Optimal Protfolio Construction and Active Portfolio Management by Simon Theodor Keel 2006

Diss. ETH No.
16514
Optimal Portfolio Construction
and Active Portfolio Management
Including Alternative Investments
A dissertation submitted to the
SWISS FEDERAL INSTITUTE OF TECHNOLOGY ZURICH
for the degree of
Doctor of Technical Sciences
presented by
Simon Theodor Keel
Dipl. Masch.-Ing. ETH
born 26 January 1976
citizen of Rebstein, SG
accepted on the recommendation of
Prof. Dr. H. P. Geering, examiner
Prof. Dr. A. J. McNeil, co-examiner
Prof. Dr. D. B. Madan, co-examiner
2006
ISBN: 978-3-906483-10-8
IMRT PRESS
c/o Measurement and Control Laboratory
ETH Zentrum, ML
Sonneggstr. 3
CH-8092 Zürich
Acknowledgements
This research was carried out at the Measurement and Control Laboratory (IMRT) at
the ETH Zurich, Switzerland from December 2002 to January 2006.
The confidence and support of my supervisor, Prof. Dr. H. P. Geering, is gratefully
acknowledged. Furthermore, I would like to thank Prof. Dr. A. J. McNeil, ETH Zurich,
and Prof. Dr. D. B. Madan, University of Maryland, for accepting to be my co-examiners.
I am indebted to the members of the Financial Control Group at the IMRT, Dr.
Gabriel Dondi and Dr. Florian Herzog, who supported me throughout my work. Their
help and support during the whole thesis is greatly appreciated. I am particularly grateful
to Dr. Lorenz Schumann for the challenging discussions, which were of invaluable help
and always encouraging. I would also like to thank the entire staff of the Measurement
and Control Laboratory, especially Mikael Bianchi.
Finally, my thanks go to my parents who helped me in every possible way throughout
my time at the ETH. Last but not least, I would like to express my sincerest gratitude to
Sonja for all her wonderful support and encouragement.
Zurich, May 2006

Abstract
One aspect of financial engineering is the development of portfolio management strategies.

The research field of optimal stochastic control is well suited for the derivation of these
strategies in a dynamic environment. It is the aim of this work to explore and extend opti-
mal portfolio construction techniques currently found in the literature. A special emphasis
is given to alternative investments. In order to derive an optimal asset allocation strategy,
a risk measure has to be introduced and the asset price dynamics have to be modeled.
This results in dynamic optimal control problems, which are well studied in control en-
gineering. However, the main emphasis of control engineering is given to deterministic
models. Since the prices of financial assets are predominantly driven by randomness, the
concepts and techniques of control engineering have to be extended to the stochastic case.
The first step of the elaboration of an asset allocation strategy is the definition of the
risk measure. However, not all risk measures are well suited for the derivation of optimal
asset allocation strategies. Therefore, the terms coherent and convex risk measures are
discussed in detail. For the modeling of asset prices, the statistical properties of asset
returns have to be taken into account. Several distributions are investigated which are
better suited than the typically found normal distribution. Since the literature is mainly
concerned with the univariate case, special consideration is given to the multivariate case.
It is found that the distribution called generalized hyperbolic and some of its limiting
cases yield much more realistic models of asset returns than the normal distribution. In
addition to parametric distributions, semi-parametric models including elliptical copulas
are analyzed. Particularly, the event of concurrent extreme losses of different financial
assets is considered.
This work includes an in-depth study of alternative investments. Special consideration
is given to their statistical properties. Hedge funds make use of dynamic asset allocation
IV
strategies and may have a large investment universe. Therefore, hedge funds need special
attention with respect to risk management. The specific structure and properties of hedge
funds are elaborated and discussed. The process of investing in hedge funds is analyzed
in detail. A wide range of different statistical properties among the different hedge funds
styles is found. Therefore, a universal treatment of hedge fund returns as such is not
possible.
Following the analysis of the static and dynamic statistical properties of asset returns,
optimal asset allocation strategies are derived. At first, a framework of continuous-time
stochastic differential equations is considered. The stochastic differential equations are
driven by Brownian motion. Again, alternative investments are analyzed in particular.
A closed-form solution of an investment strategy with common asset classes is derived.
Furthermore, the optimal asset allocation is investigated for the case in which the asset
price models contain unknown parameters or processes. It is shown that this problem
can be transformed into one in which all parameters and processes are measurable. The
properties of the Kalman filter are used for the derivation. The results of these theoretical
investigations are tested in a detailed case study including alternative investments.
Finally, the topic of active portfolio management is discussed. The importance of the
benchmark for active portfolio management is highlighted. A deeper systematic treatment
of active portfolio management has not been carried out because there exist neither a
generally accepted terminology nor a unified framework for comparing different strategies.
A specific active portfolio management problem is presented as well as a procedure for
obtaining a solution for a single-period and a multi-period formulation. The single-period
solution is backtested with historical data. The very last part of this work considers the
use of Lévy processes for the construction of optimal portfolios. The multivariate Lévy
measures of the generalized hyperbolic Lévy process and its limiting cases are presented
and derived for one limiting case. The work concludes with the presentation of optimal
portfolio strategies derived with Lévy processes.
Zusammenfassung
Portfolio Management ist ein wichtiger Aspekt des Fachgebietes Financial Engineering.
Die optimale, stochastische Regelung bietet die hierfür notwendigen mathematischen
Grundlagen. Ziel dieser Arbeit ist es, die momentan in der Literatur vorhandenen Tech-
niken für die Portfolio Konstruktion zu erweitern. Im speziellen werden alternative Anla-
gen untersucht. Um optimale Portfolio Management Strategien herzuleiten, muss vorab
ein Risikomass bestimmt und die Dynamik der Preise der Anlagemöglichkeiten model-
liert werden. Hieraus ergeben sich optimale Regelungsprobleme, welche im entsprechen-
den Fachgebiet bereits gründlich erforscht wurden. Leider sind aber viele Resultate nur
für den deterministischen Fall gefunden worden. Da aber bei Finanzproblemen die be-
trachteten Systeme hauptsächlich vom Zufall getrieben werden, müssen die Konzepte auf
den stochastischen Fall erweitert werden.
Der erste Schritt für die Entwicklung einer Portfolio Management Strategie ist die
Einführung eines Risikomasses. Es sind jedoch nicht alle Risikomasse gleichermassen
geeignet. Kohärente und konvexe Risikomasse besitzen für die betrachteten Problemstel-
lungen geeignete Eigenschaften. Die Modelle für die Renditen von Wertpapieren sollen
deren statistische Eigenschaften in realistischer Weise berücksichtigen. Hierfür werden
mehrere Distributionen untersucht, welche die häufig angetroffene Normalverteilung er-
setzen. Da in Studien oft nur der eindimensionale Fall behandelt wird, wird besonderes
Augenmerk auf den mehrdimensionalen Fall gelegt. Die Distribution, welche unter dem
Namen Generalized Hyperbolic in der Literatur zu finden ist, kann die betrachteten Ren-
diten sehr viel realistischer beschreiben als die Normalverteilung. Dies gilt auch für einige
Grenzfälle der Generalized Hyperbolic Verteilung. Zusätzlich werden elliptische Copulas
untersucht.
VI
Diese Arbeit enthält eine ausführliche Untersuchung von alternativen Anlagen. Im

