000 00000000 e74725 00000000 00f6d600010 Nevertheless, if the relationship of the 247422 000f6d600 xed income arbitrage index returns is 0000000d32 01000000 058595 d485020200 analyzed with respect to the one month lagged S&P 500 returns, the picture changes 00d32d48 a2007c 0000000000 50202000 0000000000 dramatically. Instead of a short call option prole as in Figure 4.4 (c), we again 00000000 e00020 00000000 0000000000 observe a short put option prole for the 009000 00000000 one-month lagged S&P 500 returns, see 0000000000 00000000 600310 0000000000 Figure 4.5. This regression function explains 66% of the variations of the Tremont 00000000 000616 0000000000 00000000 373704 0000000000 xed income arbitrage index. 00000000 0000000000 00000000 d53465 0.04 ffd8ffe000104a46494600010201012c012c0000ffe20c5 00000000 0000000000 84943435f50524f46494c4500010100000c484c696e6f0 400000 00000000 0001163707 21000006d6e74725247422058595a2007ce0002000900 Fi 00000000 000494 0.02 2740000015 0600310000616373704d5346540000000049454320735 x 00001163 543207 247420000000000000000000000000000f6d600010000 0000000336 e 70727400 0000d32d4850202000000000000000000000000000000 d 4657363000 00015000 352474 000000000000000000000000000000000000000000000 In 00003364 200000 0018400000 000000000000000000001163707274000001500000003 0 c 65736300 06c7774707 364657363000001840000006c77747074000001f00000 000000 o 00018400 4000001f000 0014626b707400000204000000147258595a000002180 m 00006c77 000000 0. 00000146758595a0000022c000000146258595a000002 000014626b e 74707400 000000 4000000014646d6e640000025400000070646d6464000 A 7074000002 0001f0000 rb 02 002c400000088767565640000034c0000008676696577 00014626 00000f 0400000014 000003d4000000246c756d69000003f8000000146d656 it b7074000 6d6000 7258595a00 1730000040c0000002474656368000004300000000c72 ra 00204000 0002180000 5452430000043c0000080c675452430000043c0000080 g 0.0 00014725 100000 c625452430000043c0000080c7465787400000000436f 0014675859 e 8595a000 000d32 70797269676874202863292031393938204865776c657 5a0000022c re 00218000 0.2 0.1 0 0.1 0.2 d48502 tu 4 4742d5061636b61726420436f6d70616e790000646573 0000001462 00014675 630000000000000012735247422049454336313936362 rn 8595a000 020000 58595a0000 d322e3100000000000000000000001273524742204945 regression 1 month lagged S&P500 returns Fig. 4.5. Kernel s 0.0 0022c000 000000 0240000000 4336313936362d322e310000000000000000000000000 00014625 14646d6e64 00000000000000000000000000000 000000 returns. 8595a000 of lagged S&P 500 returns vs. Tremont xed income arbitrage 0000025400 6 00240000 000000 000070646d 00014646 000000 d6e64000 6464000002 0.0 00254000 000000 c400000088 00070646 000000 4.3 Statistical Properties of Hedge Funds 7675656400 d6464000 8 00034c0000 002c4000 000000 0086766965 00088767 000000 77000003d4 56564000 The statistical properties of hedge0034c000 000000 analyzed and the implications of fund returns are 000000246c 00086766 000000 756d690000 the results discussed. Obviously, 96577000 000000 data is crucial for a statistical the quality of the 03f80000001 003d4000 46d6561730 000000 that the data quality of audited 000246c7 analysis of hedge fund returns. Liang (2003) nds 000040c000 56d69000 000000 003f80000 funds is of much better quality than of non-audited funds. Therefore, audited funds 0002474656 00146d65 000000 3680000043 61730000 000000 should be preferred to 00000000c7 040c0000 011637 2545243000 00247465 0043c00000 63680000 072740 04300000 000015 80c6754524 000c7254 30000043c0 52430000 000000 000080c625 043c0000 033646 4524300000 080c6754

573630

66 4 Alternative Investments

non-audited funds. First, the univariate properties of hedge funds are analyzed. Second, the multivariate properties are discussed.

4.3.1 Univariate Properties of Hedge Fund Returns Two important properties of univariate hedge fund returns have already been min(AIC) discussed. These are the serial correlation and the volatility clustering of hedge fund ?2 returns, examples are shown in Figures 4.2 and 4.3. In this section, the GH (unconditional) properties of univariate hedge fund returns are examined. The 5.22 methodology is as in Chapter 3, the reader is referred to Appendix A.2.3 for the GH technical details about the tted distributions.
-1.39 6.08 Dedicated Short Bias Table 4.3. Distributions for monthly Tremont hedge fund indices returns. GH 0.61 4.08 Emerging Markets GH -1.12 9.19 Equity Market Neutral Normal 0.31 3.27 Event Driven GH -3.83 30.70 Fixed Income Arbitrage NIG -3.23 20.12 Global Macro GH -0.20 5.79 Long/Short Equity t -0.02 6.88 Managed Futures Normal -0.10 3.44 Multi-Strategy NIG -1.28 6.58 Convertible Arbitrage -0.03 Hedge Fund Index ?1 Tremont Hedge Fund Indices

4.3 Statistical Properties of Hedge Funds

properties. The GH distribution handles the asymmetry of the hedge fund index returns fairly well and can also account for the fat tails.
ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c484c 696e6f021000006d6e74725247422058595a2007ce00020009000600310000616373704d5346540000000 60 049454320735247420000000000000000000000000000f6d6000100000000d32d4850202000000000000 50 000000000000000000000000000000000000000000000000000000000000000000000000000000000001 163707274000001500000003364657363000001840000006c77747074000001f000000014626b7074000 00204000000147258595a00000218000000146758595a0000022c000000146258595a000002400000001 4646d6e640000025400000070646d6464000002c400000088767565640000034c0000008676696577000 003d4000000246c756d69000003f8000000146d6561730000040c0000002474656368000004300000000 40 c725452430000043c0000080c675452430000043c0000080c625452430000043c0000080c74657874000 00000436f70797269676874202863292031393938204865776c6574742d5061636b61726420436f6d706 16e790000646573630000000000000012735247422049454336313936362d322e3100000000000000000 30 0000012735247422049454336313936362d322e310000000000000000000000000000000000000000000 00000000000 20

d e n si ty

10

return Fig. 4.6. Density estimates for the monthly Tremont convertible arbitrage index returns.

The literature is vast on descriptions of the (unconditional) hedge fund returns. They conrm the ndings of this section, see Kat and Brooks (2001) for instance. In the previous section it has been found that GARCH eects may occur for hedge fund returns. Threshold ARCH (TARCH) processes are an extension of GARCH processes and are well suited for describing volatility clustering in declining markets. Therefore, the hedge fund indices of Table 4.3 are tested for signicant (99%) TARCH eects. Table 4.3 shows the detailed results for the Tremont hedge fund index and its There are signicant TARCH eects for the convertible arbitrage and the xedsubindices including the sample skewness 1 and kurtosis 2. We nd that the GH income arbitrage index. The univariate properties of hedge fund returns may model ts the data best in terms of the log-likelihood value. Table 4.3 shows how the summarized as follows: s statistical properties hugely dier among the dierent styles. This is seen from The T results vary considerably among the dierent styles. diversely selected distributions according toand negative skewness. very diverse The T returns may have a high excess kurtosis the AIC value and the The GH distributions usually is the best model for monthly hedge fund returns, but values of 1 and 2. By inspection of Table 4.3, it is seen that the normal distribution some styles may even be reasonably modeled as normal. s is well styles have signicant equitycorrelation, indicating illiquid assets. returns. In Some suited for the case of serial market neutral and managed futures S Some styles show volatility clustering, possibly caused by describing returns of the contrary to this, the normal distribution is very bad for an increased risk tolerance of the manager because of performance fees. styles event driven and xed income arbitrage. Figure 4.6 shows the detailed results for the Tremont convertible arbitrage index. The return distribution is considerably skewed to the left, also extreme returns are present in the lower tail. The normal distribution is by far not able to model these observed

68 4 Alternative Investments

We conclude this section with the following remarks. Since the univariate properties of hedge fund returns dier considerably among the various styles, a universal treatment of hedge fund returns as such it not possible. Every fund, in contrast to most traditional assets, has to be analyzed in detail on its own.

4.3.2 Multivariate and Dependence Properties of Hedge Fund Returns The rst aspect of hedge funds, i.e., their claimed outperformance or alpha in comparison to traditional assets, has been discussed already. A further aspect to include hedge funds in a portfolio is because of their benets for diversication. First, the tail dependence of the dierent hedge fund styles is investigated. In most cases, there is no signicant tail dependence. In particular, the styles THFI convertible arbitrage, dedicated short bias, equity market neutral, xed income 0.28 arbitrage, managed futures, and multi-strategy show, if at all, only little tail 0.41 dependence among each other and to the other styles. The styles which show tail EmMa dependence among each other are shown in
1 Table 4.4. Tail dependence coecients for Tremont0.24 hedge fund styles, i.e., Tremont Hedge Fund Index 0.14 (THFI), Emerging Markets (EmMa), Event Driven (EvDr), Global Macro (GlMa), Long/Short Equity (LSEq). 0.22 EvDr 0.43 0.32 1

1 0.15 0.31 GlMa

0.13 LSEq

Hedge Fund Index 0.25 (0.44) 0.23 (0.42) 0.17 (0.44) Statistical Properties of Hedge Funds 4.3 0.11 (0.26) 0.02 (-0.12) of hedge fund indices with commodities and (0.25) 0.37 interest rates. The other tail dependence 0 (0.24) coecients are shown in Table 4.5, correlations are given in brackets. The S&P 500 is Convertible Arbitrage 0.10 (0.11) fairly tail dependent with many styles. The dedicated short bias is not tail dependent 0.08 (0.07) 0.09 (0.11) on any of the considered risk factors except for the value minus growth index. The 0.02 (0.15) 0.01 (0.12) xed income arbitrage index has only considerable tail dependence with the 0.19 (0.15) 0 (0.19) Citigroup US Corporate Bond index with maturities 3-7 years. Dedicated Short Bias 0 (-0.70) 0 (-0.65) 0 (-0.62) Table 4.5. Tail dependence coecients for Tremont hedge fund styles with common risk factors. Dow Jones 0 (-0.33) 0.16 (0.22) is abbreviated by DJ, Citigroup is abbreviated by CG. Correlations are given in brackets. 0.02 (-0.41) 0 (-0.05) Emerging Markets 0 (0.45) 0.23 (0.53) 0.27 (0.75) 0.06 (0.25) 0.06 (-0.06) 0.22 (0.33) 0 (0.02) Equity Market Neutral 0.08 (0.39) 0.01 (0.27) 0.04 (0.30) 0.03 (-0.04) 0 (-0.01) 0.1 (0.33) 0 (0.14) Event Driven 0.35 (0.53) THFI EmMa EvDr GlMa LSEq 0.27 (0.56) 0.18 (0.62) 0.08 (0.30) 0.02 (0.05) 0.23 (0.44) 0 (0.09) Fixed Income Arbitrage 0.09 (0.02) 0.02 (0.01) 0.06 (0.03) 0 (0.09) 0 (0.05) 0.02 (0.04) 0.16 (0.2) Table 4.4. The Tremont hedge fund index has large tail dependence coecients with Global Macro 0.13 (0.20) the emerging markets, the event driven, the global macro, and the long/short equity 0.02 (0.10) 0.07 (0.15) index. This may indicate that these styles are dominating the Tremont hedge fund 0.04 (0.06) 0 (0) index. Since the Tremont index is asset weighted, these styles may have more assets 0.20 (0.16) 0 (0.28) under management than the other styles in the database which Tremont uses, i.e., Long/Short Equity 0.30 (0.54) TASS. However, because this information is not publicly available, this remains a 0.00 (0.59) supposition. The long/short equity style has rather high tail dependence with the 0.02 (0.54) 0.15 (0.43) event driven style. It is plausible to state(-0.20) these styles have a considerable 0.10 that 0.38 (0.27) amount of capital invested in similar equities. 0 (0.16) Managed Futures Next, we are interested in(-0.17)tail dependence coecients of the dierent hedge 0.07 the 0.03 (-0.05) 0.02 (-0.07) 0.00 (-0.03) 0.01 (0.12) fund styles versus some of the risk factors(-0.15) 0.01 of Table 4.2. There is no signicant tail 0 (0.22) dependence Multi-Strategy 0.00 (0.07) 0.13 (0.09) 0.10 (-0.08) 0 (0.10) 0 (-0.01) 0.04 (-0.04) 0 (0.07)

70 4 Alternative Investments

in both cases almost the same, however, there is a huge dierence in the tail dependence coecient. Finally, the impact of the inclusion of hedge funds in a portfolio is discussed. We
Distribution AIC log-l consider a portfolio with equities, bonds, commodities, and hedge funds. As Copula representative for these asset classes we choose the S&P 500, the Citigroup US big log-l Normal corporations 3-7 years index, the Lehman government 1-3 years index, the Goldman 1897 -3753.9 Sachs commodities index, and the Tremont hedge fund index. Again, the Gaussian

methodology is the same as in Chapter 3. 1932.91

-3791.1 t (?=8.6) 1943.28 Skewed t 1922.4 -3792.9

t Table 4.6. Multivariate distribution 1916.5 for a portfolio including hedge funds. models

NIG 1922 -3791.9

GH 1922.4 -3790.9

The FTSE US Banks index has considerable tail dependence to many hedge fund styles. In particular, the style with the highest exposure is long/short equity. This underlines the importance of liquidity for hedge funds, provided by the banks. The emerging markets index has no tail dependence with the US market, but a signicant one with the Dow Jones emerging markets index. However, there is considerable tail dependence between the Dow Jones World index ex US and the emerging markets index. This indicates that the emerging market index is only tail-independent with the US market but not with the other developed markets. The fact that correlation does not explain the dependence for extreme events is seen from the results for the Tremont hedge fund index versus the FTSE US Banks index and the Citigroup US corporate bond index. The correlation is

4.4 Hedge Fund Investing

Embedding Hedge Funds in Traditional Portfolios The reasons for including hedge funds in a traditional portfolio are manifold. Once the decision to include hedge funds in a portfolio has been made, the next problem is to decide how much of the portfolio should consist of alternative investments. We have already encountered the problems when trying to answer this question with the mean-variance approach. Kat and Brooks (2001) and Fung and Hsieh (1998) nd that mean-variance portfolio construction with hedge funds is not suitable as well. Cvitani c, Lazrak, Martellini and Zapatero (2003) solve the problem of hedge fund allocation in a dynamic framework and with model uncertainty. They nd that the presence of model risk signicantly decreases the amount of wealth invested in hedge funds. Therefore, the over-allocation to hedge funds can be eliminated by introducing model uncertainty. For instance, if the alpha of hedge funds is modeled as random variable rather than a deterministic value, the amount of capital allocated to hedge funds is reduced. The topics of risk and performance measurement have already been discussed. Also, dynamic gives static results, the to model asset returns have been sketched. Table 4.6 and the possibilities best results are shown in bold numbers. Once the investor parametric distributions, fund which provides alpha for the existing Concerning the has determined a hedge the skewed t distribution gives very portfolio, the investor then has to make sure that the better log-likelihood values. As promising results. However, the copula models oer hedge fund has no undesirable systematic risk exposures. There assets, a huge variety of dierent approaches to for the case with only traditional exists the t copula oers the best t. However, construct a portfolio, e.g., thewith the fully parametricHowever, all these dierent optimal portfolio construction core-satellite strategy. distributions is much more methods ofthan with aconstruction lead to the same optimization problem if the convenient portfolio copula model. models for the assets and the risk measure are the same. The resulting optimization

4.4 Hedge Fund Investing problems then only dier in the constraints on the decision variables.
WeThe term portable alpha is often encountered fund investing problems. The assets distinguish between two main types of hedge in the context of alternative rst is thetraditional portfolios. fund of hedge funds funds, the portable is the problem of in problem of building a Concerning hedge portfolio. The second alpha is closely embeddingto the systematica traditional portfolio. These two problems may also be connected hedge funds in risk of hedge funds. The systematic risks of hedge funds modeled as dependent of each in detail. These risksthe investor contain make sure have already been discussed other. Nevertheless, may also has to traditional that the hedge fund or are unfavorable portfolioinvestor because these are already systematic risks which the hedge fund for the provides a signicant alpha for the current portfolio. In addition, the systematic risks ofexposures shouldpart small to be present in the traditional portfolio. However, these the hedge fund be have since analyzed in order not to interfere with fees for traditional risks. One way to dispose the investor is not interested in paying the systematic risks already present in the portfolio. the systematic risk exposures to traditional risks is by hedging these risks. Recall the hedge fund terminology of (4.1). By hedging the beta-exposures, what remains is the pure alpha. Of course, the isolation of alpha comes at a cost, i.e., the cost of hedging the unpleasant beta-exposures. Because the alpha is

72 4 Alternative Investments

now isolated from the risks of the investors portfolio, it is called portable. The investor will not alter the risk prole of the portfolio by introducing such a portable alpha. The return of the portfolio, in contrast to the risk of the portfolio which remains the same, is increased by the portable alpha. We have emphasized the importance of tail dependence for risk measurement. However, this does not make the correlation of hedge funds with traditional assets less important. The correlation is of importance because of the return maximization in normal market situations. Since hedge funds make use of dynamic trading strategies, the correlation properties with traditional asset classes may be dynamic as well. The correlation properties of hedge fund indices versus stocks and bonds are
C or calculated. The dynamic conditional correlation (DCC) GARCH model is used to nd re

the dynamic correlations. The technical detailsla can be found in Appendix B.

ti o n w Tremont Hedge Fund Index Tremont Equity Market Neutral Index 1ffd8ffe000104a46494600010201012c012c0000ffe20c5849 it 1 ffd8ffe000104a4649460001020101 43435f50524f46494c4500010100000c484c696e6f0210000 h 0.8 06d6e74725247422058595a2007ce0002000900060031000 b 0.8 2c012c0000ffe20c584943435f50524f 0616373704d5346540000000049454320735247420000000o 46494c4500010100000c484c696e6f 0.6 000000000000000000000f6d6000100000000d32d4850202 n 0.6 000000000000000000000000000000000000000000000000 C 021000006d6e74725247422058595a d or 000000000000000000000000000000000000000000000001s 2007ce000200090006003100006163 re 1637072740000015000000033646573630000018400000060. c77747074000001f000000014626b7074000002040000001 la 73704d534654000000004945432073 47258595a00000218000000146758595a0000022c0000001 4 ti 46258595a0000024000000014646d6e640000025400000070. 524742000000000000000000000000 o 0646d6464000002c400000088767565640000034c0000008 2 0000f6d6000100000000d32d485020 n 676696577000003d4000000246c756d69000003f80000001 0 w 46d6561730000040c0000002474656368000004300000000 200000000000000000000000000000 c725452430000043c0000080c675452430000043c0000080 0 it .2 000000000000000000000000000000 c625452430000043c0000080c7465787400000000436f707 h 97269676874202863292031393938204865776c6574742d50 b 000000000000000000000000000000 061636b61726420436f6d70616e790000646573630000000 .4 o 000000012735247422049454336313936362d322e3100000 0 000000116370727400000150000000 n 0000000000000000012735247422049454336313936362d3 .6 3364657363000001840000006c7774 d 22e310000000000000000000000000000000000000000000 10.5 0 0.5 1 0 s 00000000000 10.5 0 0.5 1 7074000001f000000014626b707400
0 .2 0 .4 0 .6 0 .8 1 .8 1

000204000000147258595a00000218

C 000000146758595a0000022c000000 Fig. 4.7. Correlation of Tremont Hedge Fund Indices with stocks and bonds. or re 146258595a0000024000000014646d la 6e640000025400000070646d646400 ti 0002c400000088767565640000034c Figure 4.7 shows the dynamic correlations o the Tremont hedge fund index and of 0000008676696577000003d4000000 n w 246c756d69000003f8000000146d65 the Tremont equity market neutral index with stocks and bonds. The stock returns it 61730000040c000000247465636800 h are substituted by the S&P 500 index, the bond returns by the Lehman government st 0004300000000c725452430000043c o bond 1-3 years index. The Tremont hedge fund index shows rather stable correlation 0000080c675452430000043c000008 c 0c625452430000043c0000080c7465 k with the equity market (around 50 %), the correlation with the bond market is not s 787400000000436f70797269676874 C stable and varies between 40 %. The Tremont equity market neutral index or 202863292031393938204865776c65 re 74742d5061636b61726420436f6d70 correlation is unstable with respect to stocks and bonds. The results for all other la 616e79000064657363000000000000 ti Tremont hedge fund indices are similar to the results shown in Figure 4.7. This 001273524742204945433631393636 essentially means that the correlation o n 2d322e310000000000000000000000 w 12735247422049454336313936362d it h 322e31000000000000000000000000 st 000000000000000000000000000000 o c k s

4.4 Hedge Fund Investing

properties of hedge fund indices are not always stable with respect to traditional assets. This underlines the advantage of active portfolio management, also when hedge funds are part of a portfolio.

