Dynamic Correlation or Tail Dependence Hedging for Portfolio Selection

51 Pages Posted: 15 Mar 2011

See all articles by Denitsa Stefanova

Denitsa Stefanova

Luxembourg School of Finance

Redouane Elkamhi

University of Toronto - Rotman School of Management

Date Written: March 15, 2011

Abstract

We solve for the optimal portfolio allocation in a setting where both conditional correlation and the clustering of extreme events are considered. We demonstrate that there is a substantial welfare loss in disregarding tail dependence, even when dynamic conditional correlation has been accounted for, and vice versa. Both effects have distinct portfolio implications and cannot substitute each other. We also isolate the hedging demands due to macroeconomic and market conditions that command important economic gains. Our results are robust to the sample period, the choice of the dependence structure, and both varying levels of average correlation and tail dependence coefficients.

Keywords: correlation hedging, dynamic portfolio allocation, Monte Carlo simulation, tail dependence

JEL Classification: C15, C16, C51, G11

Suggested Citation

Stefanova, Denitsa and Elkamhi, Redouane, Dynamic Correlation or Tail Dependence Hedging for Portfolio Selection (March 15, 2011). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1786928 or http://dx.doi.org/10.2139/ssrn.1786928

Denitsa Stefanova (Contact Author)

Luxembourg School of Finance ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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