speziellen werden deren statistische Eigenschaften untersucht. Hedge Funds verfolgen in
der Regel dynamische Anlagestrategien, was im Risikomanagement berücksichtigt werden
muss. Hierfür werden die spezifischen Eigenschaften von Hedge Funds untersucht und der
Anlageprozess analysiert. Die Eigenschaften von Hegde Funds variieren enorm für die
verschiedenen Hedge Fund Stile. Deshalb können keine universellen Aussagen über die
statischen und dynamischen Eigenschaften von Hedge Funds gemacht werden.
Der erste Teil der Arbeit konzentriert sich auf die statische und die dynamische Model-
lierung von Anlagemöglichkeiten. Im zweiten Teil werden aufgrund der erarbeiteten Mod-
elle optimale Anlagestrategien entwickelt. Als erstes werden Modelle betrachtet, welche auf
stochastischen Differentialgleichungen fussen. Als Zufallsprozesse in diesen werden Brown-
sche Bewegungen eingeführt. Auch alternative Anlagen werden als ein solches System
modelliert und eine optimale Anlagestrategie in geschlossener Form hergeleitet. Zusätzlich
werden Modelle betrachtet, welche für den Investor unbekannte Parameter und Prozesse
enthalten. Um dieses Problem zu lösen, wird ein Kalman Filter eingesetzt, die Resultate
werden in einem Anwendungsbeispiel getestet.
Der letzte Teil dieser Arbeit beschäftigt sich mit aktivem Portfolio Management. Die
zentrale Bedeutung des Benchmarks für das aktive Portfolio Management wird disku-
tiert. Da das aktive Portfolio Management kein eigentliches Forschungsgebiet darstellt,
ist jedoch nur eine oberflächliche Abhandlung möglich. Nichtsdestotrotz wird ein spez-
ifisches aktives Portfolio Management Problem diskutiert und werden zwei mögliche
Lösungsansätze präsentiert. Einer dieser Lösungsansätze wird mittels historischer Daten
verifiziert. Der letzte Abschnitt dieser Arbeit beschäftigt sich mit Lévy Prozessen im
Zusammenhang mit Portfolio Konstruktion. Die multivariate Lévy Dichte für einen
Grenzfall des Generalized Hyperbolic Lévy Prozesses wird hergeleitet. Die Arbeit wird
mit der Betrachtung von Lévy Prozessen für die Berechnung von optimalen Portfolios
abgeschlossen.
Contents
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Financial Engineering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Structure of the Thesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2 Financial Assets and Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.1 Financial Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 The Asset Allocation Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.3 Risk Management and Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3.1 The Concept of Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.3.2 Financial Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3 Modeling of Financial Assets and Financial Optimization . . . . . . . . . . . . 21

