Risk Containment Strategies for Investors with Multivariate Utility Functions

Posted: 2 Jul 1998

See all articles by Mark Kritzman

Mark Kritzman

Windham Capital Management

Jay Light

Harvard Business School - Finance Unit

Don R. Rich

affiliation not provided to SSRN

Date Written: January 1996

Abstract

There are many financial situations in which investors care about joint occurrences. Consider, for example, the following situations: 1) a manager is evaluated against both an absolute target and a relative target; 2) an investor seeks protection from currency losses only when they coincide with unfavorable returns from the underlying portfolio; and 3) an investor wishes to structure an incentive fee that is conditioned on the simultaneous attainment of two objectives. Conventional approaches to risk containment assume implicitly that investor utility depends on a single random variable and that risk is defined as the variability of this random variable. Investor behavior suggests, however, that investors care about multiple measures of risk. This paper develops a risk containment model in which investor utility is explicitly contingent on more than one random variable. The framework offers option-based hedging strategies that protect investors from the joint occurrence of negative outcomes. An important implication of the model is that protection for concurrent negative events is never more expensive than protection from each negative event independently. The proposed risk containment strategies, therefore, should be appealing to institutional investors who can tolerate negative events that occur simultaneously with other favorable events.

JEL Classification: D81, G24

Suggested Citation

Kritzman, Mark and Light, Jay O. and Rich, Don R., Risk Containment Strategies for Investors with Multivariate Utility Functions (January 1996). Available at SSRN: https://ssrn.com/abstract=7314

Mark Kritzman

Windham Capital Management ( email )

800 Boylston Street
30th Floor
Boston, MA 02199
United States
6174193900 (Phone)
6172365034 (Fax)

Jay O. Light

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States

Don R. Rich (Contact Author)

affiliation not provided to SSRN

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