Optimal Dynamic Portfolio Risk Management

Abstract

Numerous econometric studies report that financial asset volatilities and correlations are time-varying and predictable. Over the past decade, this knowledge has stimulated increasing interest in various dynamic portfolio risk control techniques. The two basic types of risk control techniques are: risk control across assets and risk control over time. At present, the two types of risk control techniques are not implemented simultaneously. There has been surprisingly little theoretical study of optimal dynamic portfolio risk management. In this paper, the author fills this gap in the literature by formulating and solving the multi-period portfolio choice problem. In terms of dynamic portfolio risk control, the solution shows that it is optimal to simultaneously control portfolio risk both across assets and over time. Using several datasets and performing out-of-sample simulations, the author demonstrates the superiority of dynamic portfolio risk control both across assets and over time. Specifically, he shows that portfolios with risk control only across assets outperform equally weighted portfolios and that portfolios with risk control both across assets and over time outperform portfolios with risk control across assets only.

Keywords: dynamic portfolio optimization, dynamic risk management, risk control over time, risk control across assets, out-of-sample simulations

JEL Classification: G11, G17