3.1 Statistical Properties of Asset Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.1.1 Stylized Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.1.2 Univariate Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.1.3 Methodology and Results for the Univariate Case . . . . . . . . . . . . . . . . . 29
3.1.4 Multivariate Properties and Dependence . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.1.5 Results for the Multivariate Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.2 Dynamic Models of Financial Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.3 Financial Optimization Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4 Alternative Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
4.1.1 Hedge Fund Fee Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4.1.2 Hedge Fund Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
VIII Contents
4.1.3 Hedge Fund Styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

4.1.4 Funds of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
4.1.5 Hedge Fund Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4.2 Systematic Risks of Hedge Funds and Risk Management . . . . . . . . . . . . . . . . 57
4.2.1 Systematic Risks of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
4.2.2 Risk Management for Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
4.2.3 Non-linearities in Hedge Fund Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4.3 Statistical Properties of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4.3.1 Univariate Properties of Hedge Fund Returns . . . . . . . . . . . . . . . . . . . . . 66
4.3.2 Multivariate and Dependence Properties of Hedge Fund Returns . . . . 68
4.4 Hedge Fund Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
5 Optimal Portfolio Construction with Brownian Motions . . . . . . . . . . . . . 77

5.1 The Full Information Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
5.1.1 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
5.1.2 Optimal Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
5.1.3 Case Study with Alternative Investments . . . . . . . . . . . . . . . . . . . . . . . . 86
5.2 The Partial Information Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
5.2.1 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
5.2.2 Estimation of the Unobservable Factors . . . . . . . . . . . . . . . . . . . . . . . . . . 98
5.2.3 Portfolio Dynamics and Problem Transformation . . . . . . . . . . . . . . . . . . 100
5.2.4 Optimal Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
5.2.5 Case Study with a Balanced Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
6 Active Portfolio Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

6.1 Sector Rotation Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
6.2 Portfolio Management with Lévy Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
7 Conclusions and Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
A Probability and Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

A.1 Moments of Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
A.2 Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
A.2.1 Normal Mean-Variance Mixture Distributions . . . . . . . . . . . . . . . . . . . . . 133
Contents IX
A.2.2 Univariate Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

A.2.3 Multivariate Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
A.2.4 Bessel Functions and Modified Bessel Functions . . . . . . . . . . . . . . . . . . . 139
B GARCH Models for Dynamic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

B.1 Univariate GARCH Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
B.2 Multivariate GARCH Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
C Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
C.1 Tail Dependence within a t Copula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
C.2 Transformation from Partial to Full Information . . . . . . . . . . . . . . . . . . . . . . . 146
C.3 Lévy Density of the Multivariate VG Lévy Process . . . . . . . . . . . . . . . . . . . . . 149
D Additional Data for the Sector Rotation Case Study . . . . . . . . . . . . . . . . . 151
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Curriculum Vitae . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

List of Figures
2.1 Asset allocation process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.1 Classes of distributions in finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

3.2 Density estimates for the daily Dow Jones returns. . . . . . . . . . . . . . . . . . . . . . 28
3.3 Logarithmic density estimates for the daily Dow Jones returns. . . . . . . . . . . 28
3.4 The model predictive control concept in finance . . . . . . . . . . . . . . . . . . . . . . . . 45
4.1 Assets under management by the hedge fund industry. . . . . . . . . . . . . . . . . . . 49

4.2 Serial correlation of the Tremont convertible arbitrage index. . . . . . . . . . . . . 62
4.3 Dynamic standard deviation of the Tremont long/short equity index. . . . . . 63
4.4 Non-linearities of hedge fund returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4.5 Kernel regression of lagged S&P 500 returns vs. Tremont fixed income
arbitrage returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4.6 Density estimates for the monthly Tremont convertible arbitrage index
returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
4.7 Correlation of Tremont Hedge Fund Indices with stocks and bonds. . . . . . . . 72
4.8 Hedge fund portfolio construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.9 The hedge fund selection process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
5.1 Asset allocation strategy under full information for γ = −10. . . . . . . . . . . . . 92

5.2 Asset allocation strategy performance under full information for γ = −10. . 93
5.3 Estimations of the short rate and the unobservable factors α and µ. . . . . . . 111
5.4 Asset allocation strategy under partial information for γ = −10. . . . . . . . . . 112
5.5 Asset allocation strategy performance under partial information for
γ = −10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
XII List of Figures
6.1 An MPC approach for the sector rotation problem. . . . . . . . . . . . . . . . . . . . . . 120

6.2 Performance of the sector rotation asset allocation strategy. . . . . . . . . . . . . . 122
List of Tables
2.1 Financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.2 Financial risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1 Distributions for daily Dow Jones returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

3.2 Distributions for equity index returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.3 Distributions for commodity returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.4 Distributions for bond total return index returns. . . . . . . . . . . . . . . . . . . . . . . 31
3.5 Multivariate distributions for equity indices returns. . . . . . . . . . . . . . . . . . . . . 37
3.6 Multivariate distributions for commodity returns. . . . . . . . . . . . . . . . . . . . . . . 38
3.7 Multivariate distributions for a typical portfolio. . . . . . . . . . . . . . . . . . . . . . . . 39
3.8 Copula estimations for asset returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.9 Tail dependence coefficients of weekly world equity indices returns. . . . . . . . 41
3.10 Tail dependence coefficients in a typical portfolio. . . . . . . . . . . . . . . . . . . . . . . 42
4.1 Hedge fund styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