Hedge Fund Selection What remains is the selection of appropriate hedge funds once the investor has decided how much capital of the portfolio is allocated to hedge funds. However, the engagement in a hedge fund diers enormously from an engagement in a traditional asset. We have argued that risk management is systematic and rational. The same should also apply for the construction of the alternative part of a portfolio. In Section 4.1.4, the topic of funds of hedge funds has been discussed and these results also apply for the hedge fund selection problem. The two main approaches are the topdown and the bottom-up approach. These ffd8ffe000104a46494600010201012c012c0000ffe20c58494343 5f50524f46494c4500010100000c484c696e6f021000006d6e747 25247422058595a2007ce00020009000600310000616373704d5 346540000000049454320735247420000000000000000000000 000000f6d6000100000000d32d48502020000000000000000000 000000000000000000000000000000000000000000000000000 000000000000000000000000011637072740000015000000033 64657363000001840000006c77747074000001f000000014626b 707400000204000000147258595a00000218000000146758595 a0000022c000000146258595a0000024000000014646d6e64000 0025400000070646d6464000002c40000008876756564000003 4c0000008676696577000003d4000000246c756d69000003f800 0000146d6561730000040c00000024746563680000043000000 00c725452430000043c0000080c675452430000043c0000080c6 25452430000043c0000080c7465787400000000436f707972696 76874202863292031393938204865776c6574742d5061636b61 726420436f6d70616e7900006465736300000000000000127352 47422049454336313936362d322e31000000000000000000000 012735247422049454336313936362d322e3100000000000000 0000000000000000000000000000000000000000
Fig. 4.8. Hedge fund portfolio construction

two concepts are shown graphically in Figure 4.8. The advantages and disadvantages have been discussed in Section 4.1.4. Therefore, the three main elements for hedge fund investing are: Style

Diversication Fund Hedge Selection

74 4 Alternative Investments

Risk

Monitoring In general, the asset allocation process of Figure 2.1 still applies. In the strategic asset allocation, the hedge fund styles used for diversication have to be dened. The selection of the hedge fund or managers is performed in the investment analysis and the tactical asset allocation. The risk monitoring is performed in connection with the risk management for the other assets. Style diversication has been discussed in Section 4.2. The style diversication is
Hedge Fund Universe conceptually not dierent from diversication for traditional investments. What Potential dierentiates hedge fund engagements from those in traditional investments is the Initial Qual. Analysis

hedge fund selection process. Figure 4.9 gives a schematic overview. In the rst step, potential candidates have
Due Hedge Fund Selection (Database) Filtering Candidates Quant. Analysis Short-list Dilligence

4.4 Hedge Fund Investing

tional drawdown-at-risk. Agarwal and Naik (2004) build mean-CVaR optimal portfolios and compare these with mean-variance portfolios. Agarwal and Naik nd that the mean-variance signicantly underestimates the tail risk of the portfolio. Amenc and Martellini (2002) present an improved estimator for the out-of-sample covariance matrix of hedge fund index returns. Summarizing, in the realm of hedge funds, qualitative aspects play a much more important role than for traditional investments. However, this does not make quantitative aspects less important. Hedge fund portfolio construction asks for coherent risk measures which take into account the tails of the return distributions.

Fig. 4.9. The hedge fund selection process

to be found by screening the hedge fund universe. For this, several commercial hedge fund databases should be ltered for funds with adequate properties. The elaboration of the list with potential candidates usually depends heavily on the investors preferences and less on subjective quantitative criteria. The next step is the qualitative and the quantitative analysis of the funds. This results in a short list of suitable funds. The steps performed thus far can be performed in an automated fashion. The next step, i.e., the due diligence of the funds, analyzes the fund in more details. Due diligence is in a sense a qualitative analysis, but much more comprehensive than the one of the previous step. The due diligence usually includes a visit to the fund managers by experienced professionals. Among other things, the strategy of the fund, the people involved, the infrastructure, and the processes are reviewed and analyzed in detail. Therefore, it is often called operational and structural due diligence. After the individual funds have been selected, the hedge fund portfolio has to be constructed accordingly. We have argued that the mean-variance approach is not appropriate for solving this problem. Some alternative approaches to solve this task are found in the literature. Krokhmal, Uryasev and Zrazhevsky (2002) analyze linear rebalancing strategies for hedge fund portfolios using dierent risk measures such as CVaR and condi

Optimal

Portfolio

Construction

with

Brownian Motions

Opportunity is missed by most people because it is dressed in overalls and looks like work. Thomas Edison

In Section 3.3, the optimization techniques in nance have been reviewed. In this chapter, dynamic asset allocation strategies are developed for asset prices, modeled as continuous-time stochastic dierential equations (SDEs) driven by Brownian motion. In this type of model, the conditional distribution of asset returns is normal. Therefore, asset prices are log-normally distributed. Note that the unconditional distribution of returns in this framework is not necessarily the normal distribution. The main advantage of using the continuous-time framework is that the optimal control problem can be solved analytically to a high degree. In some cases, even closed-form solutions may be derived. This gives more insight into the mechanics of an optimal asset allocation strategy than a numerical approximation thereof. However, the modeling properties are rather limited for continuous-time stochastic processes with Brownian motion. We will make use of factors for explaining expected returns of assets. Two types of problems are considered in this chapter. We consider the case were all factors which are explaining the returns of assets are known, i.e., measurable. The second case considers the situation where not all of the factors explaining returns are observable. This problem is called optimal asset allocation under partial information. The optimal asset allocation strategies are derived with a stochastic dynamic programming approach. Therefore, the Hamilton-Jacobi-Bellman (HJB) equation has to be solved. The HJB equation is a non-linear partial dierential equation, which is very hard to solve if the control variable is constrained. For problems in higher dimensions, it is virtually impossible to nd

78 5 Optimal Portfolio Construction with Brownian Motions

analytical solutions for the constrained case. This fact and the limited possibilities to model asset returns are the main disadvantages of modeling assets in continuoustime stochastic dierential framework with Brownian motion. In this chapter, when we speak of continuous-time nance, we actually refer to a continuous-time stochastic dierential framework with Brownian motion. After having introduced the dynamics of the considered assets, we are able to dene the wealth dynamics of our investor. The investors portfolio is self-nancing, i.e., there are no external in-or outows of money. We are considering two types of investors in this chapter. They are characterized by their corresponding utility functions. On the one hand, we consider the popular constant relative risk aversion (CRRA) case. On the other hand, we consider the constant absolute risk aversion case (CARA). The problems are solved by using Bellmans optimality principle. For the partial information case, we show that the separation theorem is not valid anymore, i.e., we cannot separate the estimation from the optimization. This means that we cannot simply estimate the unobservable quantities and treat them afterwards as if they were known exactly. The asset allocation strategies are all backtested with real market data. The data in this chapter is obtained from the Datastream database of Thomson Financial.

5.1 The Full Information Case

The cornerstones of continuous-time nance are the publications of Samuelson (1969) and Merton (1969, 1971). Since then, these results have been extended to a wide range of improved models and applications. The most popular application of continuous-time nance is the pricing of contingent claims by Black and Scholes (1973). The modeling of xed-income securities is also popular in the continuoustime framework. The reader is referred to Shreve (2004) and Bjork (1998) for a detailed treatment of various topics in continuous-time nance. We are less interested in solely modeling in continuous time but rather in the solution of optimal asset allocation problems resulting thereof. The solutions of optimal asset allocation problems can be used either for asset pricing or for optimal portfolio construction. In the developments of Samuelson and Merton, the optimization problem is solved under full information. For the full-information case, several closed-form solutions have been derived. Since the literature on this topic is vast, we can only mention a few. Among them

5.1 The Full Information Case

are Kim and Omberg (1996), Browne (1999), Korn and Kraft (2001), Herzog, Dondi, Geering and Schumann (2004), Wachter (2002), Keel, Herzog and Geering (2004), and Munk and Sorensen (2004). A recent publication on this subject is Schroder and Skiadas (2005). Kim and Omberg (1996) nd a closed-form solution for a single risky asset with stochastic risk premium. In addition, conditions for the solvability of the problems are discussed, although not in sucient detail. Browne (1999) gives the analytical solution for the problem of beating a stochastic benchmark. Thereby, the problem of maximizing the expected discounted reward of outperforming the benchmark, as well as the minimization of the discounted penalty paid by being outperformed by the benchmark is discussed. Wachter (2002) solves the optimal portfolio choice problem for an investor with utility over consumption under mean-reverting returns in closed form. The asset allocation problem for investing among stocks, bonds, and cash is solved for a power-utility investor with mean-reverting returns and interest rate uncertainty in Munk and Sorensen (2004). However, the excess return is perfectly negatively correlated with the asset prices, which is a limiting assumption.

Korn and Kraft (2001) analyze the problem of utility maximization over terminal wealth for stochastic interest rates. The investment opportunities are a savings account, stocks, and bonds. A verication theorem without the usual Lipschitz assumptions is proved. Keel et al. (2004) consider the application of optimal portfolio construction with interest rate risk, market risk, and the risks introduced by an alternative investment. Schroder and Skiadas (2005) introduce a class of recursive utility, which includes additive exponential utility. The solutions, including convex trading constraints, are obtained by solving a constrained forward-backward stochastic dierential equation. Since the work of Merton, it is obvious that optimal investment strategies depend on the investment horizon. Therefore, a long-term strategy diers usually in a signicant way from the myopic optimization. The long-term optimization problem contains, in addition to the myopic policy, the intertemporal hedging demand. This kind of problem is also called strategic asset allocation and is introduced in Brennan, Schwartz and Lagnado (1997). The strategic asset allocation problem including an arbitrary number of factors explaining mean returns of assets is described in Herzog, Dondi, Geering and Schumann (2004). Similar results are also found in Liu (2005).

80 5 Optimal Portfolio Construction with Brownian Motions

By introducing multiple factors, one has to solve a high-dimensional, non-linear partial dierential equation (PDE) to compute the solution. The use of numerical dynamic programming with discrete state approximation suers from Bellmans curse of dimensionality and is therefore restricted to very few factors. For an illustration of the problems involved with numerical dynamic programming, the reader may refer to Peyrl, Herzog and Geering (2004). Further advances in numerical methods for solving partial dierential equations may make this approach also applicable to higher dimensions. There are many publications on the issue of using explanatory factors for improving the asset allocation. In Fama and French (1993), ve common factors for stocks and bonds are identied. For the stock market, an overall market factor, a factor related to the rm size, and book-to-market equity are considered. For the bond market, two factors, related to maturity and default risk, are considered. Some additional publications on this subject are Moskowitz and Grinblatt (1999), Jegadeesh (1990), Bossaerts and Hillion (1999), and Rosenberg, Reid and Lanstein (1985). These papers suggest that the momentum of equities possesses predictive power. In Bossaerts and Hillion (1999), evidence is given that the relation between factors and asset returns is non-stationary. This is a further motivation for having a dynamic prediction model. In Amenc, Bied and Martellini (2003), the predictability of hedge fund returns is discussed. In Campbell and Hamao (1992) and Harvey (1995), possible factors for an international diversied portfolio are discussed. There are various extensions to the standard problems discussed in the literature. The problem of transaction costs is considered in Oksendal and Sulem (2002) and Janecek and Shreve (2004). However, the resulting problems are no longer analytically solvable. Bertsimas and Lo (1998) derive dynamic optimal trading strategies that minimize the expected cost of trading a large block of equity over a xed time horizon. Portfolio choice problems with stochastic volatility are considered in Fleming and Hernandez-Hernandez (2003) and Chacko and Viceira (2005). Since stochastic dynamic volatility is a stylized fact of asset returns, these results are more realistic than the ones with deterministic volatility.

5.1.1 The Model The investment opportunities are modeled as stochastic dierential equations. They are assumed to behave as local geometric Brownian motions. The drift terms of the asset price

5.1 The Full Information Case

dynamics are modeled as ane functions of explanatory factors. We model the factors via stochastic dierential equations as well. The diusions of the n risky price processes are driven by an n-dimensional standard Brownian motion process Wp. Similarly, the diusions of the m factor processes are driven by an m-dimensional standard Brownian motion process Wx. In addition to the risky asset, there is a riskfree asset (or bank account) whose instantaneous return is deterministic.

Nevertheless, the return on the risk-free asset may be time-dependent or even stochastic. The Brownian motion Wp of the price processes and the Brownian motion Wx of the factor processes are dened on a xed, ltered probability space (, F, {Ft}t?0, P) with Ft satisfying the usual conditions. The Brownian motions Wp and Wx do not need to be independent. Factor Dynamics In order to improve the asset allocation, factors are included in the asset models. We expect the factors to have some predictive power for the returns of the investment opportunities. The m factors x(t) R are modeled by the following stochastic vector process dx(t)=[Ax(t)x(t)+ a(t)]dt + x(t)dWx(t), (5.1) x(0) = x0,
m

where Ax(t) R

mm

, a(t) R

, x(t) R

mm

, and Wx(t) R . The matrix and

vector functions Ax(t), a(t), and x(t) are deterministic functions. In addition, x(t) is assumed to have full rank for all t. The factor process allows us to model dierent variables aecting the mean return of the risky assets. Asset Price Dynamics The set of investment opportunities of our investor consists of n 1 risky assets. The asset price processes P =(P1(t),P2(t),...,Pn(t)) R of the risk-bearing investments satisfy the stochastic dierential equations, where diag(P (t)) denotes the diagonal matrix of the vector P (t), dP (t) = diag(P (t)) {(x(t),t) dt + p(t)dWp(t)} , (5.2) P (0) > 0 ,
n

where (x(t),t) R , p(t) R

nn

, and Wp(t) R . The matrix function p is

assumed to be deterministic. From the diusion matrix p we get the instantaneous covariance

82 5 Optimal Portfolio Construction with Brownian Motions

matrix per unit time as (t)= p(t)p(t)T . The matrix function has to be invertible, therefore p has to have full rank. The correlation matrix R Brownian motion W =[Wp ,W x ] is dened as I1 (t) (t)= , T (t) I2 where I denotes the identity matrix and R
nm T T T n+mn+m

of the

, I1 R

nn

, and I2 R

mm

. In

addition, there exists a risk-free investment opportunity B(t) with instantaneous rate of return r(x(t),t) R:

dB(t)= B(t)r(x(t),t)dt , (5.3) B(0) > 0 .

The scalar function r is deterministic. The drift terms of the risk-free asset and the risk-bearing assets depend on the m factors x. Furthermore, we assume that the drift terms in (5.2) and (5.3) are ane functions of the factor levels, as given by (x(t),t)= G(t)x(t)+ f(t) , (5.4) r(x(t),t)= F0(t)x(t)+ f0(t) , (5.5) where G(t) Rnm,f(t) Rn,F0(t) R1m, and f0(t) R. The matrix and vector functions G(t), f(t), F0(t), and f0(t) are all deterministic.

Portfolio Dynamics We assume that the investors portfolio is self-nancing, i.e., there are no exogenous in-or outows of money, e.g., consumption. The dynamics of the investors wealth V may be expressed as
n ( V (t)udPi L dV (t)= dB(t) 0 +(t) ui(t) ,

B(t) Pi(t) V (0) > 0,

i=1

where u1(t),...,un(t) denotes the fraction of wealth invested in the corresponding risky asset and u0(t) accordingly in the risk-free asset at time t. The proof is either found in Merton (1992) or Bjork (1998). Because the portfolio is self-nancing, we have the constraint ? i=0 ui(t) = 1. Inserting the denitions of the asset price dynamics of (5.2) and (5.3) in (5.6), we arrive at the following wealth dynamics:
n

5.1 The Full Information Case

d T T V = {u [(x, t) 1n r(x, t)] + r(x, t)}dt + u pdWp, (5.6) V

where 1n is dened as the vector 1n = (1, 1,..., 1)T Rn and u(t)=[u1(t),...,un(t)]T . 5.1.2 Optimal Asset Allocation Optimal Asset Allocation with a CRRA Utility Function

The optimal asset allocation is derived for an investor having constant relative risk aversion (CRRA). Therefore, the expected power utility over terminal wealth is maximized. The denitions of and r, found in (5.4) and (5.5), are inserted into the wealth dynamics of 5.6. The investors optimization problem under full information becomes (with time arguments omitted for better readability) 1 max E[ V (T ) ] u()L1 n s.t. dV = V {u [Fx + f]+ F0x + f0}dt + Vu pdWp (5.7) dx =[Axx + a]dt + xdWx dWpdWx = dt,
T T

with V (0) = V0 and x(0) = x0. The parameter < 1 is the coecient of risk aversion. The deterministic matrix functions F Rnn and f Rn of the investors wealth dynamics are dened as

F = G 1nF0, (5.8) f = f 1nf0. (5.9)

The deterministic matrix functions G, f, F0, and f0 are dened in (5.4) and (5.5), the vector 1n is dened as in (5.6). In order to solve this problem with Bellmans optimality principle, we introduce the value or cost-to-go function as 1 J(t, V, x)= max E[ V (T ) ]. u()L1 n The optimal asset allocation strategy is the solution of the Hamilton-Jacobi-Bellman equation. For a proof in the recent literature see Yong and Zhou (1999). The HamiltonJacobi-Bellman partial dierential equation for this problem is

84 5 Optimal Portfolio Construction with Brownian Motions

T T Jt + max [V {u [Fx + f]+ F0(t)x(t)+ f0(t)}JV +(Axx + a) Jx uRn

+ 11 uJVV + Vu JVx + tr{Jxxx}] =0, u 2 T Vx 22

T T 1

with = p xT and terminal condition J(T,V (T ),(T )) =

V (T ). This kind of

problem is solved in Herzog, Dondi, Geering and Schumann (2004). The reader may consult this publication for the proof. The optimal control law u* of this problem is given by
* 1 u = 1(Fx + f + [K1x + k2]), (5.10)

1 where k2(t) Rm and K1(t) Rmm are the solutions of two matrix Ricatti equations. The dierential equation for the matrix K1(t) is given by
T KTK1xx K1 + K1A + A K1 1+ 1 1 T 1 T T F (F TT + F K1 + K1 F + K1x K1) =0, (5.11)

( 1)

with terminal condition K1(T ) = 0. The dierential equation for the vector k2(t) is given by k 2 + F 0 + K1xx k2 + A k2 + (F1f + F1k2 + K1T 1f + K1xT T k2) =0, (5.12) K1a TT x ( 1)
T T T

with terminal condition k2(T ) = 0. We summarize the results in the following lemma. Lemma 5.1 (Full Information, CRRA Case). The optimal asset allocation strategy under full information for the CRRA case (5.7) is given by (5.10), where K1(t) and k2(t) are the solutions of two matrix Ricatti (5.11) and (5.12), respectively. equations Proof. See Herzog, Dondi, Geering and Schumann (2004).

