Robust Portfolio Selection with Regime Switching and Asymmetric Dependence
34 Pages Posted: 7 May 2020 Last revised: 15 Mar 2021
Date Written: April 30, 2020
This paper solves the portfolio selection problem with regime switching and asymmetric dependence in financial markets. Investors sustain substantial loss in times of crisis and expect to reduce their losses. Thus, we consider the uncertainty in hidden states of the economy and define worst-case conditional value-at-risk (WCVaR) to capture extreme portfolio loss during financial crisis. Then, we formulate the portfolio selection problem with WCVaR as the measure of risk. We conduct an empirical study using 13 global equity indices. The results show that for dynamic investments, or during financial crisis, our model outperforms other models that only consider a fixed dependence structure between assets. This is because our model can significantly reduce extreme portfolio loss in times of crisis by selecting the assets with small lower tail dependence. This new portfolio strategy can help risk-averse investors cope with financial crisis.
Keywords: Robust portfolio decisions; Regime switching; Asymmetric dependence; Worst-case CVaR; R-vine copulas; Financial crisis.
JEL Classification: G01, G11, G15
Suggested Citation: Suggested Citation