4.2 Common risk factors of hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
4.3 Distributions for monthly Tremont hedge fund indices returns. . . . . . . . . . . . 66
4.4 Tail dependence coefficients for Tremont hedge fund styles. . . . . . . . . . . . . . . 68
4.5 Tail dependence coefficients for Tremont hedge fund styles with common
risk factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
4.6 Multivariate distribution models for a portfolio including hedge funds. . . . . 70
5.1 Typical values for the estimated parameters. . . . . . . . . . . . . . . . . . . . . . . . . . . 92

5.2 Key figures for the asset allocation strategy under full information . . . . . . . 94
5.3 Key figures for the asset allocation strategy under partial information. . . . . 113
XIV List of Tables
D.1 Factors for the sector rotation case study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

List of Symbols and Notation
α Excess return
β Factor exposure
γ1 Skewness
γ2 Kurtosis
I Identity matrix
P Probability measure
F Sigma algebra
Ft Filtration
N Normal (Gaussian) distribution
µ Expected return
ν(dx) Lévy measure
ν(t) Estimation error
Ω Sample space
σ Volatility
Σ(t) Instantaneous covariance matrix per unit time
1{A} Identicator function of the set A
C Copula function
c Density of a copula
C Ga Gaussian copula
Ct t copula
% Risk measure
L0 Set of all almost surely finite random variables
L1n Set of n-dimensional integrable functions
P Asset price
XVI List of Tables
r Risk-free interest rate

