Systemic Risk Driven Portfolio Selection
40 Pages Posted: 12 Jun 2019
Date Written: May 25, 2019
We consider an investor who maximizes portfolio's expected returns conditioned on the occurrence of a systemic event: financial system return being at, or at most at, its VaR level and portfolio's returns being below the CoVaR level. We obtain a closed-form solution to the portfolio selection problem, and show how VaR and CoVaR quantiles control, respectively, the relative importance of "portfolio-system correlation" and "portfolio variance". Our empirical analysis demonstrates that the investor attains a higher Sharpe ratio, compared to well known benchmark portfolio criteria, during times of market downturn. Portfolios that perform best in adverse market conditions are less diversified and concentrate on few stocks whose correlation with the financial system is low.
Keywords: Systemic Risk, Portfolio Selection, Risk Management, Sharpe Ratios
JEL Classification: G01, G11, G20, G28
Suggested Citation: Suggested Citation