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Portfolio optimization based on modified expected shortfall

Portfolio optimization based on modified expected shortfall An investor is expected to analyze the market risk while investing in equity stocks. This is because the investor has to choose a portfolio which maximizes the return with a minimum risk. The mean-variance approach by Markowitz (1952) is a dominant method of portfolio optimization, which uses variance as a risk measure. The purpose of this paper is to replace this risk measure with modified expected shortfall, defined by Jadhav et al. (2013).Design/methodology/approachModified expected shortfall introduced by Jadhav et al. (2013) is found to be a coherent risk measure under univariate and multivariate elliptical distributions. This paper presents an approach of portfolio optimization based on mean-modified expected shortfall for the elliptical family of distributions.FindingsIt is proved that the modified expected shortfall of a portfolio can be represented in the form of expected return and standard deviation of the portfolio return and modified expected shortfall of standard elliptical distribution. The authors also establish that the optimum portfolio through mean-modified expected shortfall approach exists and is located within the efficient frontier of the mean-variance portfolio. The results have been empirically illustrated using returns from stocks listed in National Stock Exchange of India, Shanghai Stock Exchange of China, London Stock Exchange of the UK and New York Stock Exchange of the USA for the period February 2005-June 2018. The results are found to be consistent across all the four stock markets.Originality/valueThe mean-modified expected shortfall portfolio approach presented in this paper is new and is a natural extension of the Markowitz’s mean-variance and mean-expected shortfall portfolio optimization discussed by Deng et al. (2009). http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Studies in Economics and Finance Emerald Publishing

Portfolio optimization based on modified expected shortfall

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Publisher
Emerald Publishing
Copyright
© Emerald Publishing Limited
ISSN
1086-7376
DOI
10.1108/sef-05-2018-0160
Publisher site
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Abstract

An investor is expected to analyze the market risk while investing in equity stocks. This is because the investor has to choose a portfolio which maximizes the return with a minimum risk. The mean-variance approach by Markowitz (1952) is a dominant method of portfolio optimization, which uses variance as a risk measure. The purpose of this paper is to replace this risk measure with modified expected shortfall, defined by Jadhav et al. (2013).Design/methodology/approachModified expected shortfall introduced by Jadhav et al. (2013) is found to be a coherent risk measure under univariate and multivariate elliptical distributions. This paper presents an approach of portfolio optimization based on mean-modified expected shortfall for the elliptical family of distributions.FindingsIt is proved that the modified expected shortfall of a portfolio can be represented in the form of expected return and standard deviation of the portfolio return and modified expected shortfall of standard elliptical distribution. The authors also establish that the optimum portfolio through mean-modified expected shortfall approach exists and is located within the efficient frontier of the mean-variance portfolio. The results have been empirically illustrated using returns from stocks listed in National Stock Exchange of India, Shanghai Stock Exchange of China, London Stock Exchange of the UK and New York Stock Exchange of the USA for the period February 2005-June 2018. The results are found to be consistent across all the four stock markets.Originality/valueThe mean-modified expected shortfall portfolio approach presented in this paper is new and is a natural extension of the Markowitz’s mean-variance and mean-expected shortfall portfolio optimization discussed by Deng et al. (2009).

Journal

Studies in Economics and Finance – Emerald Publishing

Published: Aug 8, 2019

Keywords: Portfolio optimization; Expected shortfall; Coherent risk measure; Elliptical distributions; Modified expected shortfall; G11; G32

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