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Does copula beat linearity?: Comparison of copulas and linear correlation in portfolio optimization.
Umeå University, Faculty of Science and Technology, Department of Mathematics and Mathematical Statistics.
Umeå University, Faculty of Science and Technology, Department of Mathematics and Mathematical Statistics.
2016 (English)Independent thesis Advanced level (professional degree), 20 credits / 30 HE creditsStudent thesis
Abstract [en]

Modern portfolio theory (MPT) is an investment theory which was introduced by Harry Markowitz in 1952 and describes how risk averse investors can optimize their portfolios. The objective of MPT is to assemble a portfolio by maximizing the expected return given a level of market risk or minimizing the market risk given an expected return. Although MPT has gained popularity over the years it has also been criticized for several theoretical and empirical shortcomings such as using variance as a measure of risk, measuring the dependence with linear correlation and assuming that returns are normally distributed when in fact empirical data suggests otherwise. When moving away from the assumption that returns are elliptical distributed, for example normally distributed, we can not use linear correlation as a measure of dependence in an accurate way. Copulas are a flexible tool for modeling dependence of random variables and enable us to separate the marginals from any joint distribution in order to extract the dependence structure. The objective of this paper was to examine the applicability of a copula-CVaR framework in portfolio optimization compared to the traditional MPT. Further, we studied how the presence of memory, when calibrating the copulas, affects portfolio optimization. The marginals for the copula based portfolios were constructed using Extreme Value Theory and the market risk was measured by Conditional Value at Risk. We implemented a dynamic investing strategy where the portfolios were optimized on a monthly basis with two different length of rolling calibration windows. The portfolios were backtested during a sample period from 2000-2016 and compared against two benchmarks; Markowitz portfolio based on normally distributed returns and an equally weighted, non optimized portfolio. The results demonstrated that portfolio optimization is often preferred compared to choosing an equally weighted portfolio. However, the results also indicated that the copula based portfolios do not always beat the traditional Markowitz portfolio. Furthermore, the results indicated that the choice of length of calibration window affects the selected portfolios and consequently also the performance. This result was supported both by the performance metrics and the stability of the estimated copula parameters.

Place, publisher, year, edition, pages
2016. , 78 p.
Keyword [en]
Copula, Portfolio Optimization, Extreme Value Theory, CVaR Optimization
National Category
URN: urn:nbn:se:umu:diva-124634OAI: diva2:953735
External cooperation
Case company
Educational program
Master of Science in Engineering and Management
Available from: 2016-08-19 Created: 2016-08-18 Last updated: 2016-08-19Bibliographically approved

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