u Control vector, asset allocation strategy
V Investor’s wealth, value of a portfolio
W Brownian motion
x Observable factor
y Unobservable factor
AIC Akaike Information Criterion
ARCH Autoregressive conditional heteroskedasticity
BIS Bank for International Settlements
CCC Constant conditional correlation
CRRA Constant relative risk aversion
CVaR Conditional Value at Risk
DCC Dynamic conditional correlation
EMH Efficient market hypothesis
GARCH Generalized ARCH
GH Generalized Hyperbolic distribution
GIG Generalized Inverse Gaussian
HJB Hamilton-Jacobi-Bellman
i.i.d. independent, identically distributed
ML Maximum loss
MM Method of Moments
NIG Normal Inverse Gaussian distribution
s-t Skewed t distribution
SDE Stochastic differential equation
SP Shortfall probability
TARCH Threshold GARCH
VaR Value at Risk
1
Introduction
Copy from one, it’s plagiarism; copy from two, it’s research.
Wilson Mizner
This work explores the possibilities and limits of the use of control engineering methods
and techniques in finance. This chapter presents the motivation and goals of this work and
the conceptual strategies involved. The application of control engineering methods and
techniques to financial problems is called financial engineering. It makes use of engineering
tools, i.e., it obtains quantitative results for models and problems developed in research
fields such as economics, mathematics, and econometrics. The results in economics and
mathematical finance are often of a theoretical or qualitative nature and cannot be used
quantitatively as such. The results from the area of econometrics give an indication as
to which models are quantitatively applicable. As in engineering problems, the problems
considered in this work are solved in two stages: first, modeling of the problem and then
computation of its optimal solution. Therefore, the aim of the thesis is to apply improved
financial models to optimal portfolio construction problems.
In the modeling part of the thesis, the goal is to improve the asset models used most
often today. These are discussed in detail in Chapter 3. An important point to be noted
is that modeling and optimization are not independent of each other. In general, the
more complicated the underlying model is, the more involved the necessary optimization
becomes. The models considered in this work are always chosen with the caveat of the
existence of a solution for the resulting optimization problem. As in many other research
areas, we face the tradeoff between complexity and solvability of the problems posed. In
the optimization part, we consider two important topics: reasonable objective functions,
i.e., risk measures, and multi-period optimization problems. Various objective functions
for investors are explored and their implications for the problems posed are discussed. In
2 1 Introduction
addition, we analyze the advantages and drawbacks of the use of multi-period optimization
techniques for investment problems. We obtain a multi-period optimization when it is
possible to change the portfolio composition before the end of the problem. However,
applying the multi-period optimal solution is not the same as applying optimal single-
period solutions sequentially, in general.
1.1 Financial Engineering
Financial engineering is defined as the use of mathematical finance and modeling to make
pricing, hedging, trading, and portfolio management decisions. We mainly consider port-
folio management decisions. By definition, a portfolio is a collection of investments held
by an institution or an individual. Holding a portfolio with different investments instead
of a single one is reducing the investor’s risk and is called diversification. In order to have
a model of the portfolio return, we have to model the individual assets as well as their
dependencies. Based on these models, we compute the portfolio return and its characteris-
tics. A portfolio optimization is only possible once we have a model of the portfolio return.
The investment decisions are derived from the portfolio optimization. We therefore aim to
control the financial risk that an investor takes. This raises the question of how to define
financial risk, which is still an open issue in theory and in practice. Many different risk
measures have been proposed so far, but no risk measure is well suited for all problems
arising in the area of financial engineering. This topic is discussed in Chapter 2.
Control engineering in technical problems plays a similar role as financial engineering
does in finance problems. The use of feedback control strategies, i.e., making use of new
information arriving in time is standard in technical problems, but not for financial prob-
lems. This topic is a subject of heated debates among scholars and practitioners. The
dispute is about the efficient market hypothesis (EMH), proposed in Samuelson (1965)
and Fama (1965, 1970a). The efficient market hypothesis states that security prices fully
reflect all the information available. There are several forms of the efficient market hypoth-
esis, where the strongest formulation states that all investors have the same information
available and behave in the same economic optimal fashion, i.e., investors are rational.
From this form, some relaxed forms of the EMH have been derived.
According to the EMH, only a buy-and-hold investment strategy can be optimal. How-
ever, we doubt that only buy-and-hold investment strategies are optimal under all circum-
1.1 Financial Engineering 3
stances. Among the most important reasons for this statement are: the market behavior
is non-stationary, the market has some kind of inertia, not all investors have the same
information, and since investors are not always rational, the techniques underlying the
investment strategies differ, they provide advantages or disadvantages to investors. We
will now discuss these points in more detail.
Economies go through phases, such as the well-known bull and bear market phases.
In addition, we observe long periods of time during which we cannot distinguish a mar-
ket direction, i.e., when the market sustains its level. We may speak of different regimes
in the market. As a matter of fact, optimal investment strategies in these regimes can-
not be the same. Therefore, since a buy-and-hold strategy would just average over the
different regimes, it cannot be optimal in either regime. Investors with a buy-and-hold
investment strategy have to leave the portfolio unchanged for a considerable amount of
time. Only then the optimization of the buy-and-hold investment strategy makes sense.
For most investors, this is not a feasible strategy since they are constrained by liabilities
and consumption.
It is a fact that when markets are in a stress situation, the dependence properties of
assets usually change. Assets which reasonably could be considered independent may drop
at the same time. This pattern has been observable in every crash that has occurred so far.
These facts and many other (empirical) facts show that asset prices are dynamic in their
nature and that their properties change over time. The reader is referred to Campbell, Lo
and MacKinlay (1997) for more details on this topic. As a matter of fact, financial return
series are not independent. This property can easily be verified by examining the serial
correlation of squared returns. Therefore, investment decisions taken in the past may no
longer be optimal when the market has altered its behavior.
The fact that not every investor has the same information available is obvious. The
research area of behavioral finance provides strong evidence that for economic and finan-
cial theories, the assumption of rational investors is rather bold. We stress the fact the
quantitative models used by investors differ tremendously in their degree of sophistica-
tion. This leads to further advantages and disadvantages among them. In terms of market
paradigms, we agree with the adaptive market hypothesis (AMH) of which the properties
are described in Lo (2004). They agree with the statements made so far in this chapter.
One implication of the AMH is that a relation between risk and reward exists, but it is
4 1 Introduction
unlikely to be stable over time. A second one is that arbitrage opportunities arise from
time to time. See Cvitanić, Lazrak, Martellini and Zapatero (2004) for a definition of
arbitrage. A third implication is that investment strategies which perform well in certain
environments may perform poorly in other environments. A fourth implication is that
innovation is the key to survival, which is the only objective that matters.
The main conclusion of this section is that a portfolio has to be actively managed.
The most important reasons, as mentioned, are upcoming liabilities and consumption,
changing market behavior, and the advances in research which lead to new tools and
methods. Up to this point, we have not discussed the case of arbitrageurs who seem to
persistently outperform the market. The money inflows to the hedge fund industry may
be considered as evidence, as they have steadily increased over the last years. If there are
any legal arbitrage opportunities, they tend to diminish after a reasonable time once they
are discovered by others. Therefore, arbitrageurs usually do not provide details about
the arbitrage possibilities they have identified and how they are exploiting them. As a
consequence, any systematic treatment of this subject is impossible. It is not the purpose
of this work to identify arbitrage possibilities but rather to show that quantitative methods
can produce added value in a portfolio.
1.2 Structure of the Thesis
Chapter 2: Financial Assets and Risk Management
In Chapter 2, the financial assets considered are introduced. They are categorized into
traditional and alternative investments. The traditional assets are cash, fixed-income in-
vestments, equity (stocks), real estate, and foreign exchange. The alternative investments
are hedge funds, managed futures, private equity, physical assets (e.g., commodities),
and securitized products (e.g., mortgages). A detailed description of the asset allocation
process is given. The main levels of the asset allocation process are the strategic asset
allocation, the investment analysis, the tactical asset allocation, and the monitoring of
the portfolio.
We introduce the concepts of risk, risk management, and utility functions. A sound
understanding of risk is necessary in order to successfully elaborate a dynamic asset
allocation strategy. Therefore, risk measures and their properties are analyzed in detail.
1.2 Structure of the Thesis 5
An overview of financial risks and their classification are presented and the literature on
the good properties of risk measures is reviewed. Risk measures with favorable properties
in terms of risk management are introduced as coherent and convex risk measures. Finally,
the topic of dynamic risk measures is briefly discussed.
Chapter 3: Modeling of Financial Assets and Financial Optimization
Chapter 3 starts with a brief historical survey of important asset price models proposed
so far. The main part of the chapter is devoted to the investigation of the statistical
properties of asset returns. The stylized facts of asset return distributions are listed. First,
the unconditional properties of univariate asset returns are analyzed. The models proposed
in the literature are reviewed. Three main classes of distributions are considered. These
are the elliptical distributions, the stable distributions, and the normal mean-variance
mixture distributions. In particular, distributions of the generalized hyperbolic (GH) type
are investigated. We find that the GH class of distributions fits univariate returns very
well. The distributions of the GH class account for the stylized facts which are observed
with real-world data. In addition, the GH class contains many important distributions in
form of special and limiting cases.
Having investigated the univariate case, the next part of the chapter is devoted to the
multivariate case. The multivariate version of the GH distribution also offers the best fits in
most of the cases considered. Apart from the fully parametric distributions, we investigate
the concept of copulas. A copula is a function which ties together univariate distributions
to a fully multivariate distribution. Copulas allow for constructing a dependence structure
among totally different kinds of marginal distributions. We choose non-parametric models
for the margins and only consider elliptical copulas in detail. In particular, the Gaussian
and the t copula are investigated. We find that the t copula fits the data considerably
better than the Gaussian copula.
It is a well-documented fact that correlation is not always sufficient for describing
the dependence among asset returns. Therefore, we present some alternative dependence
measures commonly found in the literature. We are particularly interested in the measure
called tail dependence. Tail dependence describes the limiting proportion of exceeding
one margin over a certain threshold, given that the other margin has already exceeded
that threshold. Tail dependence is a copula property and independent of the margins. We
6 1 Introduction
find considerable tail dependence among popular asset classes. However, stocks and bonds
offer good diversification properties with respect to concurrent extreme losses.
After having analyzed the static properties of asset returns in detail, dynamic properties
and models of asset returns are briefly reviewed. In particular, factor models and various
forms of GARCH models, which are frequently found in the literature, are discussed.
The section concludes with an overview of optimization techniques in finance. The most
common dynamic optimization technique in finance is stochastic dynamic programming.
The model predictive control approach for solving stochastic control problems is briefly
described. The main advantage of model predictive control is that constraints on the
decision variables can be taken into account.
Chapter 4: Alternative Investments
In Chapter 4, the topic of alternative investment is discussed. Only the case of hedge funds
is considered in detail. First, a brief history and an overview of the current state of the
hedge fund industry are given. The investment vehicle hedge fund is formally defined. The
special fee structure of hedge funds and its implications for investors are discussed. It is
found that high watermarks as well as a considerable amount of the investor’s own money
in the fund are favorable for protecting the investor’s interests. The terms alpha and beta
are introduced which are often found in the realm of hedge funds. A survey of different
hedge fund styles found in the literature is presented. The advantages and disadvantages
of funds of hedge funds are discussed. We find the most severe disadvantage of funds of
hedge funds to be the double layer of fees.
The performance of hedge funds is reviewed and the inherent problems of the perfor-
mance measurement are highlighted. Because of several biases in the available hedge fund
databases, an accurate assessment of the performance of hedge funds is difficult. The most
common biases such as survivorship bias, selection bias, and backfill bias, are discussed
in detail. The literature on the quantifications of these biases is reviewed. All reviewed
publications on this topic find considerable biases in common hedge fund databases. It is
also found that the most popular risk-adjusted performance measure for hedge funds is
the Sharpe ratio, although the deficiencies of the Sharpe ratio are notorious.
Systematic risks are an important input for the risk management of hedge funds.
Therefore, the role of the idiosyncratic risk for hedge funds is analyzed. It is observed that
the variance of a hedge fund portfolio is decreased by combining an increasing number