Optimal Asset Allocation with a CARA Utility Function

The optimal asset allocation is derived for an investor having constant absolute risk aversion (CARA). Therefore, the expected exponential utility over terminal wealth is maximized. For the problem to be solvable, we model the risk-free interest rate r(t) as a function of time only, i.e., independent of x(t). Therefore, we set F0 0 in (5.5). We proceed as in the CRRA case and state the investors optimization problem as

5.1 The Full Information Case

[
u()L1n

max Ee

V (T )] 1

s.t. dV = V {u [Gx + f]+ r}dt + Vu pdWp (5.13) dx =[Axx + a]dt + xdWx WpdWx = dt, d

with V (0) = V0 and x(0) = x0. The parameter > 0 is the coecient of risk aversion, f is as dened in (5.9). The value or cost-to-go function for this problem is [ 1V (T )] J(t, V, )= max Ee. u()L1 n This results in the following Hamilton-Jacobi-Bellman partial dierential equation for this problem
T T Jt + max [V {u [Gx + f]+ r}JV +(Axx + a) Jx uRn

11 2 T tr{JV }] =0. xx xx 22 This type of HJB partial dierential equation is solved in Herzog, Dondi, Geering and Schumann (2004). The optimal solution u * is given by * 1 1( Gx + f + [K1x + k2]).

+ u uJVV + Vu JVx +

(5.14)

V k3 It remains to dene the functions K1(t), k2(t), and

k3(t). The matrix function K1(t) is the solution of the following linear matrix dierential equation K1 + K1xx K1 + K1A + A K1 F
T T T 1

FF
T

K 1

K1

F K1x x K1 =0, (5.15)

with terminal condition K1(T ) = 0. The vector function k2(t) is the the solutions of the following dierential equation k 2 + K1xx k2 + A k2 + K1a F
T T T T

fF

k 2

K1

f K1x x k1 =0, (5.16)

with terminal condition k2(T ) = 0. Finally, the scalar function k3(t) is the solution of the following dierential equation k 3 + f0(t)k3 =0,k3(T )= . (5.17) We summarize the results in the following lemma.

86 5 Optimal Portfolio Construction with Brownian Motions

Lemma 5.2 (Full Information, CARA Case). The optimal asset allocation strategy under full information for the CARA case (5.13) is given by (5.14), where K1(t), k2(t), and k3(t) are the solutions of the dierential equations (5.15), (5.16), and (5.17), respectively. Proof. See Herzog, Dondi, Geering and Schumann (2004).

5.1.3 Case Study with Alternative Investments

We consider an investor having three risky investment opportunities. These are the stock market, the bond market, and alternative investments. Each of the three investment opportunities oers a dierent risk-return prole. For the xed income part, the short rate model of Vasicek (1977) is used. As second investment opportunity, we consider the stock market. We chose a stock market index as a proxy for the market portfolio. It is modeled by a geometric Brownian motion. Its drift and diusion are constant. For the hedge fund, we use a model originating from Sharpes capital asset pricing model including the Greek letters and . However, we only use the terminology of the CAPM but do not need the assumptions of the CAPM. Since the model is in continuous time, the intertemporal capital asset pricing model (ICAPM) of Merton (1973a) is used. Cvitanic et al. (2003) use a similar model for hedge funds. As a consequence, the alternative investment does not have a constant risk premium. This is also the case for the market portfolio since the risk-free interest rate is not constant. The investment opportunities are modeled by appropriate stochastic dierential equations. The investors utility function is chosen to have constant relative risk aversion.

The Model In order to derive the optimal investment strategy, we rst need to model the three considered investment opportunities. The Brownian motions of the continuous-time stochastic dierential equations involved are dened on a xed, ltered probability space (, F, {Ft}t?0, P) with Ft satisfying the usual conditions. As mentioned, a short rate model is used for the xed income part. The investor is able to put money into a bank account. The bank account has an interest rate equivalent to the short rate. We have the following SDE for the short rate r:

5.1 The Full Information Case

dr = ( r)dt + rdWr, (5.18) r(0) = r0,

where , , r R are the constant parameters of the short rate. Given the short rate, we solely need to determine the price of risk to determine the dynamics of the bond B with maturity T , r r dB = B(r + aT )dt BaT dWr, (5.19) B(T )=1, where the scalar function aT (t) is dened as aT (t)=1 e. (T t) (5.20) The reader is referred to Vasicek (1977) for details. The second investment opportunity is a passive equity fund, regarded as a proxy of the market portfolio. The passive fund S has the SDE dS = Ssdt + SsdWs, (5.21) S(0) = S0,

where s,s R are the constant parameters of the model. Furthermore Ws is assumed to be independent of Wr. As a last step, the model for the alternative asset remains to be introduced. The price of the alternative asset, denoted by A, is modeled by dA = A(r + (s r)+ )dt + AA(dWs +1 2dWA), A(0) = A0, where , , A, R are the constant parameters of the model. Furthermore WA is assumed to be independent of Wr and Ws. In this context, r + (s r) describes the risk adjusted return of the asset with respect to the market, whereas denotes the outperformance of the alternative asset. The parameter is dened to be cov(dS/S, dA/A) A == , (5.22)2 S S where denotes correlation of the return of the market portfolio and the return of the alternative asset. We introduce a three-dimensional control vector u. The three components of u represent the percentage of total wealth invested in the respective investment category. In our case, the wealth equation becomes

88 5 Optimal Portfolio Construction with Brownian Motions

T T dV = V [u (r, t)+ r]dt + Vu dW,

where u R , W =[Wr,Ws,WA] R and initial condition V (0) = V0. The vector (r, t) is ? aT (t) r (r, t)= Fr + f(t)= s r , (s r)+ whereas the matrix (t) is dened to be ? r aT (t)0 0 (t)= 0 s 0 . 0 AA 1 2 The matrix (t)T (t) has to be invertible and therefore || < 1. Solution to Asset Allocation with CRRA Utility The portfolio choice problem is to maximize the expected power utility dened over terminal wealth. Furthermore, we assume that leveraging, short-selling, and borrowing at the risk-free rates are unrestricted. Mathematically, the problem statement is {1 } max EV (T ) u() s.t. dV = V [u
T T (r, t)+ r]dt + Vu dW

dr = ( r)dt + rdWr,

with initial conditions V (0) = V0 and r(0) = r0. The time horizon is denoted by T and < 1 denotes the coecient of risk aversion. The solution of this problem, given (t)= (t)(t)T and e1 = [1, 0, 0]T , is
* 1 r u (t, r)= (t) ((t, r) aT (t)[k1(t)r(t)+ k2(t)]e1). (5.23) 1 2

1 The two functions k1(t) and k2(t) are the solutions of two coupled ordinary dierential equations (ODEs). The ODE for k1(t) is 2

k 1 2k1 + k r h1 =0,k1(T )=0 . (5.24) 1 1

2

5.1 The Full Information Case The only unknown in the ODE for k1(t) is the constant h1, which is dened by
2

h1 = .

The ODE for k1 is independent of k2 and can be therefore solved independently. Because of the form of (5.24), there exists a ( closed-form solution. Dene the function to be {(T t) + (t) 1) )} atanh( (t) = tanh We nally have for the solution of k1 1 ( (t)) k1(t)= 2 r
s

+ 2 , = ? 2 1 r 1 h .

The remaining unknown of the solution is k2(t). From the general solution we know that k2(t) is the solution of an ODE which is dependent of k1(t). The ODE for k2(t) is, for our specic case, given by k 2 k2
(

r) k1

+ k1h3 + h2 =0,k2(T )=0 . (5.25)

The constants h2 and h3 are found to be h2 = + h1S ,h3 = r. 1 Again, we can give an analytical solution, but the form of the solution of (5.25) is more complicated than for k1(t), i.e., 1 (1 k2(t)= C 1 (t)2 + h3 + h2 2 r ) (t) h 1 3 2 .

The integration constant C has to be chosen such that the terminal condition k2(T )=0 is met, therefore we get ) 2 2 (h3(1 ) h2 2 r 2 2

C=

The conditions for existence of a solution are r 0, s = 0, and < 0. Since we want to = optimize a portfolio with alternative investments, we are especially interested in the third component of u * in (5.23). It reects the fraction of wealth allocated to the alternative investment and is given by 2 2 u*= . (1
3

)(1

90 5 Optimal Portfolio Construction with Brownian Motions

The amount of capital invested in the alternative investment increases linearly with . The closer the variance of A is to zero, the more is invested in the alternative investment. At rst sight, it is counter-intuitive that the larger the absolute value of the correlation , the more is invested in the alternative asset. But if we take a look at u2*, the fraction of wealth invested in the market, we observe that, for large absolute values of , the value of u
* 2

changes signicantly. The asset allocation rule

exploits this correlation property by taking much more extreme positions when a large positive or negative correlation is present,
* 1 A * u2 =(S r) 2 3 . u (1 )S S

The rst term of u2 is seen to be the well known solution of Merton (1992), whereas the second term depends on the amount of wealth invested in the alternative investment u3*. If the correlation is equal to zero, the position in the market is the same as in the standard Merton case. If is positive, the position in the market is reduced in favor of the position in the alternative investment (assuming a positive ). The interesting property lies in the fact that, if the correlation is negative, the optimal weight in the market is larger than in the positively correlated case. The lower the correlation, the more the downturns of the alternative investment are hedged by the position in the stock market. One reason to include hedge funds in portfolios is because of their benets of diversication, i.e., low correlation. In the perfectly independent case, i.e., = 0, the fraction of wealth invested in the market remains unaected in terms of the Merton solution. Because of the lack of dependence between the bond market and the stock market and the alternative investment, respectively, the amount of wealth invested in the bond is independent of the characteristics of the market and the alternative investment. Analysis and Backtest of the Asset Allocation Strategy with US Data The optimal control vector u(t) is computed for real market conditions. We use US stock market data and the Tremont hedge fund index. For the equity fund, i.e., the substitute for the market portfolio, the S&P 500 is used. As a proxy for the short rate, we use three month Treasury bills, which have interest rates close to the ones paid on a money market account. For the bond portfolio part, the Datastream USA Total 35 years bond index is used. In order to account for the coupon payments, the total return index data is used

5.1 The Full Information Case

which is a suitable approximation for the zero coupon bond. The data is obtained on a weekly basis except for the Tremont hedge fund index which is only available on a monthly basis. The three-month Treasury bills are used as a proxy for the short rate for two reasons. The rst is because of its long availability (since 1972), which is important for the estimation of the short rate parameters. The second reason is that the federal fund rate is locally deterministic and therefore not suited as proxy for the short rate. The resulting control vector u(t) crucially depends on the parameters chosen. The parameters used for the market portfolio can be estimated with long time series of data and are therefore reliable long term estimates. This is also the case for the xed income security. The stochastic dierential equation for the short rate (5.18) is discretized with the method of Euler, see Kloeden and Platen (1999) for details. We get rt+1 = Lt + (1 Lt)rt + r r, Lt

where Lt is the time increment and r is a standard normal white noise process. The parameters of the short rate are estimated by doing an ordinary least squares estimation on the discrete version of the short rate. We assume that the bond has a xed duration, i.e., having a roll-over bond portfolio part in the entire portfolio. This can be achieved by changing the timevarying function aT (t) in (5.20), to be a function of the duration of the bond portfolio part only. We discretize the stochastic dierential equation of the logarithmic bond prices (5.19) with the method of Euler and get 2 r 1 r r ln(Bt+1) ln(Bt) rtLt = ( aT ()+ ( aT ( )) )Lt + aT ( ) Lt B, 2 where Lt is the time increment and B is a standard normal random variable. The duration and the price of risk of the bond index are estimated by estimating mean and variance of the series above. The drift and the diusion of the market portfolio are computed in the same way as the bond prices. The price process (5.21) is transformed with the natural logarithm. The resulting stochastic dierential equation is then used in its discrete version, using the method of Euler. This gives the relationship ln(St+1) ln(St)= (S )Lt + S LtS, 1 2 2 S

92 5 Optimal Portfolio Construction with Brownian Motions

where Lt is the time increment and S is a standard normal random variable. The drift and the diusion of the Tremont hedge fund index are computed analogously to the market portfolio. The correlation is estimated by calculating the correlation of the residuals of ln(A) and ln(S). With these estimates at hand, can be estimated by subtracting r + (S r) from the mean of the Tremont hedge fund index returns.
Table 5.1. Typical values for the estimated parameters. Parameter value std. error t stat. 0.26 0.05 4.8 0.07 p.a. 0.005 13 Parameter value std. error t stat. S 0.1 p.a. 0.008 11.7 ? 0.16 p.a. 0.004 38.8 0.49 S ? 0.02 p.a. 0.0007 27.5 0.56 r 0.04 14.8 3.66 years 0.4 8.9 ? 0.09 p.a. 0.006 14.1 A 0.07 6.9 0.05 p.a. 0.014 3.27

Using the time series of the market and the short rate from 1972 to 2005, the bond index from 1980 to 2005, and the alternative asset from 1994 to 2005, we estimate the parameters of the stochastic processes. Table 5.1 shows the results. By considering the t statistics of all parameters, it is seen that they are all signicant.

ffd8ffe000104a46494600010201012c012c0000ffe20 c584943435f50524f46494c4500010100000c484c696e ffd8ffe000104a46494600010201012c012c0000 2 6f021000006d6e74725247422058595a2007ce000200 ffe20c584943435f50524f46494c4500010100000 09000600310000616373704d5346540000000049454 c484c696e6f021000006d6e74725247422058595 1.5 320735247420000000000000000000000000000f6d60 a2007ce00020009000600310000616373704d53 P 465400000000494543207352474200000000000 or 1 00100000000d32d4850202000000000000000000000 tf 0000000000000000000000000000000000000000000 ffd8ffe000104a46494600010201012c01 00000000000000000f6d6000100000000d32d48 ol 2c0000ffe20c584943435f50524f46494c4 0.5 0000000000000000000000000000000116370727400 502020000000000000000000000000000000000 io 500010100000c484c696e6f021000006d6 w 0001500000003364657363000001840000006c77747 000000000000000000000000000000000000000 e74725247422058595a2007ce000200090 0 ei 00600310000616373704d534654000000 074000001f000000014626b707400000204000000147 000000000000000000000011637072740000015 g 004945432073524742000000000000000 0. 258595a00000218000000146758595a0000022c0000 00000003364657363000001840000006c777470 ht 0000000000000f6d6000100000000d32d4 s 00146258595a0000024000000014646d6e640000025 74000001f000000014626b70740000020400000 850202000000000000000000000000000 5 ui 000000000000000000000000000000000 400000070646d6464000002c4000000887675656400 0147258595a00000218000000146758595a0000 000000000000000000000000000000000 1 1.500034c0000008676696577000003d4000000246c756 022c000000146258595a0000024000000014646 001163707274000001500000003364657 2 d69000003f8000000146d6561730000040c000000247 d6e640000025400000070646d6464000002c400 363000001840000006c77747074000001f 0123456789 000000014626b70740000020400000014 4656368000004300000000c725452430000043c0000 000088767565640000034c00000086766965770 7258595a00000218000000146758595a00 10 080c675452430000043c0000080c625452430000043c 00003d4000000246c756d69000003f800000014 Time [years] Fig. 5.1. Asset 00022c000000146258595a000002400000 0000080c7465787400000000436f7079726967687420 6d6561730000040c00000024746563680000043 0014646d6e640000025400000070646d6 allocation 464000002c40000008876756564000003 for ?= 10. strategy under full information 2863292031393938204865776c6574742d5061636b6 00000000c725452430000043c0000080c675452 4c0000008676696577000003d40000002 1726420436f6d70616e7900006465736300000000000 430000043c0000080c625452430000043c00000 46c756d69000003f8000000146d6561730 00012735247422049454336313936362d322e310000 80c7465787400000000436f7079726967687420 000040c00000024746563680000043000 Note that price of risk 00000c725452430000043c0000080c6754 for the bond has a positive sign as in the original Vasicek 0000000000000000001273524742204945433631393 2863292031393938204865776c6574742d50616 52430000043c0000080c62545243000004 (1977) model although36b61726420436f6d70616e7900006465736300 sign in it is often found to be introduced with a negative 6362d322e3100000000000000000000000000000000 3c0000080c7465787400000000436f7079 0000000000000000000000 726967687420286329203139393820486 000000000000127352474220494543363139363 recent 5776c6574742d5061636b61726420436f6 62d322e31000000000000000000000012735247 d70616e79000064657363000000000000 422049454336313936362d322e3100000000000 0012735247422049454336313936362d3 22e310000000000000000000000127352 000000000000000000000000000000000000000 47422049454336313936362d322e31000 0000 000000000000000000000000000000000
2.5 000000000000000000

5.1 The Full Information Case

texts. In Figure 5.1, the asset allocation for an investor with a risk aversion coecient = 10 is shown. We see that for the observed parameter values, the weight in the bond is always the biggest. This may change by choosing dierent parameter values. The bigger , the more aggressive the asset allocating strategy becomes. Because of our model, only the bond part of the portfolio is time-dependent for a given parameter set. However, in the implementation of the strategy, also the other portfolio weights vary because the parameters are constantly updated. Finally, the asset allocation strategy is implemented. In order to have reasonable estimates for all parameters, the investment strategy is implemented starting in January 1997. The portfolio is adjusted every month. ffd8ffe000104a46494600010201012c012c0000ffe20c58494343 5f50524f46494c4500010100000c484c696e6f021000006d6e747 25247422058595a2007ce00020009000600310000616373704d5 3465400000000494543207352474200000000000000000000000 00000f6d6000100000000d32d485020200000000000000000000 000000000000000000000000000000000000000000000000000 0000000000000000000000001163707274000001500000003364 657363000001840000006c77747074000001f000000014626b70 7400000204000000147258595a00000218000000146758595a00 00022c000000146258595a0000024000000014646d6e64000002 5400000070646d6464000002c400000088767565640000034c00 00008676696577000003d4000000246c756d69000003f8000000 146d6561730000040c0000002474656368000004300000000c72 5452430000043c0000080c675452430000043c0000080c625452 430000043c0000080c7465787400000000436f70797269676874 202863292031393938204865776c6574742d5061636b61726420 436f6d70616e7900006465736300000000000000127352474220 49454336313936362d322e310000000000000000000000127352 Mar97 Jul98 Dec99 Apr01 Sep02 Jan04 May05 47422049454336313936362d322e310000000000000000000000 Time 00000000000000000000000000000000
Fig. 5.2. Asset allocation strategy performance under full information for ?= 10.

