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## Heavy-tail Sensitivity of Stable Portfolios

This thesis documents a heavy-tailed analysis of stable portfolios. Stock market crashes occur more often than is predicted by a normal distribution,which provides empirical evidence that asset returns are heavy-tailed. The motivation of this thesis is to study the effects of heavy-tailed distributions of asset returns. It is imperative to know the risk that is incurred for unlikely tail events in order to develop a safer and more accurate portfolio. The heavy-tailed distribution that is used to model asset returns is the stable distribution. The problem of optimally allocating assets between normal and stable distribution portfolios is studied. Furthermore, a heavy-tail sensitivity analysis is performed in order to see how the optimal allocation changes as the heavy-tail coefficient is altered. In order to solve both problems, we use a mean-dispersion risk measure and a probability of loss risk measure. Our analysis is done for two-asset stable portfolios, one of the assets being risk-free, and one risky. The approach used involves changing the heavy-tail parameter of the stable distribution and finding the differences in the optimal asset allocation. The key result is that relatively more wealth is allocated to the risk-free asset when using stable distributions than when using normal distributions. The exception occurs when using a loss probability risk measure with a very high risk tolerance. We conclude that portfolios assuming normal distributions incorrectly calculate the risk in two types of situations. These portfolios do not account for the heavy-tail risk when the risk tolerance is low and they do not account for the higher peak around the mean when the risk tolerance is high.

Identifer | oai:union.ndltd.org:WATERLOO/oai:uwspace.uwaterloo.ca:10012/5427 |

Date | 24 August 2010 |

Creators | Agatonovic, Marko |

Source Sets | University of Waterloo Electronic Theses Repository |

Language | English |

Detected Language | English |

Type | Thesis or Dissertation |

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