of hedge funds. In contrast to variance, the kurtosis is increased when the number of
hedge funds in the portfolio is increased. This is a very unfavorable behavior. However,
by combining a sufficiently large number of hedge funds, only the systematic part of risk is
expected to remain. The systematic risk is described by a factor model. The most common
systematic risk factors for hedge funds are summarized. These risk factors also include
non-linear dependencies with respect to traditional asset classes. Sometimes, option-like
pay-off structures to traditional assets are found for hedge funds.
The risk management of hedge funds demands far more sophisticated methods than
traditional assets do. This is due to the fact that the statistical properties of hedge funds
are quite different from those of traditional assets. In particular, the topic of tail risk
has to be considered carefully. Some returns of hedge fund styles show serial correlation
and volatility clustering effects. Market frictions such as illiquidity are the reason for the
serial correlations in hedge fund returns. Volatility clustering may be caused by a higher
risk-taking of the hedge fund manager because of incurred losses.
As for traditional assets, the univariate and multivariate statistical properties of hedge
fund returns are analyzed. We find that the results vary considerably among the different
hedge fund styles. As in the case of traditional assets, the GH distribution is found to
be well suited for describing hedge fund returns. Concerning dependence, the t copula
gives far better fits than the Gaussian copula. Finally, the process of hedge fund investing
is described. The approaches for constructing a fund of hedge funds portfolio as well as
the embedding of hedge funds in the traditional portfolio are discussed. We find that the
correlation properties of some hedge fund styles with respect to traditional assets such
stocks and bonds are not stable over time.
Chapter 5: Optimal Portfolio Construction with Brownian Motions
In Chapter 5, dynamic asset allocation strategies are developed for asset prices modeled as
continuous-time stochastic differential equations (SDEs) driven by Brownian motion. The
main advantage of using the continuous-time framework is that to a high degree the opti-
mal control problem can be solved analytically. In some cases, even closed-form solutions
may be derived. This gives more insights into the mechanics of an optimal asset alloca-
8 1 Introduction
tion strategy than a numerical approximation could. However, the modeling properties
are rather limited for continuous-time stochastic processes with Brownian motion.
The use of factors for explaining expected returns of assets is common in finance. Two
different types of problems are considered. We consider the case in which all factors which
are explaining the return of assets are known, i.e., measurable. The second case considers
the situation where not all of the factors explaining returns are observable. This problem
is called optimal asset allocation under partial information. The optimal asset allocation
strategies are derived with a stochastic dynamic programming approach. This is done
by solving the Hamilton-Jacobi-Bellman (HJB) equation. The HJB equation is a non-
linear partial differential equation, which is very hard to solve if the control variable is
constrained. For problems in higher dimensions, it is virtually impossible to find solutions
for the constrained case. This fact and the limited possibilities for modeling asset returns
are the main disadvantages of modeling assets in a continuous-time stochastic differential
framework with Brownian motion.
The portfolio dynamics can be derived once the dynamics of the considered assets are
defined. The portfolio is modeled to be self-financing, i.e., there are no external in- or
outflows of money. Two types of investors are considered who are characterized by their
corresponding utility functions. On the one hand, we are considering the popular case of
constant relative risk aversion (CRRA). On the other hand, we are considering the case
of constant absolute risk aversion (CARA). The problems are solved by using Bellman’s
optimality principle. For the partial information case we show that the separation theorem
is no longer valid, i.e., we cannot separate the estimation from the optimization. This
means that we cannot simply estimate the unobservable quantities and then treat them
as if they were known exactly.
The general solutions are analyzed in two case studies, one for the full information case
and one for the partial information case. The former is simpler to analyze than the latter.
The model used for the full information case study is simpler than the one for partial
information. However, the full information problem possesses a closed-form solution. This
is not the case for the partial information problem. In both case studies, the opportunity
set of the investor consists of a bank account, stocks, bonds, and an alternative investment.
The resulting dynamic trading strategies are backtested with historical data, for which the
parameters are adapted in every step. In both cases, the resulting risk-adjusted returns
are higher for the actively managed portfolio than for the passive investments. It is found
that the partial information approach is superior to the full information approach in the
chosen investment framework.
Chapter 6: Active Portfolio Management
Chapter 6 discusses the role of active portfolio management as well as implementation

