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Diversification
Diversification is the key principle upon which Modern Portfolio Theory (MPT) is built - although the concept of not putting all of ones eggs into one basket dates all the way back to biblical times. Central to this is the concept of Correlation as measure of dependence between assets
Key Assumptions
Correlation ( the standardised covariance between assets ) as the measure of dependence between assets
Normally distributed returns. The assumption that asset returns are normally distributed about their means.
Normality Testing
Normality Testing
ETF's
Hedge Funds
Normal Not-Normal
Normal Not-Normal
Assumed Normal
Assumed Normal
Assumed Normal Fund PDF (Normal)
Normal VaR
Normal CVaR
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
Assumed Normal
Assumed Normal
Assumed Normal Fund PDF (Normal)
Normal VaR
Normal CVaR
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
Assumed Modified
Assumed Normal and Modified Distributions
Assumed Normal Fund PDF (Normal)
Normal VaR
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
If is a sequence of distributions converging to the standard normal distribution , the Edgeworth- and Cornish-Fisher approximations present better approximations (asymptotically for ) than the normal approximation itself. The approximated functions and are not necessarily monotone. -quantiles becomes less and less reliable
has the ``wrong tail behavior'', i.e., the Cornish-Fisher approximation for for (or ).
The Edgeworth- and Cornish-Fisher approximations do not necessarily improve (converge) for a fixed order of approximation, .
and increasing
For more on the qualitative properties of the Cornish-Fisher approximation see (Jaschke; 2001). It contains also an empirical analysis of the error of the Cornish-Fisher approximation to the 99%-VaR in real-world examples as well as its worst-case error on a certain class of one- and two-dimensional delta-gamma-normal models:
http://fedc.wiwi.hu-berlin.de/xplore/tutorials/xfghtmlnode8.html
-5.00%
0.00%
VaR ( Modified )
5.00%
10.00%
15.00%
20.00% -6 -4 -2 0 Skewness 2 4 6
http://discussions.ft.com/alchemy/forums/edhec-risk-forum/hedge-fund-risk-management-models-for-the-return-distribution/
90.00%
Normal CDF
18
80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4
Kurt
S
12
Good Z Z
0
1500.00%
Skew
1000.00%
500.00%
-6
0.00% -30.0%
Z
-6 -4 -2 0 2 4 6
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
90.00%
Normal CDF
18
80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4
Kurt
S
12
Good Z Z
0
1500.00%
Skew
1000.00%
500.00%
-6
0.00% -30.0%
Z
-6 -4 -2 0 2 4 6
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
OK
OK
WARNING: Degenerate Cornish Fisher. CDF w ill turn in tails WARNING: Degenerate Cornish Fisher. CDF w ill turn in body
WARNING: Degenerate Cornish Fisher. CDF w ill turn in tails WARNING: Degenerate Cornish Fisher. CDF w ill turn in body
Gumbel (Max) 7.8% Gumbel (Min) 8.2% Johnson (Lognormal) 13.5% Johnson (Unbounded) 0.6% Mixture of Normals 20.1% Modified Normal 35.8% Normal 12.9% Uniform 1.0%
Gumbel (Max) 23.3% Gumbel (Min) 13.2% Johnson (Lognormal) 13.2% Johnson (Unbounded) 2.6% Mixture of Normals 15.9% Modified Normal 21.2% Normal 6.9% Uniform 3.7%
Assumed Normal
Assumed Normal
Assumed Normal Fund PDF (Normal)
Normal VaR
Normal CVaR
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
Assumed Modified
Assumed Normal and Modified Distributions
Assumed Normal Fund PDF (Normal)
Normal VaR
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
Best Fitting
Best Fit and Assumed Normal and Modified Distributions
Best Fit Fund PDF (Gumbel (Min)) Assumed Normal Fund PDF (Normal) Assumed Modified Normal Fund PDF (Modified)
Best Fit VaR Normal VaR Best Fit CVaR Normal CVaR Modified VaR Modified CVaR -
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
Goodness of Fit
Cummulative Probability Distributions
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% -20% 0% -40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00% -25% 0% -25% -5% -10% -15% 20%
Best Fit Fund CDF (Gumbel (Min)) Assumed Normal Fund CDF (Normal) Empirical CDF Fund
Series1 15% 10% 5% Fund Best Fit (Gumbel (Min)) Fund Assumed (Normal)
-20%
-15%
-10%
-5%
0%
5%
10%
15%
6.00%
4.00%
FUND A
0.00%
-2.00%
-4.00% -6.00% -4.00% -2.00% 0.00% 2.00% FUND B 4.00% 6.00% 8.00% 10.00%
6.00%
4.00%
FUND A
2.00%
Linear Regression
0.00%
-2.00%
-4.00% -6.00% -4.00% -2.00% 0.00% 2.00% FUND B 4.00% 6.00% 8.00% 10.00%
6.00%
Linear Regression
4.00%
FUND A
2.00% 0.00% -2.00% -4.00% -6.00% -4.00% -2.00% 0.00% 2.00% FUND B 4.00% 6.00% 8.00% 10.00%
30.00%
Linear Regression
20.00%
FUND C
10.00% 0.00% -10.00% -20.00% -8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% FUND D
FUND E
0.00%
-5.00%
-10.00%
-15.00% -6.00% -4.00% -2.00% 0.00% FUND F 2.00% 4.00% 6.00% 8.00%
FUND G
2.00%
0.00%
-2.00%
10.00%
Linear Regression
0.00%
FUND I
-10.00% -20.00% -30.00% -40.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% FUND J 10.00% 15.00% 20.00% 25.00% 30.00%
FUND K
0.00%
-10.00%
-20.00%
-30.00%
-40.00% -50.00% -40.00% -30.00% -20.00% -10.00% 0.00% FUND L 10.00% 20.00% 30.00% 40.00% 50.00%
-0.50
0.00
Correlation to S&P500
0.50
1.00
Gold US Bonds Cash US High Yield Bonds Global Bond Index US Real Estate
5.00% 0.00%
US Dollar CTA's
Volatility
World Equities
-20.00% -1.00
-0.50
0.00
Correlation to S&P500
0.50
1.00
30.00%
30.00%
Linear Regression
Linear Regression
0.00%
0.00%
Corn Fund
-10.00%
Corn Fund
-10.00% -20.00% -20.00% -30.00% -30.00% -40.00% -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% DB Crude Oil Long ETN -40.00% -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% United States Oil Fund
12.00%
12.00%
10.00%
8.00%
Linear Regression
4.00%
4.00%
2.00%
2.00%
0.00%
0.00%
-2.00%
-2.00%
-4.00%
-4.00%
-6.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% SPECTRUM Lg Cap U.S. Sector ETN
25.00%
25.00%
Linear Regression
Linear Regression
10.00%
10.00%
5.00%
5.00%
0.00%
0.00%
-5.00%
-5.00%
-10.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% SPDR Barclays Capital High Yield Bond ETF
40.00%
20.00%
Linear Regression
Linear Regression
0.00%
10.00%
5.00%
0.00%
-10.00%
-5.00%
-20.00%
-10.00%
-15.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% SPDR DJ Wilshire Global Real Estate ETF
Conclusions
Distributions do differ from Normal at least 15 20% of the time and up to 30 40% of the time depending on the data set being used Test them
The Cornish Fisher modification is not strictly monotone and should probably not be used at confidence levels above 95% The Cornish Fisher modification has poor tail behaviour almost half of the time CHECK Correlation is a limited and linear measure of dependence only Non-Linear Copula based methods offer significant promise in helping to find better diversification and pairs trading opportunities
http://nz.linkedin.com/in/peterurbani