The investment horizon of the investor ends in December 2005. As new observations are available, the model parameters are recalculated using all past data available. The application of the data is done as in Brennan et al. (1997) and Bielecki, Pliska and Sherris (2000). The investment strategy is always implemented in an out-ofsample manner. Figure 5.2 shows the results for = 10. The investment strategy outperforms the S&P 500 and the Tremont hedge fund index by far. Table 5.2 shows the key gures of the considered time series. The Sharpe ratio of the equity market is rather poor compared to the others. This is due to the bear market from 2000 to 2003. It is noteworthy that the Sharpe ratio of our portfolio does not change

94 5 Optimal Portfolio Construction with Brownian Motions

signicantly for dierent s. The high Sharpe ratios in Table 5.2 give evidence that the risk adjusted returns of the investment strategy are superior to the ones of the single assets.
Table 5.2. Key gures for the asset allocation strategy under full information return volatility Sharpe (p.a.) (p.a.) ratio = 5 0.17 0.12 0.93 = 10 0.12 0.09 0.93 = 20 0.08 0.04 0.90

5.2 The Partial Information Case

measurable with respect to the investors ltration. Since the values of these factors are not known, the investor has to estimate their values. In this framework, the methods of the Kalman lter are used. The usage of factors with predictive power is motivated by the literature. Linear ltering is a well-established research area since the work of Kalman (1960) and Kalman and Bucy (1961). The Kalman lter is well-suited for the investors dynamic inference problem and is used as maximum likelihood estimator of the current values of the unobservable processes as well as predictor for their further evolvement. In order to work with the Kalman lter, we need a priori estimates of the starting values of the unobservable processes as well as their error covariance
S&P500 0.07 0.16 0.21 Tremont DS 3-5 years 0.06 0.04 0.62

matrix. From the dynamics of the Kalman lter, we may deduce the future 0.10 0.08 0.84 evolvement of the expected values as well as their error covariance matrices. The rst results July 1998 to December 1999, the investment strategy found in In the phase of for economic problems under incomplete information aredoes not Detemple (1986), Dothan and Feldman (1986), enormous drop of the hedge fund show a good performance. This because of theand Gennotte (1986). The results in these papers are causes the controller closed-form solutions are derived for index in 1998 which rather specic, i.e., to signicantly reduce its position in the logarithmic utility In the beginning (1998) analyzes the case starting to asset with alternative asset. functions. Brennanof 2001, the controller is of one risky take short a constant, unknown drift parameter. The investor is assumed considered time positions in the market, which is still the case at the end of theto have constant relative risk aversion. Numerical results study, the reader is case. Brennan et al. period. For more details about this caseare presented for this referred to Keel(1998) also shows that the myopic investor, having a logarithmic utility function, does not (2004). hedge against unfavorable changes of the drift of the risky asset. Therefore, the myopic investor is not able to improve the asset allocation strategy by inspecting asset prices over time. Xia (2001) analyzes the case of dynamic unobservable factors Asset price models usually contain unknown parameters. This fact is not taken into and nds the opportunity costs of ignoring the predictability of asset returns as account in general. In the application of optimal asset allocation strategies, the substantial. A closed-form solution for one single risky asset is also found in Rogers estimated parameters are often treated as deterministic. This may lead to falsied (2001). Rogers observes that the impact of parameter uncertainty is more severe investment decisions when the uncertainty on the parameters is signicant. In order than the problem of infrequent trading, i.e., the investor cannot continuously change to improve the asset allocation, we do not only consider the problem of unknown the composition of the portfolio. parameters but also include external factors in the model. By carefully choosing In Brennan and Xia (2001b), the returns, we expect the to derive a of the explanatory variables for the assetsame methodology is used performance general equilibrium model for stock prices. The non-observability of the these factors are optimal asset allocation strategy to improve. The dynamics of expected dividend growth rate is used in order to derive representative agent number and nature modeled as well and have to be includedain the optimization. Themodel with rational behavior. The are crucial for numerically as well. In Brennan and Xia (2001a), an of the factorsresults are testedthe quality of the results of the optimization. We optimal two kinds of factors. On the for hand, we consider observable a price consider portfolio strategy is developed one an investor who has detected factors, anomaly. Cvitanic et al. (2003) analyze the optimal asset allocation for portfolios whose current values are known to the investor, i.e., no estimation is necessary. On including hand, we consider unobservable factors which are, technically speaking, the other hedge funds, the proofs not

5.2 The Partial Information Case

96 5 Optimal Portfolio Construction with Brownian Motions

are found in Cvitanic et al. (2004). The authors derive an analytical solution in the case of unobservable market returns as well as unobservable abnormal or excess returns of the hedge fund. As in the papers of Brennan and Xia, the results are applied to nancial data. The model for the problem in this chapter is similar to the model in Sekine (2001). However, Sekine (2001) uses the convex-duality method to derive the solutions whereas we us a dynamic programming approach. This results again in two matrix Riccati equations, which express the solution of the primal and the dual problem. The dual optimizer denes the equivalent martingale measure. For a comparison of the two methods, the reader may refer to Runggaldier (2003). The innite-time horizon problem is considered in Bielecki and Pliska (1999) and Nagai and Peng (2002). For a survey on the topic of optimal control under uncertainty, the reader may refer to Runggaldier (1998), who also considers the case of discrete-time problems.

5.2.1 The Model The investment opportunities are modeled via stochastic dierential equations. They are assumed to behave as local geometric Brownian motions. The drift terms of the asset price dynamics are modeled as ane functions of explanatory factors. The values of these factors are either known or unknown to the investor. We model the observable and unobservable factors as stochastic dierential equations as well. In the case of the unknown factors, the investor has to estimate current values of the factors. Because of our model, we may use model-based ltering, i.e., we make use of the Kalman lter. The diusions of the n risky price processes are driven by an ndimensional standard Brownian motion process Wp. Similarly, the diusions of the m observable and the k unobservable factors processes are driven by the m-and kdimensional standard Brownian motion processes Wx and Wy, respectively. The drift terms of observable and unobservable factors are linearly dependent. In addition to the risky asset, there is a risk-free asset (or bank account) whose instantaneous return is deterministic. However, the return on the risk-free asset may be timedependent or even stochastic. The Brownian motion Wp of the price processes and the Brownian motions Wx and Wy of the factor processes are dened on a xed, ltered probability space (, F, {Ft}t? 0, P) with Ft satisfying the usual conditions. The Brownian motions Wp, Wx, and Wy do not need to be independent.

5.2 The Partial Information Case

Factor Dynamics In order to improve the asset allocation, factors are included in the investors model. We expect the factors to have some predictive power for the returns of the investment opportunities. We consider two kinds of factors. On the one hand, there are observable factors whose values are known to the investor. On the other hand, there are unobservable factors whose values are unknown to the investor. The m observable factors x(t) R are modeled as the following stochastic vector process
m

dx(t)=[Ax(t)x(t)+ Ay(t)y(t)+ a(t)]dt + x(t)dWx(t) (5.26) x(0) = x0,

where Ax(t) R

mm

, Ay(t) R

mk

, a(t) R

, x(t) R

mm

, and Wx(t) R . The

k

matrix and vector functions Ax(t), Ay(t), a(t), and x(t) are all deterministic functions. In addition, x(t) is assumed to have full rank. The k unobservable factors y(t) R are modeled similarly as

dy(t)=[Cx(t)x(t)+ Cy(t)y(t)+ c(t)]dt + y(t)dWy(t) (5.27) y(0) = y0,

where Cx(t) Rkm , Cy(t) Rkk , c(t) Rk , y(t) Rkk, and Wy(t) Rk. The matrix and vector functions Cx(t), Cy(t), c(t), and y(t) are deterministic functions. Since y(0) is not known, we need an a priori estimate of y(0), denoted by m(0). The error variance of this estimation is denoted by the covariance matrix (0). Asset Price Dynamics The set of investment opportunities of our investor consists of n 1 risky assets. The asset price processes P =(P1(t),P2(t),...,Pn(t)) R of the risk-bearing investments satisfy the stochastic dierential equations, where diag(P (t)) denotes the diagonal matrix of the vector P (t), dP (t) = diag(P (t)) {(x(t),y(t),t) dt + p(t)dWp(t)} (5.28) P (0) > 0 , where (x(t),y(t)) R , p(t) R
n nn n

, and Wp(t) R .

The matrix function p is assumed to be deterministic. The drift vector contains the relative expected instantaneous changes of the prices P . From the diusion matrix p, we get the instantaneous

98 5 Optimal Portfolio Construction with Brownian Motions

covariance matrix per unit time as (t)= p(t)p(t)T . The matrix function has to be invertible, therefore p has to have full rank. In addition, there exists a risk-free investment opportunity B(t) with instantaneous rate of return r(x(t)):

dB(t)= B(t)r(x(t),t)dt (5.29) B(0) > 0 .

The scalar function r is deterministic. The drift terms of the risk-free asset and the risk-bearing assets depend on the m observable factors x. In addition, the drift terms of the risk-bearing assets depend on the k unobservable factors y. Furthermore, we assume that the drift terms in (5.28) and (5.29) are ane functions of the factor levels, as given by (x(t),y(t),t)= G(t)x(t)+ H(t)y(t)+ f(t) (5.30) r(x(t),t)= F0(t)x(t)+ f0(t) , (5.31) where G(t) R
nm

,H(t) R

nk

,f(t) R ,F0(t) R

1m

, and f0(t) R. The matrix and

vector functions G(t), H(t), f(t), F0(t), and f0(t) are all deterministic.

5.2.2 Estimation of the Unobservable Factors Since the investor cannot observe the values of y, some kind of estimation (ltering) of the values of y is needed. The estimation with the introduced dynamics is a standard ltering problem and can be solved with the methods of the Kalman lter. The asset prices depend on the unknown values of y(t). Because of this, we cannot derive the optimal asset allocation strategy based on these asset price dynamics. This would not result in an admissible investment process, see Bielecki and Pliska (1999) for details. Therefore, the asset price dynamics need to be transformed as well. The main idea to overcome this problem is to transform the factor and the asset price dynamics such that they are independent of y. For notational convenience, we introduce the vector = [log(P motion W =[Wp ,W x ] R
T T T n+m T

),x ] R

n+m

containing the logarithmic prices and the observable factors. We dene the Brownian , where Wp is as in (5.28) and Wx as in (5.26). The diusion Rn+mn+m and the matrix Dy are dened as term Rn+mk p 0 H = ,Dy = . 0 x A y

5.2 The Partial Information Case

The Brownian motions Wp, Wx, and Wy need not be independent. The correlation
ypx matrix of the n + m + k dimensional Brownian motion W =[W T ,W T ,W T ]T Rn+m+k

as

is dened I1 yp(t) yx(t) T I1 y(t) (t)= (t) I2 (t) = , px yp y T T yxpxI3 T (t) (t)

(t) (t)

where I denotes the identity matrix and yp R

kn

, yx R

km

, px R

nm

, I1 R

kk

, I2 Rnn, and I3 Rmm. In order to be regular, the correlation matrix needs to be symmetric and positive-denite for all t. We summarize the result in the following lemma. Lemma 5.3 (Transformation of the Price Dynamics). Let the price dynamics evolve as introduced in (5.28) and the factors as in (5.26) and (5.27). The function (x, y) is dened in (5.30). Summarized, dP = diag(P ) {(x, y) dt + pdWp} dx =[Axx + Ayy + a]dt + xdWx dy =[Cxx + Cyy + c]dt + ydWy. Then, there exists a Brownian motion W
T T T

Rn+m which generates the same

information as [Wp ,W x ] . The estimate of y with the Kalman lter is denoted by m, the estimation error by . The transformed dynamics with the new Brownian motion W are

dP = diag(P ){(x, m)dt + pdW } dx =[Axx + Aym + a]dt + xdW dm =[Cxx + Cym + c]dt +[B1 + Dy ]B2dW
T

T T T = Cy + C yy B3 [B1 + D ]B2[B1 + D ] y + T T (0) = E[(y(0) m(0))(y(0) m(0)) ]. where B1 = yyT , B2 =[T ]1 , and B3 = yyT . The volatility matrices are obtained from (5.32). Proof. See Appendix C.2. The volatility matrices Rn+mn+m , p Rnn+m, and x are obtained by the Rmn+m relationship for the following block matrices

100 5 Optimal Portfolio Construction with Brownian Motions

y y y 0 = 0 0

p = . x
1 2 , i.e., 1

(5.32)

The Cholesky factorization of is a good choice for2

is an upper triangu

lar matrix. The transformation of the price dynamics of the investment opportunities is necessary to transform the partial-information problem into a full-information problem. 5.2.3 Portfolio Dynamics and Problem Transformation We assume that the investors portfolio is self-nancing, i.e., there are no exogenous in-or outows of money, e.g., consumption. The dynamics of the investors wealth V may be expressed as

n dV (t)= i(t) dB(t) dPV (t)u0 + L ui(t)), (5.33)

B(t) Pi(t) V (0) > 0,

i=1

where u1(t),...,un(t) denotes the fraction of wealth invested in the corresponding risky asset and u0(t) accordingly in the risk-free asset at time t. The proof is either found in Merton (1992) or Bjork (1998). Because the portfolio is self-nancing, we have the constraint ? i=0 ui(t) = 1. By using Lemma 5.3, we can transform the investors wealth dynamics into a full information process. De?ne 1n
n

as Theorem 5.4 (Transformation of the Wealth Dynamics). the vector 1n = Let the price dynamics evolve as in (5.28), where the factors evolve as in (5.26) and (5.27). (1, 1, . . . , 1)T ? Rn . Then the investors wealth dynamics under partial information evolve like = {u T [(x, y, t) 1ndV t)] + r(x, t)}dt r(x, +u
T

?pdWp

5.2 The Partial Information Case 101

dV

= {u [(x, m, t) 1n r(x, t)] + r(x, t)}dt + u V pdW dx =[Axx + Aym + a]dt + xdW
T

dm =[Cxx + Cym + c]dt +[B1 + Dy ]B2dW V (0) > 0.

Proof. The proof is straightforward. The results of Lemma 5.3 are applied to the selfnancing portfolio dynamics introduced in (5.33). By using Theorem 5.4 we may transform a partial-information problem into a fullinformation problem as shown in the next section.

5.2.4 Optimal Asset Allocation Optimal Asset Allocation with a CRRA Utility Function The optimal asset allocation is derived for an investor having constant relative risk aversion (CRRA). The expected power utility over terminal wealth is maximized. We may state the investors optimization problem under full information by using Theorem 5.4. Therefore, the problem is formulated in terms of the Wiener process W, the time arguments are omitted for better readability, as 1 max E[ V (T ) ] u()L1 n s.t. dV = V {u T
T [(x, m, t) 1nr(x, t)] + r(x, t)}dt + Vu pdW (5.34) T

dx =[Axx + Aym + a]dt + xdW

dm =[Cxx + Cym + c]dt +[B1 + Dy ]B2dW V (0) > 0. dx =[Axx + Ayy + a]dt + xdWx

The parameter < 1 is the coecient of risk aversion. The covariance matrix of the dy =[Cxx + Cyy + c]dt + estimation error is also present in the optimization problem. Since is the solution of the ordinary ydWy V (0) equation (see Lemma 5.3), it is a deterministic function. dierential > 0. The matrices Bwealth 2 are also dened fullLemma 5.3. For convenience, we introduce The investors 1 and B dynamics under in information, written in terms of W, are TT T m+k ] those under partial information. =[x, m to R identical and rewrite the problem above asThe same notation and denitions apply as in Lemma 5.3. The wealth dynamics under full information are

102 5 Optimal Portfolio Construction with Brownian Motions

1 max E[ V (T ) ] u()L1 n s.t.

d T T V = {u [F + f]+ F 0 + f0}dt + u pdW , (5.35) V

d =[A + b]dt + dW , V (0) > 0. Rnm+k R1m+k Rn The deterministic matrix functions F , F 0 , and f of the investors wealth dynamics are dened as [] F = G 1nF0,H (5.36) [] F 0 = F0, 0 (5.37) f = f 1nf0. (5.38)

The deterministic matric functions G, F0, f, f0, and H are dened in (5.30) and (5.31), for the vector 1n we have 1n = (1, 1,..., 1) R . Additionally, the deterministic matrix functions A Rm+km+k and b Rm+k of the dynamics of are Ax Ay a A = b = . (5.39) , Cx Cy c The components of A and b are dened in (5.26) and (5.27). The diusion matrix of , denoted by Rm+kn+m, is only used in this form for the proof and is dened as = . (5.40) x T (B1 + Dy )B2 In order to solve this problem with Bellmans optimality principle, we introduce the value or cost-to-go function as 1 J(t, V, )= max E[ V (T ) ]. (5.41) u()L1 n The optimal asset allocation strategy is the solution of the Hamilton-Jacobi-Bellman equation, which for this problem is T T Jt + max [V (u [F + f]+ F 0 + f0)JV +(A + b) J + u uJVV + Vu p JV + tr{J }] =0, (5.42) 11 2 T V 22
T T T uRn T n

5.2 The Partial Information Case 103

with terminal condition J(T,V (T ),(T )) = problem is given by 1 u * = 1(

V (T ) . The optimal control law u of this

F + f + p [K1 + k2]). (5.43) T 1 We want to eliminate the parameters introduced by and with the following denitions m+km+k R

the ltering. Therefore, we introduce two new matrices R

nm+k

T T T = p px,T T + =[p x pypy H ] (5.44)

xx xyxy + AT T T T T y = = , (5.45) T T yyx + A (B1 + DT )B2(B1 + DT )T xyy y where B1 are B2 are dened as in Lemma 5.3. We can nally give the solution of the TT T ] optimal asset allocation strategy ( =[x,m Rm+k), 1 * 1 u = (F + f + [K1 + k2]), (5.46) 1 where K1(t) Rm+km+k and k2(t) Rm+k are the solutions of two matrix Ricatti equations. The dierential equation for the matrix K1(t) is given by 1 1 T K1 + K1 K1 + K1A + A K1

T 1 T 1 T 1 (F F + F K1 + K1 F ) =0, (5.47) 1with terminal condition K1(T ) = 0. The dierential equation

for the vector k2(t) is given by

T 1 T k 2 + F + k2 + A k2 + K1b K1 0 T 1 T 1 1 T 1 (F f + F k+ K1 f) =0, (5.48) 2 1with terminal condition k2(T ) = 0. We summarize the

results in the following theorem. Theorem 5.5 (Partial Information, CRRA Case). The optimal asset allocation strategy under partial information for the CRRA case (5.34) is given by (5.46), where K1(t) and k2(t) are the solutions of two matrix Ricatti equations (5.47) and (5.48), respectively. Proof. The problem in (5.34) is the full-information representation of the partialinformation problem. The transformation is based on Theorem 5.4. The solution of the problem is found in Lemma 5.1. full-information

104 5 Optimal Portfolio Construction with Brownian Motions

Note that (5.47) is a well-known Riccati type equation. In the case where all the parameters are constant, the Riccati equation (5.47) possesses a positive-denite and nite solution for T , if the following two conditions are met: 1 ] [( T 1 )() 1 2 F A, 11 is controllable, and [( F T 1F ) 1 ( )] 2 T 1F A , (5.50) 1 1 1 is observable in the control engineering sense, see Xu and Lu (1995). The matrix ( 2 1 ) 1 1 1 T 1 is a full rank factor is a full rank factorization of ( ) and the matrix ( F F 2 ) 11 ization of ( 1 F ). Additionally, the matrix ( F F 11
1 1 T T 1

(5.49)

F ) and the matrix ( )

must be positive-denite. The conditions for solving matrix Riccati equations are wellknown in control engineering. For further details the reader may refer to Anderson
1 T 1 T Moore (1990). If the matrix ( 11 A is invertible and (5.47) pos K1 F + ) and

sesses a positive-denite nite solution, then (5.48) possesses a nite solution for T . Note that for > 0, the Riccati equation (5.47) possesses no nite solution, Kim and Omberg (1996) call the solution for this case nirvana solution.