examples. First, a formal definition of active portfolio management is given and the im-
portance of the definition of the benchmark is highlighted. The key components of active
portfolio management are found to be the investment universe and the investment strat-
egy. A crude classification of active portfolio management strategies is given. We differen-
tiate between security selection and market timing. However, there is neither a generally
accepted terminology nor a unified framework to compare different strategies. Therefore,
a deeper systematic treatment of this topic is not possible.
A case study concerning the sector rotation problem is presented and implemented
with historical data. The S&P 500 index with its ten sector indices is considered. The
active portfolio management strategy is presumed to beat the S&P 500 by over- and
under-weighting the single sectors. Two implementation possibilities are presented, i.e., a
multi-period and a single-period environment. The actual implementation of the strategy
with historical data is done with the single-period strategy. The conditional value at risk
(CVaR) is used as risk measure. In both settings, GARCH models for modeling dynamic
volatility are used. The ten-dimensional return vector of the sector indices is assumed
to have a multivariate normal inverse Gaussian distribution. An adaptive factor model is
used to predict the returns of the different sectors. The implementation of the mean-CVaR
optimization in an out-of-sample manner is run for the period from 1999 to 2005. The
results are promising; we observe an alpha of 5% and an information ratio 0.96.
Finally, the use of Lévy processes for optimal portfolio construction is discussed. For the
description of asset returns in Chapter 3, we have found that the generalized hyperbolic
(GH) distribution and its limiting cases are well suited. Because the GH distribution
is infinitely divisible, we may construct a Lévy process whose increments have a GH
distribution. Therefore, we can construct dynamic models in continuous time which take
the statistical properties of asset returns well into account. The limiting cases of the GH
distribution such as the normal inverse Gaussian (NIG) and the variance gamma (VG)
10 1 Introduction
distribution are also well suited for optimal portfolio construction. The necessary Lévy
densities are given for describing the corresponding Lévy processes. The study of Lévy
processes is one of the most promising research areas in mathematical finance because of
the fine properties of Lévy processes.
2
Financial Assets and Risk Management
Being a language, mathematics may be used not only

