Tail Risk and Robust Portfolio Decisions

Management Science, Forthcoming

50 Pages Posted: 7 Nov 2016 Last revised: 13 Apr 2020

See all articles by Xing Jin

Xing Jin

University of Warwick - Warwick Business School

Dan Luo

School of Finance, Shanghai University of Finance and Economics

Xudong Zeng

Shanghai University of Finance and Economics, School of Finance

Date Written: April 18, 2017

Abstract

Return jumps on equities exhibit slowly-decaying tail behavior admitting severe downside risk; moreover, heavy-tailed jump size distributions governing these rare events pose further challenges to econometric estimation. This paper formulates a portfolio choice problem in a multi-asset incomplete market characterized by ambiguous jumps and arbitrary tail assumptions. We derive the optimal portfolio in closed-form through a decomposition approach. We show that, due to fear of tail incidents, an investor diminishes portfolio diversification, and even more so under heavy-tailed jumps which intensify misspecification concerns. We then calibrate the model to international equity indices to quantify the economic consequences of tail risk. We find that, without jump ambiguity, a CRRA investor suffers negligible wealth losses from underestimating tail risk, given that the first two moments of the jump size distributions are preserved regardless of the tail properties. In stark contrast, sizable losses are encountered in the presence of jump ambiguity.

Keywords: Tail risk; Jump ambiguity; Robust decisions; Portfolio selection

JEL Classification: G01, G11, G12

Suggested Citation

Jin, Xing and Luo, Dan and Zeng, Xudong, Tail Risk and Robust Portfolio Decisions (April 18, 2017). Management Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2865064 or http://dx.doi.org/10.2139/ssrn.2865064

Xing Jin

University of Warwick - Warwick Business School ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom

Dan Luo (Contact Author)

School of Finance, Shanghai University of Finance and Economics ( email )

Shanghai, 200433
China
+86-21-65904920 (Phone)

HOME PAGE: http://sof.shufe.edu.cn/80/46/c6894a98374/page.htm

Xudong Zeng

Shanghai University of Finance and Economics, School of Finance ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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