Optimal Asset Allocation with a CARA Utility Function The optimal asset allocation is derived for an investor having constant absolute risk aversion (CARA). The expected exponential utility over terminal wealth is maximized. For the problem to be solvable, we model the risk-free interest rate r(t) only as a function of time and independent of x(t). Therefore, we set F0 0 in (5.31). We proceed as in the CRRA case and therefore state the investors optimization problem as [ V (T )] 1 maxEe 1 u()L n s.t. dV = V {u [(x, m, t) 1nr]+ r}dt + Vu pdW (5.51)
T T

dx =[Axx + Aym + a]dt + xdW dm =[Cxx + Cym + c]dt +[B1 + Dy ]B2dW V (0) > 0.
T

TT T The parameter > 0 is the coecient of risk aversion. We introduce =[x,m Rm+k ]

for convenience and rewrite the problem above as

5.2 The Partial Information Case 105

[
u()L1n

max Ee

V (T )] 1

s.t. dV = V {u [F + f]+ f0}dt + Vu pdW (5.52)

=[A

b]dt

dW V (0) > 0. The deterministic matrix function F R

nm+k

is dened as

[] F = G,H , (5.53) f = f 1nf0. (5.54)

The deterministic matrix functions A Rm+km+k and b Rm+k are dened in (5.39). Rm+kn+m The diusion matrix is, again, only used for the proof and is dened as in (5.40). The value or cost-to-go function for this problem is dened as 1 [ V (T )] J(t, V, )= max Ee. (5.55) u()L1 n The Hamilton-Jacobi-Bellman partial dierential equation for this problem is
T T Jt + max [V {u [F + f]+ f0}JV +(A + b) J

+ 11 uJVV + Vu p JV + tr{J }] =0. (5.56) u 2 T V 22 The optimal solution u * is

T T T

uRn

given by u =
*

(F + f + [K1 + k2]), (5.57) V k3

1

where is dened in (5.44). What remains to be done is to derive the functions K1(t), k2(t), and k3(t). The matrix function K1(t) is the solution of the following linear matrix dierential equation K1 + K1A + A K1 F
T T 1

FF

K1 K1

F = 0 (5.58) K1(T )=0 .

The vector function k2(t) is the the solutions of the following dierential equation k 2 + A k2 + K1b + F
T T 1

fF

k2 + K1

f = 0 (5.59)

k2(T )= 0 .

106 5 Optimal Portfolio Construction with Brownian Motions

Finally, the scalar function k3(t) is the solution of the following dierential equation k 3 + f0(t)k3 =0,k3(T )= . (5.60) We summarize the results in the following theorem. Theorem 5.6 (Partial Information, CARA Case). The optimal asset allocation strategy under partial information for the CARA case (5.51) is given by (5.57), where K1(t), k2(t) and k3(t) are the solutions of the dierential equations (5.58), (5.59), and (5.60), respectively. Proof. The proof is analogous to the proof of Theorem 5.5.

For the conditions for solvability of the CARA problem, the reader may use the same methodology as for the CRRA case.

5.2.5 Case Study with a Balanced Fund The previously obtained results are applied in a balanced fund example. The balanced fund consists of cash, bonds, stocks, and an absolute return product, which is deemed to be a hedge fund. The investment opportunities are modeled similarly to the ones in the case study for the full information case. However, the model is improved in some aspects. The drift of the equity market is stochastic and not known exactly to the investor. We model the excess return of the absolute return product as an unknown constant. Asset Models We rst introduce the dynamics of the short rate (or money market interest rate), denoted by r. Let r be a mean-reverting process, dr = ( r)dt + rdWr, (5.61) r(0) = r0,

where , , r R are the constant parameters of the short rate. This process can be observed in continuous-time. The dynamics of the xed income security is derived from the short rate, based on the methods of Vasicek (1977). We therefore get for the zero-coupon bond dynamics

5.2 The Partial Information Case 107

B dB r= r (r + aT )dt BaT dWr, (5.62) B(T )=1, where the scalar function aT (t) is dened as aT (t)=1 e. (T t) (5.63)

The dynamics of the bond price B(t) are derived from the short rate by no-arbitrage reasoning. As already mentioned in the introduction, we do not consider a single bond but rather a bond index. We model the equity market index by its stochastic dierential equation as given by dS = Sdt + SsdWs, (5.64) S(0) = S0,

where s R is the constant parameter of the model. The drift of the equity market is assumed to be stochastic. It is modeled as mean-reverting process and satises the following stochastic dierential equation, (0) = 0, d = ( )dt + dW, (5.65) dWsdW = dt, where , , R are the constant parameters of the model. The correlation of the two Brownian motions Ws and W is denoted by R. Note that we have an incomplete market model for ||= 1. Since we do not deal with the problem of pricing contingent claims, this is not a limiting assumption. It remains to model the alternative asset in order to analyze the balanced fund. As mentioned above, we use a model resembling to Mertons intertemporal capital asset pricing model (ICAPM). Therefore, the price of the alternative asset, denoted by A(t), evolves like

dA = A(r + ( r)+ )dt + AA(dWs +1 2dWA), (5.66) A(0) = A0,

where , A, R are the constant parameters of the model. The excess return of the alternative investment, denoted by R, is assumed to be an unknown constant.

108 5 Optimal Portfolio Construction with Brownian Motions

The excess return is unknown to the investor, i.e., not measurable by the investor. The value of describes the ability of hedge fund managers to outperform the market. In order to comply with the general model, the Brownian motion W R is introduced. Since W does not inuence , it does not aect the solution of the problem. It is therefore assumed to be independent of the other dynamic processes. The main reason to model as unknown constant is the lack of available data for alternative investments. We do not want to build a model for which we cannot obtain reasonable parameter estimates. Furthermore, the Brownian motions Wr, Ws, W, WA, and W are assumed to be mutually independent except that Ws and W are correlated with . Therefore, the correlation matrix yx is a zero matrix for this case study. Again, r + (s r) describes the risk adjusted return of the asset with respect to the market, whereas denotes the outperformance of the alternative asset. The parameter is dened to be cov(dS/S, dA/A) A == , (5.67) s2s where denotes correlation between the diusions of the equity market index and the diusion of the alternative asset. We introduce a three-dimensional control vector u. The three components of u represent the percentage of total wealth invested in the corresponding investment category.

Optimization Problem The observable factors consist of r, dened in (5.61). Therefore we set x = r. This results for the matrices Ax, Ay, a, and x in the model of (5.26) in [] [] [][] Ax = , Ay =0 0 ,a(t)= , x = r . (5.68) The driving Brownian motion Wx of the observable factors is dened as Wx = Wr. The unobservable factors consist of , as dened in (5.65), and , which is an unknown constant. The vector y is thus dened as y =[, ]T , and the matrices Cx, Cy, c, and y in (5.27) are 0 0 0 , , , Cx = Cy = c = y = . (5.69) 0 000 00
T

The Brownian motion Wy is dened as Wy =[W,W] .

5.2 The Partial Information Case 109 The vector of asset price processes of (5.28) is P =[B, S, A]T . The drift terms of the risky investment opportunities are dened in (5.30). We therefore need to dene the matrices G, H, and f in this equation, which are r 1 00 aT G = 0 ,H = 10 ,f = 0 . (5.70) 1 10 The drift term of the risk-free asset is dened in (5.31). For its determination we need to dene the terms F0 and f0, which are F0 =1,f0 =0. (5.71) The diusion of the risky investment opportunities of (5.28) are determined by the covariance matrix p. From the asset price dynamics of (5.62), (5.64), and (5.66) we get a (t) 00 T p(t)= 0 s 0 . (5.72) r 0 AA 1 2
T

The Brownian motion Wp is dened as Wp =[Wr,Ws,WA] . The correlation matrix is dened as a block matrix. The three block matrices in this case are 1 yp = 0 0 0 ,yx = ,px = 0 . (5.73) 000 0 0 Recall that m(t) denotes the expected values of the unobservable factors. We may now TT ]T use Theorem 5.5 to derive the optimal solution for this problem, where =[x,m, as * 1 1 u = (F + [K1 + k2]). 1 The matrix function F in the equation above is dened in (5.36). The deterministic matrix functions and are dened in (5.44) and (5.45), respectively. The matrix and vector function K1 and k2 are the solutions of the matrix Riccati equations, as given in (5.47) and (5.48).

Backtest with Historical Data We nish the case study by applying the derived results to historical US data. The data is the same as in the case study for the full information case. Therefore, the three-month

110 5 Optimal Portfolio Construction with Brownian Motions

Treasury bills are chosen as a substitute for the short rate, the S&P 500 for the market portfolio, the Datastream USA Total 3-5 years for the bond index, and the Tremont hedge fund index for the alternative part of the portfolio. Again, we assume that the bond has a xed duration. Therefore, the time dependent function aT (t) is redened as a function of the duration of the bond only. The parameters of the xed-income model are estimated by using regression techniques with the discrete versions of the stochastic dierential equations. The parameters of the short rate are estimated by doing an ordinary least squares estimation on the discrete-time version of the short rate. We discretize the stochastic dierential equation for the short rate, rt+1 = Lt + (1 Lt)rt + r r, Lt where Lt is the time increment and r is a Gaussian white noise process. With the same procedure we arrive at the parameters of the bond index. 2 r 1 r r ln(Bt+1) ln(Bt) rtLt = ( aT ( )+ ( aT ()) )Lt + aT () Lt r. 2 The duration and the price of risk of the bond index are estimated by estimating mean and variance of the series above.

The problem of parameter estimation for the equity market index is more involved than for the bond index because of the unobservable drift process of (5.65). We use the Kalman lter as a tool for parameter identication. The methodology of using the Kalman lter for parameter identication is discussed in Hamilton (1994). For parameter identication in nancial problems, the reader may consult Kellerhals (2001). We do not give full details of the parameter estimation but, nevertheless, give the problem statement. Dene p to be the logarithmic stock prices, i.e., p = log(S). The discrete dynamics with sampling time Lt then are 2 1 pk+1 1 Lt pk s 2Lt s 0 s = Lt + + , k+1 01 Lt k Lt 2 1 where s and are two independent Gaussian white noise processes. We observe a large negative correlation of the equity index S and its drift , denoted by . This behavior is also found in Wachter (2002) and the references therein. Having estimated the parameters of the equity market index, the parameters for the alternative investment may be estimated. The parameters are not estimated altogether

5.2 The Partial Information Case 111

because only monthly data is available for the hedge fund index. We estimate the excess or abnormal return and the correlation coecient again with the methods of the Kalman lter. Dene to be the logarithmic prices of the alternative investment, i.e., = log(A). The discrete dynamics with sampling time Lt are
1 2 2A

k+1 01 Lt 00 k Lt k+1 1 Lt (1 )LtLt k Lt = + rk+1 00 1 Lt 0 rk Lt k+1 00 01 k 0 A 1 2A 00 s 0 2 0 A + Lt , 1 00 0 r 00 00 r where s, A, , and r are independent Gaussian white noise processes. In order to have accurate parameters, the parameter estimation is conducted before every

adjustment of the portfolio. Figure 5.3 shows the estimated trajectories of and . The time ranges from January 1994 to June 1999 with a monthly sampling frequency. We observe a very strong stock market in this time period. We interpret this as high condence of the investors that the stock market would rise constantly, as it did in this time period. ffd8ffe000104a46494600010201012c012c0000ffe20c584943435 0.2 f50524f46494c4500010100000c484c696e6f021000006d6e747252 47422058595a2007ce00020009000600310000616373704d53465 0.18 40000000049454320735247420000000000000000000000000000 f6d6000100000000d32d485020200000000000000000000000000 0.16 00000000000000000000000000000000000000000000000000000 00000000000000001163707274000001500000003364657363000 0.14 001840000006c77747074000001f000000014626b707400000204 000000147258595a00000218000000146758595a0000022c00000 0.12 0146258595a0000024000000014646d6e64000002540000007064 6d6464000002c400000088767565640000034c000000867669657 0.1 7000003d4000000246c756d69000003f8000000146d6561730000 040c0000002474656368000004300000000c725452430000043c0 0.08 000080c675452430000043c0000080c625452430000043c000008 0c7465787400000000436f7079726967687420286329203139393 0.06 8204865776c6574742d5061636b61726420436f6d70616e790000 646573630000000000000012735247422049454336313936362d3 0.04 22e31000000000000000000000012735247422049454336313936 362d322e310000000000000000000000000000000000000000000 00000000000

112 5 Optimal Portfolio Construction with Brownian Motions

The estimated is a little bit less than 4% for this time period. In Figure 5.4, the optimal asset allocation strategy is plotted for a rather aggressive investor, i.e., = 10. Because the involved Riccati equations, the resulting strategy is a non-linear function of time. The investment horizon is a little bit less than twelve years. The strategy of Figure 5.4 would be applied if the investor would not use any further information until the end of the problem at time T . The position in the bond index is highly leveraged and is slowly decreasing in time. The proportion of wealth invested in the stock market is more or less constant, only in the beginning and in the end, minor non-linearities are observed. The position in the hedge fund is increasing with time. The reason for this the high uncertainty of . The estimated variance of the Kalman lter is decreasing over time and therefore the position in the hedge fund is accordingly increased. Because of the uncertainty of , the optimal asset allocation strategy allocates less capital to the alternative investment. We generally state that the asset allocation strategy is less aggressive under partial information than under full information.
ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c484c696e6f021000006 d6e74725247422058595a2007ce00020009000600310000616373704d53465400000000494543207352474200000000000 00000000000000000f6d6000100000000d32d4850202000000000000000000000000000000000000000000000000000000 000000000000000000000000000000000000000001163707274000001500000003364657363000001840000006c777470 74000001f000000014626b707400000204000000147258595a00000218000000146758595a0000022c000000146258595a 0000024000000014646d6e640000025400000070646d6464000002c400000088767565640000034c000000867669657700 0003d4000000246c756d69000003f8000000146d6561730000040c0000002474656368000004300000000c725452430000 043c0000080c675452430000043c0000080c625452430000043c0000080c7465787400000000436f7079726967687420286 3292031393938204865776c6574742d5061636b61726420436f6d70616e790000646573630000000000000012735247422 049454336313936362d322e31000000000000000000000012735247422049454336313936362d322e3100000000000000

P 0000000000000000000000000000000000000000Time [years] or tf ol io w ei g ht s ui

Fig. 5.4. Asset allocation strategy under partial information for ?= 10.

Table 5.3 gives the key gures of the dierent strategies. The asset allocation is performed for three risk aversion coecients, i.e., = 5, = 10, and = 20. The return, volatility, and Sharpe ratio are reported for the dierent time series. The bond index, denoted by DS 35 years, has the lowest return but still an attractive Sharpe ratio because of its low volatility. The equity index, in this case the S&P 500, has a poor per

5.2 The Partial Information Case 113

formance in terms of the Sharpe ratio. The actively managed portfolio has a much better performance than the single investment opportunities. We also observe that the Sharpe ratios dier slightly for the actively managed portfolios. This dierence stems from the fact that the Riccati equations depend on the risk aversion coecient. This causes the relative portfolio weights to dier for dierent risk aversion coecients . The wealth
Table 5.3. Key gures for the asset allocation strategy under partial information. return volatility Sharpe (p.a.) (p.a.) ratio = 5 0.25 0.17 1.30 = 10 0.17 0.10 1.32 = 20 0.12 0.07 1.29

114 5 Optimal Portfolio Construction with Brownian Motions

long time of severe decline in value. The Kalman lter and the investment strategy do correctly identify the directions of market movements and also their degree of uncertainty. If the unobservable factors were modeled as observable, the Sharpe ratio would drop considerably, in the case of = 10 to 0.67. The return of the actively managed portfolio is still reasonably good (15% p.a.), however, the variance increases tremendously because the strategy is much more aggressive.

DS 3-5 years 0.06 0.02 0.74 S&P 500 0.06 0.16 0.15 Tremont 0.10 0.08 0.81

evolution for an investor with risk aversion = 10 is shown in Figure 5.5. We observe a steady growth with some minor drawdowns. This gives evidence that the dynamic trading strategy is superior to the passive investments. After the year 2000, the stock market has ffd8ffe000104a46494600010201012c012c0000ffe20c584943 435f50524f46494c4500010100000c484c696e6f021000006d6e 74725247422058595a2007ce00020009000600310000616373 704d5346540000000049454320735247420000000000000000 000000000000f6d6000100000000d32d485020200000000000 00000000000000000000000000000000000000000000000000 00000000000000000000000000000000001163707274000001 500000003364657363000001840000006c77747074000001f0 00000014626b707400000204000000147258595a0000021800 0000146758595a0000022c000000146258595a000002400000 0014646d6e640000025400000070646d6464000002c4000000 88767565640000034c0000008676696577000003d400000024 6c756d69000003f8000000146d6561730000040c00000024746 56368000004300000000c725452430000043c0000080c67545 2430000043c0000080c625452430000043c0000080c7465787 400000000436f7079726967687420286329203139393820486 5776c6574742d5061636b61726420436f6d70616e7900006465 Mar97 Jul98 Dec99 Apr01 Sep02 Jan04 73630000000000000012735247422049454336313936362d32 2e310000000000000000000000127352474220494543363139 Time Fig. 5.5. Asset allocation strategy 36362d322e3100000000000000000000000000000000000000 0000000000000000

performance under partial information for ?= 10.

