Model Averaging and Value-at-Risk Based Evaluation of Large Multi Asset Volatility Models for Risk Management

52 Pages Posted: 19 Jan 2005

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

P. Zaffaroni

Imperial College London; Bank of Italy

Multiple version iconThere are 2 versions of this paper

Date Written: December 2004

Abstract

This paper considers the problem of model uncertainty in the case of multi-asset volatility models and discusses the use of model averaging techniques as a way of dealing with the risk of inadvertently using false models in portfolio management. In particular, it is shown that under certain conditions portfolio returns based on an average model will be more fat-tailed than if based on an individual underlying model with the same average volatility. Evaluation of volatility models is also considered and a simple Value-at-Risk (VaR) diagnostic test is proposed for individual as well as "average" models and its exact and asymptotic properties are established. The model averaging idea and the VaR diagnostic tests are illustrated by an application to portfolios of daily returns based on twenty two of Standard & Poor's 500 industry group indices over the period January 2, 1995 to October 13, 2003, inclusive.

Keywords: model averaging, value-at-risk, decision based evaluation

JEL Classification: C32, C52, C53, G11

Suggested Citation

Pesaran, M. Hashem and Zaffaroni, P., Model Averaging and Value-at-Risk Based Evaluation of Large Multi Asset Volatility Models for Risk Management (December 2004). Available at SSRN: https://ssrn.com/abstract=642681

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

P. Zaffaroni

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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