Volatility vs. Downside Risk: Optimally Protecting Against Drawdowns and Maintaining Portfolio Performance

28 Pages Posted: 12 Nov 2014

See all articles by Diana Barro

Diana Barro

Ca Foscari University of Venice - Dipartimento di Economia; SSAV

Elio Canestrelli

Ca Foscari University of Venice - Dipartimento di Economia

Fabio Lanza

Independent

Date Written: November 7, 2014

Abstract

As a consequence of recent market conditions an increasing number of investors are realizing the importance of controlling tail risk to reduce drawdowns thus increasing possibilities of achieving long-term objectives. Recently, so called volatility control strategies and volatility target approaches to investment have gained a lot of interest as strategies able to mitigate tail risk and produce better risk-adjusted returns. Essentially these are rule-based backward looking strategies in which no optimization is considered. In this contribution we focus on the role of volatility in downside risk reduction and, in particular, in tail risk reduction.

The first contribution of our paper is to provide a viable way to integrate a target volatility approach, into a multiperiod portfolio optimization model, through the introduction of a local volatility control approach. Our optimized volatility control is contrasted with existing rule-based target volatility strategies, in an out-of sample simulation on real data, to assess the improvement that can be obtained from the optimization process.

A second contribution of this work is to study the interaction between volatility control and downside risk control. We show that combining the two tools we can enhance the possibility of achieving the desired performance objectives and, simultaneously, we reduce the cost of hedging.

The multiperiod portfolio optimization problem is formulated in a stochastic programming framework that provides the necessary flexibility for dealing with different constraints and multiple sources of risk.

Keywords: Volatility, tail risk, stochastic programming, risk management

JEL Classification: C61, C63, D8

Suggested Citation

Barro, Diana and Canestrelli, Elio and Lanza, Fabio, Volatility vs. Downside Risk: Optimally Protecting Against Drawdowns and Maintaining Portfolio Performance (November 7, 2014). University Ca' Foscari of Venice, Dept. of Economics Working Paper Series No. 18/WP/2014. Available at SSRN: https://ssrn.com/abstract=2521007 or http://dx.doi.org/10.2139/ssrn.2521007

Diana Barro (Contact Author)

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

SSAV ( email )

Venice
Italy

Elio Canestrelli

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

Fabio Lanza

Independent

No Address Available

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