Active Portfolio Management

Successful investing is anticipating the anticipations of others. John Maynard Keynes

The reasons for active portfolio management are manifold, as highlighted in Chapter 1. The most important reasons are that the market behavior is non-stationary and investors are constrained by liabilities and consumption. These constraints may also be dynamic and stochastic. The growing demand for absolute return products also gives evidence that many investors are no longer willing to be fully exposed to traditional risks. This chapter introduces the main concepts of active portfolio management and its instruments. We begin with the denition of active portfolio management Denition 6.1 (Active Portfolio Management). Active portfolio management is the implementation of a dynamic investment strategy in order to beat a predened benchmark at a predened time in the future. From this denition, the importance of the benchmark for active portfolio management is evident, in terms of risk as well as performance measurement. Not all active managers give a benchmark, making the risk and performance measurement of an investment strategy ambiguous. We denote the residual returns as the portfolio returns minus the corresponding benchmark returns. The mean of the residual returns is usually called alpha, the standard deviation tracking error. The quotient of alpha divided by the tracking error is called information ratio. As for ordinary returns, the variance may not be an appropriate risk measure for analyzing residual returns. Coherent or convex risk measures should be used for analyzing the realized returns. The benchmark can either be stochastic or deterministic. In addition, the benchmark returns may be strictly positive. In this case, the strategy is usually termed an absolute return strategy.

116 6 Active Portfolio Management

The returns of an actively managed portfolio stem from two sources, the systematic risk of the involved assets and the investment strategy. Investment strategies are crudely categorized into security selection and market timing.

S Summarizing, the key components of active portfolio management are:

T The Investment universe The Investment strategy Security selection Market timing

6 Active Portfolio Management 117

(B)

nn (P ) (t)= L i (t)r(B)(P ) (t)= L i (t)ri(t). i(t),r

i=1 i=1

Therefore, the investment universe consists of n investment opportunities and ri denotes the return of the i-th investment opportunity. Additionally, we impose the n n (B)(P ) ? (t)=1 and ? (t) = 1. From these models, the excess return is obtained i=1 ii=1 i constraints as L (P )(B) (t)= (i (t) i (t))ri(t).
i=1 n

The mechanics of active portfolio management are easily seen from this equation. For the case be 0, the exposure benchmark should consist of all big as the In order to ri(t) representative, theof the manager should at least be asinvestment (P )(B) exposure, i (t) (t). Accordingly for the case ri(t) : 0, we would like to portfolio i.e.,present in i the investment universe. In addition, the benchmark have opportunities should i investable, i.e., trivial equations show that, the a mathematical point of nonbe(t) : i (t). These the investment positions of from benchmark at time t are view, anticipating. Mathematically speaking, are the same because in both time t are security selection and market timing the investment positions at cases, the (P ) measurable with respect to ithe (t) by the mechanics tdescribed above. This can be investors ltration F . The exposure to the single portfolio manager controls securities in theby a discretionary or are usually constrained within the investment either achieved investment universe is systematic approach. However, the crucial strategy. In general, the actual investment strategy is not known by the investor point for successful security selection and market timing remains the correct since the active manager is reluctant to give insights into the production of alpha. In prediction of ri(t). Note that the correct prediction of security returns is not the only source of alpha. some cases, the investor does not even know the investment universe as such, which We have argued that the signicance of the outperformance of an investment is the case for some hedge funds. strategy is reected by the information ratio. By now, we have shown that the Obviously, the outperformance of the active portfolio stems for the underinformation ratio can be increased by better predictions of security prices. Obviously, weighting of poorly performing assets and over-weighting of well performing assets. the information ratio may also be increased by a smaller variance of the residual The security selection approach, in its simplest form, only identies the forthcoming returns, given that the mean of the residual returns remains the same. Loosely winners and losers. Correspondingly, the manager takes long positions in the speaking, one way to make money is by not losing it. For an illustrative example of winners, may be also short position in the losers. The amount of capital allocated to the value of superior risk management, see Lo (2001). Again, the stylized facts of each asset needs not be sophisticated, e.g., equally weighted. However, if the mean asset returns support this claim. For instance, asset returns are not serially of the residual returns is positive, the manager has actually beaten the benchmark. correlated, however, squared asset returns are. Therefore, predicting risk is easier Whether this outperformance is signicant or not is reected by the information than predicting returns. ratio. Therefore, the information ratio should rather be seen as an indicator of the Treynor and Black (1973) is the rst systematic active portfolio management managers skill than as performance measure. There are other risk measures than approach, coupling the identication of alpha and risk management. These ideas variance which are much better choices for measuring risk, as already discussed. have been rened in Black and Litterman (1991, 1992) by introducing uncertainty about the model parameters. A more recent publication on this topic is Grinold and We aim to put the above statements into a more mathematical framework. Let the Kahn (1999). The academic literature usually does not distinguish between (P ) active benchmark returns r(B) and the returns of the actively managed portfolio r be portfolio management and optimal portfolio construction. As for hedge funds, there is dened by the following factor models: neither a generally accepted terminology nor a unied framework to compare dierent strategies. We do not attempt to ll
(P )(B)

118 6 Active Portfolio Management

these gaps since this is virtually impossible. However, what all active portfolio strategies have in common is that the outperformance has to be gained through altering investment positions. This is illustrated next in a case study.

6.1 Sector Rotation Example

In this case study, we are considering the S&P 500 index with its ten subindices, also called sectors indices. All data used in the sequel of this chapter is obtained from the Datastream database of Thomson Financial. In our case, the data ranges from 1995 to 2005 on a weekly basis. The ten sectors are consumer discretionary, consumer staples, energy, nancials, health care, industrials, information technology,

materials, telecommunication services, and utilities. The weight of a sector in the index is determined by the corresponding market capitalization. The investors goal is to outperform the S&P 500 index by over-and under-weighting the individual sectors. Two implementation possibilities are presented: a multi-period and a singleperiod environment. The actual implementation of the strategy with historical data is done with the single-period strategy. Asset Return Prediction In order to improve the performance of the strategy, an adaptive factor model is used to predict returns on a short term basis. A fairly large set of factors is chosen. In general, a large set of factor gives good in-sample predictions. However, the resulting out-of-sample prediction is usually poor. This problem is also called overtting. Therefore, the number of factors is reduced to avoid this problem. The returns are modeled as a linear function of the factor values. In order to nd the corresponding beta values of the individual factors, an ordinary least squares procedure is used, see Hamilton (1994) for details. To avoid the mentioned overtting problem, the following methodology is used:

6.1 Sector Rotation Example 119

1Start with the full model Mm, i.e., chose all m factors 2Exclude the factor from the current model which increases the
sum of squared residuals the least. 3Repeat step 2 until only one factor remains. This results in a sequence of m models M1 M2 Mm. 4Chose the model in the sequence M1 M2 Mm which has the smallest information criterion, in this case we chose Akaike (1974).

120 6 Active Portfolio Management Predictions: Predictions: Predictions: Adaptive factor model Unconditional mean Unconditional mean CCC-GARCH model Unconditional Variance Unconditional Variance r(t) ? NIGn(?1, ?1, ?, ?) r(t + 1) ? NIGn(?2, ?2, ?, ?) r(t + 4) ? NIGn(?3 , ?3 , ?, ?)

The chosen factors to start with consist of world equity indices returns, commodities returns, bond indices returns, real estate indices returns, volatility indices, interest rates, dividend yields, price-earnings ratios, and foreign exchange rates. Table D.1 (page 151) shows a detailed list of all the factors used for the return prediction. The momentum is calculated on all equity indices. Therefore, an exponentially weighted moving average has to be calculated using a smoothing factor of 0.96. The reader is referred to Alexander (2001) for details on calculating exponentially weighted moving averages. A Multi-Period Asset Return Model The volatilities of the ten sector indices are modeled as GARCH processes. A fairly simple model for the dependence is used, in this case, the constant conditional correlation (CCC) model is chosen. The technical details are found in Appendix B. Of course, a dynamic conditional correlations (DCC) model could have been chosen as well. By using a CCC model, however, we can make use of the convolution property of the NIG distribution, as found in Appendix A.2.3. Therefore, we use dynamical variances with NIG distributed innovations. For the asset allocation strategy, a model predictive approach is chosen. At time t, the covariance matrix of the ten sectors is estimated by the CCC-GARCH model. This gives the straightforward prediction of the covariance matrix for t + 1. For the predictions of the covariance matrices for t t + 4, the unconditional covariance matrix is used. As mentioned, the returns are assumed to have a normal inverse Gaussian distribution. The model is summarized in Figure 6.1. Note that the parameter in the NIG distributiondropped. standardized to one and therefore is

6.1 Sector Rotation Example 121

see Appendix A for the technical details. As risk measure, the conditional value at risk (CVaR) is used. The asset allocation strategy consists of a mean-CVaR Zt be a random vector whose components are NIG distributed with zero mean optimization. Let 10 and +1 t +4 T R1 0 tt unit variance. The sector returns are denoted by the random vector Rt R whose covariance matrix is denoted by t. The return predictions t are obtained as described above. The unconditional mean of the past returns is denoted by . In terms of risk management, only the mean of the past returns is used in order not to The components of the vector (t) denote corresponding sector weights in the avoid biases. Mathematically, the problem at time t is formulated as follows: index. The control vector u(t) denotes the fraction of the investors wealth, invested max u t t This results in the corresponding assets. CVaR(u tin the following portfolio return distribution utRn Rt) T TT T T at time T R(T ) NIGn (4,u 1 + u t+43,u ut,u ), s.t. tt+1 2 + u tt 1/2 Rt = + t,t = t Zt, 2 4 =( 1 + 2 + 3) . 2 2 2 kk k t,k = a0 + a1t 1,k + b 1t 1,k,k =1,..., 10 . TTT We have made the assumptions uut TT uut+1 uut+4 and u u 1010 Lt = diag(t,1,...,t,10) R utT +4. In this setup, transaction costs tt+1t+4tt+1 may trivially be integrated. The inclusion of risk constraints at t + 1, t + 4, and T may t = LtR(Qt)Lt, 1 1 T ) Qt = (1 a the topic of multi-period t1] + b1 Qt1. also be included. However, 1 b1 Qc + a1L t1[L risk management has not been T addressed yet. From NIG (, ,in T , u T tutwe T u Rt the results u Chapter 2, ,u know that coherent single-period ) tt t risk measuresaret not necessarily coherent in a multi-period setting. A possible multiperiod solution is the measuring of risk by penalty functions. The reader is referred to The operator R is given in the appendix, see Denition B.1 (page 142). In Figure 6.2, Dondi (2005) for a detailed case study. However, we prefer to work with a monetary the out-of-sample performance of the active portfolio versus the benchmark is shown risk measure. Therefore, we consider a single-period version of the investment for = 1. The data ranges from 1995 to 2005, the implementation of the investment strategy. strategy starts in 1999 in order to have sucient data for the parameter estimation. The model selection is repeated every 50 weeks, i.e., the factor list is updated every 50 weeks. The Asset Return Model A Single-Period active portfolio obviously outperforms the benchmark considerably. Recall that the vector (t) denotes the corresponding sector weights in the As in the multi-period case, the volatilities of the ten sector indices are modeled as benchmark. The control vector u(t) denotes the fraction of the investors wealth, GARCH processes. However, a more sophisticated model for the correlation is 1 (t) invested in the dierent sectors. We impose the lower constraint for u(t) as used, 2 i.e., the upper constraint as 3 (t). The resulting and the dynamic conditional correlation (DCC) model is used. The technical details 2 are found in Appendix B. By using a DCC model, we can make use of the dynamic strategy has an alpha of 4.8% p.a. and a tracking error of 5.0% p.a. This results in an dependence structure of the multivariate asset returns. The NIG distribution is used information ratio of 0.96, which is reasonably good. The benchmark has a to model the multivariate asset returns. disappointing performance in the considered time period, the return is -0.2% p.a. and the volatility is 17%. The return of the active portfolio is 4.7% p.a. with a standard The DCC-GARCH parameters are estimated by a quasi maximum-likelihood deviation of 18%. approach,not observeis referred to McNeil et the (2005) for details. is omitted, i.e., the We do the reader an outperformance if al. return prediction Because the NIG distribution is a normal its own does not generate outperformance indistribution risk management on mean variance mixture distribution, the portfolio this setup. is easily calculated; However, if only
t1 t1 T T

Fig. 6.1. An MPC approach for the sector rotation problem.

122 6 Active Portfolio Management

ffd8ffe000104a46494600010201012c012c0000ffe20c584943435f50524f46494c4500010100000c484 c696e6f021000006d6e74725247422058595a2007ce00020009000600310000616373704d5346540000 1.3 000049454320735247420000000000000000000000000000f6d6000100000000d32d485020200000000 0000000000000000000000000000000000000000000000000000000000000000000000000000000000 000001163707274000001500000003364657363000001840000006c77747074000001f000000014626b 1.2 707400000204000000147258595a00000218000000146758595a0000022c000000146258595a0000024 000000014646d6e640000025400000070646d6464000002c400000088767565640000034c0000008676 696577000003d4000000246c756d69000003f8000000146d6561730000040c000000247465636800000 4300000000c725452430000043c0000080c675452430000043c0000080c625452430000043c0000080c 1.1 7465787400000000436f70797269676874202863292031393938204865776c6574742d5061636b61726 420436f6d70616e790000646573630000000000000012735247422049454336313936362d322e310000 1 00000000000000000012735247422049454336313936362d322e310000000000000000000000000000 00000000000000000000000000 0.9

V al u e

0.8

0.7

Time Fig. 6.2. Performance of the sector rotation asset allocation strategy.

the return predictions are used for the asset allocation, the information ratio is decreased by 20%. This case study gives evidence that active portfolio management may produce added value if implemented correctly. Similar case studies are found in Herzog, Dondi and Geering (2004) and Herzog, Geering and Schumann (2004).

6.2 Portfolio Management with Levy Processes

Stochastic processes in continuous time, driven by Brownian motion, have been extensively discussed in Chapter 5. Most of the disadvantages which are present in this type of model may be overcome by replacing the Brownian motion with a more general process. A Levy process is a continuous-time stochastic process with independent and stationary increments, and is continuous in probability. Levy processes belong to the class of semimartingales. The reader is referred to Protter (1990) for details on semimartingales. Brownian motion itself is a Levy process and is the only one whose sample paths are not only continuous in probability but also with probability one. Levy processes can take the stylized facts of asset returns much better into account than Brownian motion. The reader is referred is referred to Schoutens (2003) for details on Levy processes in nance. For more technical details on Levy processes and semimartingales see Protter (1990), Sato (1999), and Applebaum (2004). We will use the following conventions, LX(t) denotes the

6.2 Portfolio Management with Levy Processes 123

the jump of the process X(t) at time t, X(t) = lim X(s), LX(t)= X(t) X(t).
s t

In order to dene a stochastic process with independent and stationary increments, the distribution of the increments has to be innitely divisible. We briey discuss innitely divisible distributions because of their importance in the realm of L evy processes. We call the logarithm of the characteristic function of a distribution its characteristic exponent. The characteristic exponent of an innitely divisible distribution may be decomposed by the Levy-Khinchine representation, see Protter (1990) for details. Because of this property, every Levy process L may be decomposed by the Levy-Ito decomposition, i.e., every Levy process L is fully characterized by the Levy triplet (, ,). We use the abbreviation = . The third component is called the Levy measure and describes the expected number of jumps and their sizes. The Poisson random measure N(t, A) denotes the number of jumps of L of size LL(t) A which occur before or at time t. Here, N N(dt, dz)= N(dt, dz)(dz)dt is called the compensated Poisson random measure. Then we may write L(t) with the Levy-Ito decomposition as
t t T T

z N L(t)= t + W (t)+N(dt, dz)+zN(dt, dz) t 0|z|<R 0|z| ? R = t + W (t)+zN(dt, dz)= t + W (t)+ L LL(s),
0R 0<s t

where W (t) is a standard n-dimensional Wiener process, R> 0 an arbitrary constant, and N(dt, dz), if |z| <R N N(dt, dz)= N(dt, dz), if |z| R. The reader is referred to Oksendal and Sulem (2004) and Cont and Tankov (2004) for the technical details. This means that Levy processes may be decomposed into a deterministic part, a Brownian motion part, and a discontinuous or jump part. Besides optimal portfolio construction, Levy processes are also well suited for asset pricing, e.g., the pricing of contingent claims is. However, if asset prices are modeled as Levy processes, the market model is incomplete, in general. This means there is no unique martingale measure, i.e., there exist an innite number of equivalent martingale measures. The publications on derivative pricing with Levy processes are numerous, e.g., see Madan

124 6 Active Portfolio Management

and Milne (1991), Madan, Carr and Chang (1998), Prause (1999), Schoutens (2003), and Carr and Wu (2004). However, we do not consider derivative pricing with Levy processes in this context. Since we are more interested in optimal portfolio construction, the literature on this topic is briey reviewed. Kallsen (2000) considers the multi-dimensional problem of maximizing the expected logarithmic utility from consumption or terminal wealth in a general semimartingale market model. The solution is given explicitly in terms of the semimartingale characteristics of the securities price process. Benth, Karlsen and Reikvam (2001b) consider a similar problem. However, the problem is solved in one dimension by a viscosity solution approach. The NIG Levy process is applied in Benth, Karlsen and Reikvam (2001a), where the solution is given in one dimension. A multi-dimensional solution is found in Emmer and Kluppelberg (2004) with a Capitalat-Risk constraint. Optimal portfolio construction with the variance gamma (VG) L evy process is considered in Cvitanic, Polimenisz and Zapatero (2005) and Madan and Yen (2005). The Generalized Hyperbolic Levy Process and its Limiting Cases We can dene a corresponding Levy process for every innitely divisible distribution. In Chapter 3, we have found that the generalized hyperbolic (GH) distribution is well suited for describing returns of various assets. We may dene a L evy process whose increments have a GH distribution because Barndor-Nielsen and Halgreen (1977) proved that the GH distribution is innitely divisible. The GH distribution contains a huge variety of important distributions in nance as limiting cases. Among these are the hyperbolic, normal inverse Gaussian (NIG), a version of the skewed t, variance gamma, t, and the normal distribution. All these limiting cases are derived in Eberlein and von Hammerstein (2004) for the univariate case. In order to work with the GH Levy process, we need to know its Levy triplet. The notation for the GH distribution of Appendix A.2.3 is used. The corresponding Levy triplet is (, 0,GH (dx)), i.e., there is no Brownian motion part and therefore, the GH L evy process is a pure jump process. Note that if the Levy measure is of the form (dx)= (x)dx, we call (x) the Levy density. The n-dimensional Levy measure of the GH Levy process is

6.2 Portfolio Management with Levy Processes 125

T

GH (dx)=

2e

1x
n

(2)n det()(xT 1x) 4 (2 +2y) 4nK(2(+2y)(xx) )

n

n { max(0,) ( T n2 K 2

T 1x

2 + 2 2 2 |||| 0 y(J ( 2y)+ Y (2y) where =

}dx, dy)

+ T 1, J and Y are Bessel functions, see Appendix A.2.4 for details.

