Risk Containment Strategies for Investors with Multivariate Utility Functions
Posted: 2 Jul 1998
Date Written: January 1996
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: Suggested Citation