The proof for this result is found in Masuda (2004). Accordingly, the n-dimensional L evy measure of the NIG distribution is T 1 n+1 2 ex( + T 1 ) 4 n+1 NIG(dx)= K( xT 1x( + T 1) )dx, n+1 T 12 (2) det()xx see Masuda (2004) for the proof. Note that Masuda uses the notation of Blaesild and Jensen (1981). The parameters and are in both cases the same, the correspondences of the others are

, = + T 1, = , =

, = .

The derivation of the Levy densities is based on the fact that the GH Levy process can be introduced via Brownian subordination. The main idea of constructing a Levy process by a Brownian subordination is to replace calendar time of a Brownian motion with a random time, given by a stochastic process which is called subordinator. For the construction of the GH Levy process, the generalized inverse Gaussian (GIG) Levy process is used a subordinator. The proof of this statement is found in Eberlein (2001). Correspondingly, the limiting cases of the GIG distribution may also be used as subordinators. Note that a subordinator is nondecreasing and always of nite variation. The Levy measure of the n-dimensional VG distribution is
x 1 2e T 1 + ( VG(dx)= 1x (2)n det()
T

)xT

n 4

( Kn 2

xT

2 ))dx, 1 x(T 1 + 2, we arrive

see Appendix C.3 for the proof. By setting = and = Levy density as in Madan at the same et al. (1998, Equation (14)) for the univariate case. The L evy

measures of the NIG and the VG Levy process are much more convenient to work with than the Levy measure of the GH Levy process. Therefore, they are more often found in nancial applications than GH Levy processes.

Portfolio Dynamics and Optimal Control Problem Formulation We are considering a market which contains n investment opportunities. The price process of the i-th investment opportunity is described as

126 6 Active Portfolio Management

Pi(t)= Pi(0)e, Pi(0) > 0,

Li(t)

where Li(t) is a Levy process. The returns of the single assets Li are assembled in the n-dimensional vector Levy process L =(L1,...,Ln)T Rn . In addition, there exists a risk-free investment opportunity B(t) with instantaneous rate of return r(t) R:

dB(t)= B(t)r(t)dt , B(0) > 0 . Recall that in the Black-Scholes framework, L(t) is a Wiener process. The stochastic processes considered in this context are dened on a xed, ltered probability space (, F, {Ft}t? 0, P) with Ft satisfying the usual conditions. In order to account for the stylized facts of asset returns, let L(t) be an ndimensional Levy process with characteristic triplet (, T ,), Rn , Rnn, and (dx) R. The Levy measure describes the expected number of jumps of a certain height in a time interval of length 1. A Levy process is of innite activity if almost all paths of a Levy process have an innite number of jumps on every compact interval. The return vector L(t) may have nite, e.g., the Poisson process, or innite activity, e.g., the generalized hyperbolic Levy process. If the process is of innite activity, we may omit the diusion component. For nite activity jump processes we must not omit the diusion because this would lead to absence of local activity which is not a reasonable assumption. On the topic of disentanglement of the diusion and the jump part in a stochastic process, the reader is referred to AitSahalia (2004). We assume that the investors portfolio is self-nancing and there are no exogenous in-or outows of money (e.g., consumption). We denote by the vector h(t) R the amount of each corresponding asset held by the investor at time t. The dynamics of the investors wealth V are self-nancing if the following relation holds dV (t)= h (t)dP.
T n

The reader is referred to Cont and Tankov (2004) for the proof. Note that h(t) is a simple predictable process, see Protter (1990) for details, and therefore the equality h(t)= h(t) holds. Denote by u(t) the fraction of wealth invested in the corresponding Itos lemma asset. Using we get the following dynamics for the price processes,

6.2 Portfolio Management with Levy Processes 127

{1} LL dP (t) = diag(P (t))diag()dt + dL + e 1 LL, 2 z 1 = diag(P (t)){[ + diag()+ {e 1n z}(dz)] dt 2 |z|<1 + dW (t)+ {e 1n}N(dt, dz)
Rn z

where diag(P (t)) denotes the diagonal matrix of the vector P (t), diag() denotes the vector of the diagonal elements of the matrix , e=(e1 ,...,en )T Rn , and 1n= (1,..., 1) R . The same result is also derived in Kallsen (2000). The self-nancing dynamics of the investors wealth V may be expressed as
n = u0 dPi(t) dV (t) dB(t)(t)+ L ui(t) , V (t) B(t) Pi(t) T n zzz

i=1

where u1(t),...,un(t) denotes the fraction of wealth invested in the corresponding risky asset and u0(t) accordingly in the riskless(t?) = V asset at time t. Because the portfolio is n diT ui self-nancing, we have the constraint ? iu =0 [2(t) = 1. We may then rewrite the wealth ag(?) ? 1nr] LL?T(t?)(dL + e+ r dt + u dynamics as 1n? LL) dV (t)1 1

128 6 Active Portfolio Management

T Jt(t, V ) + max [JV (t, V )b(u)V + 1 (t, V )u uV JVV T z 2

uU 2 T z + J(t, V + Vu {e 1n}) J(V, t) JV (t, V )Vu {e 1n}(dz)] =0

Rn with

b(u) as in (6.1) and with the terminal condition J(T,V (T )) =

V (T ) .

Plugging the separation ansatz J(t, V )= h(t)V (t) into the HJB equation results in
T h(t)V (t) + h(t)V (t) max [b(u) + ( 1)u u 1 uU 2 T z T z + (1+ u {e 1n}) 1 u {e 1n}(dz)] =0. Rn

In order to compute the optimal asset allocation strategy, the constrained optimization problem above needs to be solved numerically. This completes the derivation of the optimal asset allocation strategy for Levy driven asset prices. The optimal control vector u is fully determined by the Levy triplet of the risky investment opportunities.

{( u T[ + T{e z}(dz))} z = diag() 1nr]+ r + u 1ndt 2 |z|<1 " vu"

b(u)

+ u dW (t)+ u {e 1n}N(dt, dz) (6.1)

Rn

V (0) > 0.

The second equality is obtained by using the Levy-Ito decomposition. In order for the wealth to remain positive for all t, we impose the constraint u 1n : 1 for u 0, i.e., u U = {u Rn|uT1n: 1,u 0}. Having derived the wealth dynamics of the considered investor, we can nally state the optimization problem. We consider the case in which the investors utility function of the constant relative risk aversion (CRRA) type. In order to solve this problem with Bellmans optimality principle, we introduce the value or cost-togo function as [1] J(t, V )= max EV (T ) , u()L n 1 where denotes the coecient of risk aversion. The Hamilton-Jacobi-Belman equation for this problem is
T

Conclusions and Outlook

If we knew what it was we were doing, it would not be called research, would it? Albert Einstein

The aim of this thesis is to shorten the gap between the development of sophisticated nancial models and their application in practice. In order to achieve this goal, methods and models from nancial engineering are used. However, these are conceptually the same as those found in feedback control theory. Therefore, the ideas of feedback control are applied to nancial problems. The main dierence between the control of technical systems and the control of nancial systems is that nancial systems are heavily dominated by randomness. This rules out the use of deterministic models since these cannot take the main properties of asset returns into account. By modeling asset prices as dynamic stochastic models, optimal asset allocation strategies can be derived through dynamic stochastic optimization.

In Chapter 2, the dierent components of asset allocation are presented. The considered nancial assets are briey described, while the asset allocation process as such is described in greater detail. Risk measurement and management skills are key factors for successful active portfolio management. Therefore, the topic of static and dynamic risk measures is discussed. Chapter 3 reviews the current state of asset price modeling and dynamic optimization techniques in nance. Dierent models are tested for their suitability to describe univariate and multivariate asset returns. The generalized hyperbolic distribution and its limiting cases oer a very rich modeling family for describing asset returns. These types of distributions t real-world nancial data considerably better than the predominantly encountered normal distribution. The dependence properties of various nancial assets are analyzed as well. It is found that the simultaneous occurrence

130 7 Conclusions and Outlook

of extreme losses cannot be explained by correlation alone. This type of phenomenon is called tail dependence and empirical evidence is given that investors should be aware of concurrent extreme losses. In Chapter 4, the topic of hedge funds is discussed. Since hedge fund managers actively manage their portfolios, the hedge fund industry is an inspiring area for active portfolio management strategies. A wide range of dierent styles categorize the strategies of hedge fund managers. However, the performance measurement considering the whole hedge fund industry is dicult because of the lack of transparency. This also complicates the modeling of hedge funds because their the real sources of returns are hard to discover. The statistical properties of hedge funds are analyzed in detail. As for traditional assets, the generalized hyperbolic distribution and its limiting cases are exible enough to accurately take the possible skewness and fat-tailedness of hedge funds returns into account. However, returns of some styles show volatility clustering and serial correlation, which are both awkward properties of hedge fund returns. A possible explanation for serial correlation are the presence of illiquid assets in the hedge fund managers portfolio. Finally, the peculiarities of hedge fund investing and risk management for hedge funds are discussed. extensively discussed the modeling properties of nancial assets in the Having rst part, the second part is devoted to the conception and implementation of asset allocation strategies. Chapter 5 considers the well-studied continuous-time models driven by Brownian motion. A closed-form solution is derived for an investor with constant relative risk aversion and three risk-bearing investment opportunities. One of the investment opportunities is an alternative investment. The optimal fraction of wealth invested in the alternative investment is analyzed in detail. In the second part of Chapter 5, the optimal asset allocation strategy is derived for the case in which not all factors inuencing the return of the risky assets are exactly known to the investor. We call this type of problem optimal asset allocation under partial information. This problem is solved by using the methods of Kalman ltering to shown that the partial information problem can be transformed to a full information problem whose solution is known. The results are applied in a balanced fund case study including alternative investments. Chapter 6 is devoted to active portfolio management, for which a formal denition is given. Active portfolio management, per denition, needs an associated benchmark, otherwise risk and performance measurement are ambiguous. The returns of an active

7 Conclusions and Outlook 131

portfolio management strategy are driven by the investment universe and the investment strategy. An active portfolio management case study concerning the sector rotation problem is conducted. An adaptive factor model is used for the prediction of the returns and a dynamic volatility model with normal inverse Gaussian distributed innovations is used to perform the risk management. The results of an out-of-sample case study are promising, yielding an alpha of 5% and an information ratio of 0.96. The remaining part of the chapter discusses the use of L evy processes for active portfolio management. The necessary Levy densities are given for describing the corresponding multivariate Levy processes. Outlook Since so many research areas such as economics and mathematics intersect in nancial engineering, the room for improvement is vast. However, the statistical testing of asset price models as well as the implementation of optimal asset allocation strategies is time consuming. Concerning the statistical properties of asset returns, it would be interesting to compare the -stable models against the hyperbolic models analyzed in this work. On the subject of copulas, only two members of the class of elliptical copulas are analyzed in this work. However, there is a huge variety of dierent copulas which may be better suited for describing the dependence of multivariate asset returns. For instance, the copula of the generalized hyperbolic distribution should oer better results than the t copula. Since the introduction of Levy processes in nance, dynamic asset models in continuous-time have become much more promising for further research. Since the use of Levy processes for solving optimal asset allocation problems is still a rather young research area, many questions remain unanswered. This is also the case for dynamic risk measures. Dynamic stochastic optimization in continuous-time is a well-known procedure. However, the numerical computation of constrained problems is still limited to small problems. Nevertheless, viscosity solutions oer a powerful tool for solving nonlinear partial dierential equations. Their use for optimal portfolio construction would have exceeded the scope of this work. For the unconstrained case, either Bellmans optimality principle or Pontryagins maximum principle can be used to nd optimal solutions. The solution of the partial information problem in a general Levy framework, however, is not straightforward and has not been found yet. The use of copulas in connection with optimal portfolio construction is particularly well suited in a stochastic programming framework. Clearly,

132 7 Conclusions and Outlook

there are still a lot of interesting problems to be solved in nancial engineering, and in optimal portfolio construction in particular.

A Probability and Statistics

A.1 Moments of Random Variables

We consider an n-dimensional random vector X. The rst central moment is the mean vector, denoted by = E[X]. The second central moment is the covariance matrix, dened as cov(X) = E[(X )(X )T ]. We consider the skewness and kurtosis instead of the third and fourth central moments. The univariate skewness 1 and the kurtosis 2 are dened as 1(Xi)= , E[(Xi ) ] (var(Xi))
3 2

E[(Xi ) ] 2(Xi)= , var(Xi) respectively. In the literature the term excess kurtosis is often found instead of kurtosis. The excess kurtosis is dened as 2(Xi)3. The excess kurtosis to the normal distribution is zero. There also are measures of multivariate skewness and kurtosis, e.g., see Mardia (1970).

A.2 Probability Distributions

A.2.1 Normal Mean-Variance Mixture Distributions Let U be a random variable on [0, ), Rnn a covariance matrix, and , Rn two arbitrary vectors. The random variable X| U = u N ( + u, u)

134 A Probability and Statistics

is said to have a normal mean-variance mixture distribution. This distribution is elliptical for = 0 and is called normal variance mixture in this case. The characteristic function of random variable X which has normal mean-variance iyT (1 ) mixture distribution is iyT X T T X (y) = E[e ]= eHy y iy , 2 where H is the Laplace-Stieltjes transform of the distribution of the mixing variable. See Bingham and Kiesel (2002) for the proof. An important property of normal mean-variance mixture distributions is that they are closed under linear operations, i.e., let X as introduced above, and Y = AX + b with A R
kn k

and b R . The characteristic function of Y becomes Y (y)= E[e

iyT (AX+b)

]= e
T

)X AiyT b i(yiyT b T ]= ey) iyT (A+b) (1 ) E[e X (A T T

= eHy AA y iy A. 2The refore, we have for the random vector Y Y | W = w N (A + b + wA, wAA ) The mean and the variance of X are calculated as a E[X]= + E[W ], , T cov[X] = E[W ] + var[W ] .
T

A.2 Probability Distributions 135

2 ( ) K+( ) E[X ]= , R. K( )

The Laplace transform H of the X GIG(, , ) distribution is given by

2 ( K( ( +2s)) ) H (s)= , s> 0. ?

+2sK( ) For more details on the GIG distribution and its properties see Jorgensen (1982). ) K?+1( E[X]= + K?( ) var[X]= K2 ( )
K?+2( ) K?( )K2 (

)?+1

Inverse Gaussian (IG) Distribution The best-known limiting distribution of the GIG distribution is the inverse Gaussian distribution X IG(, ) = GIG(
1 , 2

, ), the density of which is

3 1 1 f(x)=ex 2 e (xx> 0.) 2 , +x

2 The Laplace transform of the inverse Gaussian distribution is

(+2s) H(s)= e ,s> 0.

These equations are easily derived from the properties of the modied Bessel function of the third kind, see Appendix A.2.4. E[X]= The reader is referred to McNeil et al. (2005) for more details. var[X]= 1 A.2.2 Univariate Probability Distributions Gamma (?) Distribution Generalized Inverse Gaussian (GIG) Distribution Another important X R has a generalizeddistribution is, for > 0 and =i.e.,the A random variable limiting case of the GIG inverse Gaussian distribution, 0, X gamma ,distribution X (, /2) = GIG(, 0,). Its density is (/2) GIG(, ), if its density is 1 12 ( /) 1 xe 2 , x>+x) 1( 1 0, f(x)=f(x)= xx ,x> 0. e x 2K( ) () The R, R, and R. K denotes the with Laplace Bessel function gamma distribution is modiedtransform of the of the third kind with index , see Appendix A.2.4 for details. The parameters satisfy > 0, 0 ( < 0; > 0, > 0 if = 0; and 0, > 0 if > if ) H(s)= , s> 0. 0. The GIG density contains the gamma and+2s inverse gamma densities as limiting s E[X]=2 cases. The non-central moments of the GIG density are: var[X]=4

2

136 A Probability and Statistics Inverse Gamma (I?) Distribution For < 0 and = 0, we get another limiting case of the GIG distribution. This case is called the inverse gamma distribution X I (, /2) = GIG(, , 0). Its density is (/2) 1 f(x)= x e ,x> 0. () The Laplace transform of the inverse gamma distribution is 2 ? 2K( 2x)(x/2) H(x)= , x> 0. () E[X]= 1 var[X]=
1 2 2 , (2) 4(+1)< 2. 2 +1 1 2 x1

Univariate Skewed t There are several methods for constructing a skewed t distribution. One is found in Fernandez and Steel (1998). It is a method for extending a unimodal and symmetric distribution to a skewed version. Let t(, , 2) denote the univariate t density. The following density is a skewed version of the univariate t density, f(x)= 2
1 2 2 () t(, (x )/, )I[,)(x)+ t(, (x ), )I(,)(x). (A.1)

The skewness is measured by the parameter (0, ). We have no skewness for = 1. A.2.3 Multivariate Probability Distributions Multivariate Normal A random variable X Rn has a normal distribution, i.e., X Nn(, ), if its density is (x)T 1(x) 2 f(x)= (2)n det() withe, Rn, and Rnn. The mean and

covariance are E[x]= and cov[X]= , respectively.

A.2 Probability Distributions 137

Multivariate t A random variable X Rn has a t distribution, i.e., X tn(, , ), if its density is (+n
1 (+n) )1 ) 2 T 1 ( ) (x ), (A.2) 1+ (x n nn ( 2 )() det() with R, R , and R , denotes the

f(x)=

2 n

gamma function. The mean and the covariance are E[X]= and cov[X]= , respectively. The univariate skewness2 6 3(2) and kurtosis are 1(X) = 0 and 2(X) = + 3 = 4 4 , respectively. The k-th moment is not dened for k>. For , the t-distribution converges to the normal distribution.

Multivariate Generalized Hyperbolic (GH)

A generalized hyperbolic random variable has a normal mean-variance mixture distribution, the mixing variable has a GIG distribution. The random variable X R has a multivariate generalized hyperbolic distribution, i.e., X GHn(, , , , , ), if its density is K n ( ( +(x )T 1(x ))( + T 1))e f(x)= c
2 n

(x)T 1

, (A.3)

42

( +(x )T 1(x ))
n nn

where R, R, R, R , R is given as

, and R . The normalizing constant c

? n 42

( /)( + T 1)

c = , (2)n det() K( ) K denotes the modied Bessel function of the third kind with index . The domain of variation of the parameters is as for the GIG distribution. Many dierent kind of parametrizations of the generalized hyperbolic distribution are found in the literature. The advantage of the present parametrization is that the GIG parameters are scale and location invariant. Note that we cannot distinguish between the parameterizations GHn(, /c, c, , c, c) and GHn(, , , , , ) for an arbitrary c> 0. We therefore introduce the constraint = 1 when tting the GH distribution.

K?+1( ) K? ) ( 2 K?+1( ) K?+2( ) K?( )K? +1( ) cov[X]= +K?( TK2 ( ) )

E[X]= +

138 A Probability and Statistics

Multivariate Normal Inverse Gaussian (NIG) A random variable X Rn has a multivariate normal inverse gaussian distribution, i.e., 1 X NIGn(, , , , ), if its density is a GHn( = 2 , , , , , ). The characteristic function of the NIG distribution is, by using the properties the normal mean-variance mixture distributions, X (t) = E[e
itT X itT + (+tT t2itT )

]= e

From this, we immediately see that the class of NIG distributions is closed under convolutions, i.e., NIGn(1, , 1, , ) ?NIGn(2, , 2, , ) = NIGn(3, , 3, , ), where 3 = 1 + 2 and 3 =( E[X]= + T cov[X]= ( + 1 ) The NIG distribution is a normal mean-variance mixture distribution with the IG distribution as mixing variable. 1 + 2) .
2

Multivariate Skewed t (s-t) A random variable X R has a multivariate skewed t distribution, i.e., X stn(, , , ), if its density is a GHn( = 2 , = , 0, , , ), > 0. If the limit 0 is evaluated in (A.3), we arrive at f(x)= c , (A.4)
2

(x)T 1 K+n ( ( +(x )T 1(x ))T 1)e

4

(( +(x )T 1(x )))

+n

where R, Rn , Rnn, and Rn. The normalizing constant c is given as +n +n+n 44 2(T 1)( ) 2 2(T 1)( 2 ) 2 2 n n ( c == . ) (2) det() ( ) () det()
22

The limiting case 0 results in the multivariate t distribution as described in (A.2). The skewed t distribution is a normal mean-variance mixture distribution with the inverse gamma distribution as mixing variable. E[X]= +
2

2 T var[X]= + 2 , > 4, for =0, > 2, for 0.

A.2 Probability Distributions 139

VG(?, ?, ?, ?), if its density is a GHn(? Multivariate Variance Gamma (VG) = 1 ? , ? ? 0, ? = A random variable X Rn has a multivariate variance gamma distribution, i.e., X 2 ? , ?, ?, ?), ? > 0. If the limit ? ? 0 is evaluated in (A.3), we arrive at

f(x)= c

(((x?2K1 T 1(x ))(2 ((x )T+ 1(x1))) Rnn, and T ), n ) ? ? , n

24 R . The normalizing constant c is given as (x??)T ??1 ?e

where R, n R

2(2 c= 1

+ T 1) 4

1 2

n (2) det()

, ( 1)

2 Note that we have chosen = to be most conform with the notation in Madan et al. (1998). To arrive at the same distribution as in Madan et al. (1998) for the univariate case, set = and = . The VG distribution is a normal mean-variance mixture distribution with the gamma distribution as mixing variable. The characteristic function of the VG distribution is, by using the properties the normal mean-variance mixture distributions,
1 1 T T T itT X ]= e it (1+ ( t t it )) X (t) = E[e 2 From this, we immediately see

that the class of VG distributions is closed under convolu tions, i.e., VG(, 1, , ) ?VG(, 2, , ) = VG( ,1 + 2, 2, 2). 2 E[X]= + cov[X]= + T

2(2)2(4)

140 A Probability and Statistics

J(x) cos() J(x) N(x)= , | arg(x)| < . sin() Modied Bessel functions are solutions of the following dierential equation,
2 2 d f df 2 x + x (x 2

dx dx

+ )f =0.

I is called modied Bessel function of the rst kind and has the following series representation
2k (x/2) I(x)=(x/2) L . k=0

k!( + k + 1)

K denotes the modied Bessel function of the third kind with index . The modied Bessel function of the third kind is also called MacDonald function. K may be expressed as function of I, i.e., I(x) I(x)1(x) K(x)= = te 2 sin() 22 0 A special case is =
1 , 2
4t

dt.

1 t x

(A.5)

the modied Bessel function of the third kind becomes 1 K 1 (x)= x 2 2 2

x

e.

Useful properties of the modied Bessel function of the third kind are K(x)= K(x), 2 K+1(x)= K(x)+ K1(x). x
3 1 K From this, we immediately get K (x)= (x)(1 + 2 2

). For the asymptotic expansions for 1 ()x , < 0. More details

x 0 we get K(x) 2

()x

, > 0,K(x) 2

are found in Abramowitz and Stegun (1972) and Gradshteyn and Ryzhik (1994). A.2.4 Bessel Functions and Modied Bessel Functions Bessel functions are solutions of the following dierential equation, d2f 2df 2 2 x + x +(x )f =0. dx2 dx J is called Bessel function of the rst kind and has the following series representation
(x/2) J(x)=(x/2) L , | arg(x)| < . k=0 2k

k!( + k + 1)

The Bessel function of the second kind, N(x), is dened as

B GARCH Models for Dynamic Volatility

We follow the notation of Zivot and Wang (2002), see McNeil et al. (2005) for the technical details. The estimations are all done by a maximum likelihood approach.

B.1 Univariate GARCH Processes

Univariate GARCH(p,q) Process Let zt be independent, identically distributed (i.i.d.) random variables with zero mean and unit variance. The process yt is a GARCH(p,q) process if it has the following dynamics yt = + t,t = ztt,

2 = t j=1

pq LL 2 2 a0 + ait i + bjt j, i=1

where a0 > 0, ai 0, i =1,...,p, and bj 0, i =1,...,q.

Univariate TARCH(p,o,q) Process

Let zt be i.i.d. random variables with zero mean and unit variance. The process yt is a TARCH(p,o,q) process if it has the following dynamics yt = + t,t = ztt, bj
poq2 = a + 0 + tk + tj, i=1 k=1 j=1 tti 2 2L L ai2 L 1{ tk<0}k

where 1 denotes the identicator function, a0 > 0, ai 0, i =1,...,p, and bj 0, i =1,...,q.

142 B GARCH Models for Dynamic Volatility

B.2 Multivariate GARCH Processes

The operator follows: R is dened as

Denition B.1 (Operator R). Let be a positive-denite covariance matrix. By d we dene the diagonal matrix whose elements are the square roots of the diagonal elements of . The operator R is dened as
1 1/21/2 R()=(d ) )1 d , ( 1/2

where R() is the correlation matrix of . Constant Conditional Correlation (CCC) GARCH Process Let Zt Rn be a random vector whose components are i.i.d. random variables with zero mean and unit variance. The process Yt is a multivariate CCC-GARCH process if it has the following dynamics Yt = + t,t = t Zt,
1/2

where t is the Cholesky factor of a positive-denite matrix t which is mea Rnn Rnn surable with respect to the ltration Ft1. Let Lt be a diagonal matrix whose elements are the square roots of the univariate GARCH(pk,qk) processes is of the form
p 2 2 kqkkk 2 k = + L a+ L b k =1,...,n . a t,k 0 iti,k jtj,k, i=1 j=1

1/2

where, for all k, a > 0, a 0, i =1,...,pk, and b 0, i =1,...,qk. The conditional 0 ij covariance matrix t is dened as

t =

LtRcLt,

where Rc is a positive-denite correlation matrix. Dynamic Conditional Correlation (DCC) GARCH Process Let Zt Rn be a random vector whose components are i.i.d. random variables with zero mean and unit variance. The process Yt is a multivariate DCC-GARCH process if it has the following dynamics

B.2 Multivariate GARCH Processes 143

Yt = + t,t = t Zt,

1/2

where t is the Cholesky factor of a positive-denite matrix t which is mea Rnn Rnn surable with respect to the ltration Ft1. Let Lt be a diagonal matrix whose elements are the square roots of the univariate GARCH(pk,qk) processes is of the form
pkqk2 k L k2 L b k2 j + tj,k, i=1 j=1 i = a0 + ak =1,...,n . t,k ti,k

1/2

where, for all k, ak > 0, ak 0, i =1,...,pk, and bk 0, i =1,...,qk. The conditional 0 ij covariance matrix t is dened as t = LtR(Qt)Lt, where R(Qt) is the conditional correlation matrix and Qt has the dynamics
pqpq(1

L L)Qc L aiL1 ti[L1 L T Qt = ai bi+ ti]titi i=1tj. i=1 j=1 + bj Q j=1

Qc is a positive-denite covariance matrix. As noted in McNeil et al. (2005), Qc should be estimated in one step by maximum likelihood. However, we use the unconditional covariance of the standardized residuals resulting from the rst stage estimation for convenience.

Proofs

C.1 Tail Dependence within a t Copula

Suppose we have an n dimensional random vector with t copula C t At rst we are R, . interested in

the distribution of the rst n 1 components, therefore we integrate over the whole range of xn in (3.2) for the t copula (3.3). By Rwe denote the correlation matrix which equals R but has the n-th row and column removed. We make use of the
integration rule 1 f(g(x))g (x)dx = 1 b g(b)

f(u)du, note that ui = Fi(xi) and = ag(a) dun (un))

nt

1 1d(t (un))

1 f1, (t

f(x1,...,xn1)=

cR, (F1(x1),...,Fn(xn)) n fi(xi)dxn

i=1

n1 n fi(xi) i=1 1 n1

cR, (u1,...,un)dun t
0

n 1 fR, (t 1(u1),...,t 1(un)) n1 = fi(xi) dun (u )) f1,(t1(un)) 0 1 i f1,(t i=1 i=1

1 fR, 1 (u n fi(xi) (t dxn (u1),...,t n n1)),xn) = (C.1) 1 f1, (t (ui)) n1 1 1 i=1 i=1 (t (u1),...,t1(un1))) n fR, = fi(xi) n f1,(t1(ui)) i=1 i=1 n1 1 n1

n t = fi(xi)c (F1(x1),...,Fn1(xn1)). R,
i=1

In order to solve the integral of C.1, we make use of the properties of the multivariate t density, see Kotz and Nadarajah (2004). From this result we can apply the formula for the tail dependence (3.5) for every pair in an n-dimensional t copula. Every pair in a n-dimensional t copula has a bivariate t copula with the corresponding correlation coecient and the same degree of freedom parameter as the n-dimensional copula.

146 C Proofs

C.2 Transformation from Partial to Full Information

Let the price dynamics evolve as introduced (5.28), the factors as in (5.26) and (5.27). The function (x, y) is dened in (5.30). Summarized, dP = diag(P ) {(x, y) dt + pdWp}, dx =[Axx + Ayy + a]dt + xdWx, dy =[Cxx + Cyy + c]dt + ydWy. n We calculate the dynamics of the logarithmic prices p = ln(P ) R with Itos lemma, where diag{} denotes the vector of the diagonal elements of the matrix . Note that the time arguments are omitted from now on wherever possible. 1 dp =[(x, y, t) diag{}] dt + pdWp , 2 p(0) = ln(P (0)).
TT T ] For notational convenience, we introduce the new vector =[p,x Rn+m, containing

all the observable processes. We dene the Brownian motion W =[Wp ,W

T T x ]

Rn+m , where Wp is introduced in Equation (5.28) and Wx in Equation (5.26). The ltering problem then consists of

dy =[C + Cyy + c] dt + ydWy, d =[D + Dyy + d] dt + dW, where the deterministic matrix functions C Rkn+m Rn+mn+m and D are dened as [] 0G

C =0 Cx ,D =

, 0 Ax

the deterministic vector function d Rn+m The deterministic matrix function Dy and Rn+mk are 2 Hf diag{}Dy = ,d = . Ay a
1

The matrix and vector functions Cy, c, and y are dened in (5.27). The diusion term of , denoted by R
n+mn+m

, is easily seen to be

C.2 Transformation from Partial to Full Information 147

p 0 = . (C.2) 0 x The Brownian motions Wp, Wx, and Wy need not be independent. The correlation
ypx matrix of the n + m + k dimensional Brownian motion W =[W ,W ,W ] R T T T T n+m+k

as

is dened I1 yp(t) yx(t) I1 y(t) (t)= T (t) I2 (t) =px (C.3) , yp T (t) (t) y T yxpxI3T (t) (t)
kn

where I denotes the identity matrix and yp R

, yx R

km

, px R

nm

, I1 R

kk

, I2 Rnn, and I3 Rmm. In order to be regular, the correlation matrix needs to be symmetric and positive-denite for all t. Therefore, the matrix square root of ,
2 2 by 2 1 , denoted exists. Since the matrix square root of , we have the relationship = 2( )T . is 1 11

We may construct the new Brownian motions W (t) by W (t)= 1 we 1 have for the increments dW =2

(s)dW (s). Thus, are

dW . The n + m + k Brownian motions W

uncorrelated. The ltering problem with uncorrelated Brownian motions then is dy =[C + Cyy + c]dt + ydW y + ydW , (C.4) d =[D + Dyy + d]dt + dW , (C.5) where the volatility matrices y R
kk

,y R

kn+m

, R

n+mn+m

are obtained by the identity of the

following block matrices

y y y 0 1 = (C.6) 2 . 0 0 1 1 2 2 The Cholesky factorization of is a good choice for , i.e., is an upper triangular

matrix. The equality above still holds when the left and the right hand side are multiplied by their transposed. This simple block matrix calculations gives T T T yy (C.7) T T y+ y y yyyy =. T T T T T y yy From Lipster and Shiryaev (2001a, Theorem 10.3) we get the instantaneous changes of the estimation m, or the conditional mean, of the factors y with the Kalman lter as dm =[C + Cym + c]dt +[B1 + D ]B2[d {D + Dym + d}dt] , (C.8) y m(0) = E[y(0)| (0)].
T

148 C Proofs

The denition of B1 is given in (C.10). The error of the estimation is denoted by . In Lipster and Shiryaev (2001a, Theorem 10.3) it is proofed that the variance of m, denoted by R
kk

, evolves according to the following dynamics

T T T T

= Cy + Cy yy B3 [B1 + D ]B2[B1 + D ] , (C.9) + (0) = E[(y(0) m(0))(y(0) m(0)) ]. The matrices B1 R

kn+m

T
kk

, B2 R

n+mn+m

, and B3 R
T

are dened as

B1 = y B2 =[ B3 = y

= yy , (C.10) ]1 , (C.11)
T

T 1 T =[ ] T

T y

+ y = yy , (C.12) y

where the second equalities are obtained from (C.7). In the dynamics of m in (C.8), the term d is involved. But d is a function of the unobservable factors y, therefore we cannot derive the optimal asset allocation strategy in this setup. Like this, we would not get an admissible investment process (see Bielecki and Pliska (1999) for details). To overcome this problem, we introduce the innovation process W (t) given

by the following stochastic dierential equation

dW 1 {D + Dym + d}dt] = [d

Dy[y m]dt + dW . (C.13)

It is proved in Lipster and Shiryaev (2001b, Theorem 12.5) that W Wiener process and that
Ft

is indeed a

= Ft

0,W

"

. (C.14)

Or, informally speaking, the information generated by is equivalent to the information generated by (0,W ). This new innovation process, as given in (C.13), (C.5) and (C.8). This results in is inserted into dm =[C + Cym + c]dt +[B1 + Dy ]B2dW , (C.15) d =[D + Dym + d]dt + dW . In order to derive the asset price dynamics under the new innovation process W, we decompose into
T

C.3 Levy Density of the Multivariate VG Levy Process 149

= (C.16) ,
p

where p R

nn+m

, and x R

mn+m

x . With this decomposition we may also

decompose in p and x. This yields the following new dynamics of p and x as 1 dp =[(x, m, t) diag{}]dt + pdW , (C.17) 2dx =[Axx + Aym + a]dt + xdW . (C.18)

From (C.7) we can identify the relationship T = T . By inserting (C.2) and (C.16) in this relation we get pp px pT ppxx T p T T = . (C.19) T T T T T xp xx xpxp xx We now state the price may

dynamics with respect to the Wiener process W . Lemma C.1. Let the price dynamics evolve as in (5.28), where the factors evolve as in (5.26) and (5.27). Then the dynamics of the prices dP (t) = diag(P (t)) {(x(t),y(t),t) dt + p(t)dWp(t)} , are the same as written in terms of W, i.e., dP (t) = diag(P (t)){(x(t),m(t),t)dt + p(t)dW (t)}, (C.20) where W is dened as in (C.13) and the factors x and m are dened as in (C.18) and (C.15), respectively. Proof. The logarithmic prices are dened in (C.17). By using the equality ppT = ppT = from (C.19) we get (C.20) by using Itos lemma.

The transformation of the price dynamics of the investment opportunities is necessary to transform the partial-information problem into a full-information problem.

C.3 Levy Density of the Multivariate VG Levy Process

We proceed as in Masuda (2004). First, we make use of the subordination property of the VG distribution and use Sato (1999, Theorem 30.1) or Cont and Tankov (2004, Theorem 4.2). Therefore,

150 C Proofs

where ?? 1 1 ( xT 1x+sT 1 x 1 nes is the L?evy Tdensity of the gamma distribution, )?? (s) i.e., 2 n 2s VG(B)= ? (s) e dsdx, B 0 (2) det() = 1 ?s e? 1 ? s, where we
1 2

D Additional Data for the Sector Rotation Case Study have set = and = (see Schoutens (2003) for the denition of the Levy density
of the gamma distribution). Evaluation the integral yields T 1 T 1? exT11 1 x ? x n s n 222 s( 1 +) VG(B)= s e dsdx. B (2) det() 0
1

ab

bc 1

a+1

T 1 cx n T1 T 1 By using theTequality 1 ses scds = 1(1 taet tdt sector rotation case study. Table D.1. Factors for the we get 1 x ?1 e 1 x?1 n ( ) 1+ 2 0 VG(B)= ( + )te dtdx. B (2)n2det()2 t22 t

S&P 500 Composite Index FTSE US Real Estate Index S&P Global 1200 Index Gold Dow Jones World Ex US Index Crude Oil S&P Europe 350 Index Platinum Dow Jones World Emer. Markets Index GSCI Commodity Index Dow Jones Wilshire Small Cap

Making use of theLehman Corporate A+ Index Dow Jonesthe modied Bessel function of the third Index integral representation of Wilshire Large Cap Index Lehman kind as given Corporate Enhanced BB Index S&P 500 Barra Value Index Citigroup German 1-3Y in (A.5) yields Bond Index S&P 500 Barra Growth Index Citigroup German 10+Y Bond Index T T 1 + 2n 2e( 1Composite ( Citigroup Japan 2 ) Bond Index FTSE 100 Index NASDAQ x ) Index 1-3Y 4 VG(B)= K xx(T 1 + ) dx. n 1 Citigroup Japan 10+Y Bond Index France CAC 40 IndexTCitigroup US Big Corp. 1-3Y n B (2) det()xx T 1 Bond Index DAX 30 Performance Index Citigroup US2Big Corp. 10+Y Bond Index
AEX Index Citigroup UK 1-3Y Bond Index Swiss Market (SMI) Index Citigroup UK 10+Y Bond Index TOPIX Index Citigroup UK All Mat. Bond Index NIKKEI 225 Index VIX Volatility Index ASX All Ordinaries Index VDAX Volatility Index HANG SENG Index 3 months US Tr. Bills rate S&P CNX 500 Index 1 month LIBOR rate Korea SE Composite (KOSPI) Index US Treas. 10 yr Bond red. Yield Brazil Bovespa Index US Corporate Bond Moodys AAA rate Mexico IPC (BOLSA) Index US Corporate Bond Moodys BAA rate UK to US $ Exchange Rate US Corporate Bond middle rate Euro to US $ Exchange Rate Dividend yield on S&P 500 Swiss Franc to US $ Exchange Rate Price/Earnings ratio on S&P 500 US $ to Japanes YEN Exchange Rate Dividend yield on Dow Jones Japanese Yen to Euro Exchange Rate Price/Earnings ratio on Dow Jones Swiss Franc to US $ Exchange Rate Dividend yield on FTSE 100 FTSE W Japan Real Estate Index Price/Earnings ratio on FTSE 100

References

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