to inform but also, among other things, to seduce.
Benoı̂t Mandelbrot
2.1 Financial Assets
A financial investment, contrary to a real investment which involves tangible assets such
as land or factories, is an allocation of money with contracts whose values are supposed
to increase over time. Therefore, a security is a contract to receive prospective benefits
under stated conditions like stocks or bonds.
The two main attributes that distinguish securities are time and risk. Usually, the
interest rate or rate of return is defined as the gain or loss of the investment divided
by the initial value of the investment. An investment always contains some sort of risk.
Therefore, the higher an investor considers the risk of a security, the higher the rate of
return or premium the investor demands, see Sharpe, Alexander and Bailey (1998) for
details.
We divide financial assets in two main categories, i.e., traditional and alternative in-
vestments. Table 2.1 summarizes the considered assets. The main traditional assets are
Table 2.1. Financial assets
Traditional Alternative
Cash Hedge Funds
Fixed-Income Managed Futures
Equity (stocks) Private Equity
Real Estate Physical Assets (Commodities, Art, Wine, ...)
Foreign Exchange Securitized Products (Mortgages, Loans, ...)
12 2 Financial Assets and Risk Management
cash, fixed-income securities, and stocks. We assume that cash is stored in some kind of
bank account, the interest rate on this account is often referred to as risk-free interest rate.
We briefly describe fixed-income securities. For short-term borrowing, governments and
corporations issue securities with a year or less to maturity. This market, where govern-
ments and corporations manage their short-term cash needs, is called money market. Two
important money market interest rates are the London Interbank Offered Rate (LIBOR)
and the interest rate on Treasury Bills. Treasury Bills, in the U.S., are issued by the New
York Federal Reserve Bank in weekly auctions. The large banks in London are willing to
lend money to each other at the LIBOR rate.
The long-term borrowing needs of corporations and governments are met by issuing
bonds. A bond contract provides periodic coupon payments and redemption value at
maturity to the bondholder. Bonds are either traded over-the-counter or in secondary
bond markets. For more details on fixed-income securities, the reader may refer to Fabozzi
(2005).
Stocks are issued by corporations, which convey rights to the owner. The stock owners
elect the board of directors and have claims on the earnings of the company. The stock
holders are compensated with cash dividends, whose amount is determined by the board
of directors. When we refer to stocks, we mean public stocks. Public trading of stocks
(shares) is regulated by the government. The process of arranging the public sale of
stocks of a private firm is called initial public offering (IPO). In this context, privately
held stocks are referred to as private equity.
Real estate investments are also usually found in institutional portfolios, either direct
or indirect via investment trusts. Since the end of the Bretton-Woods agreement for fixed
exchange rates in 1973, foreign exchange or derivatives on foreign exchange rates are also
found in portfolios. This is usually the case for international investors who want to hedge
against currency risks. As alternative investments we consider hedge funds, managed
futures, private equity, physical assets (e.g. commodities), and securitized products (e.g.
mortgages). Alternative investments are discussed in detail in Chapter 4.
2.2 The Asset Allocation Process
Obviously, the asset allocation process refers to the process of investing money in different
financial assets. There is no generally accepted methodology for this problem. However,
2.2 The Asset Allocation Process 13
there are many keywords describing different stages of the asset allocation process, e.g.,
strategic and tactical asset allocation. We consider the asset allocation process as an
iterative process since a continuous monitoring of the portfolio characteristics is essential.
We consider the assets of Table 2.1 as investment opportunities. Note that the iterative
nature of the asset allocation process implies active portfolio management.
Investement Philisophy
Strategic Investment Objectives and Benchmarks ¾
Asset Allocation Investment Universe
Risk tolerance
?
Traditional Assets:
Investment Security-, Sector-, Global-Market Selection ¾ Strategy
Analysis Alternative Investments: Reassessment
Style Analysis, Manager Selection
?
Review of
Modelling the Investment opportunities Investment
Tactical
Define Mathematical Risk Measure ¾
Asset Allocation Analysis
Implement Strategy
Update of
? the Model
Analysis of realized returns
Monitoring
Benchmark comparison
Fig. 2.1. Asset allocation process
In Figure 2.1, the asset allocation process is shown graphically. The asset allocation
process starts with the strategic asset allocation. The strategic asset allocation is the most
important part of a successful investment strategy. It defines the investment objectives,
the way risk is measured, gives the set of investment opportunities, and sets the constraints
on the single investment positions. The strategic asset allocation should be based on a
long-term focus. Therefore, the outermost feedback loop in Figure 2.1, representing the
process of the strategy reassessment, has a much lower frequency than the other loops.
The next stage is the investment analysis. It may be regarded as a filter for the next
step of the asset allocation process. The main task is the further containment of the
investment universe. This step includes the fundamental analysis of countries, sectors,
companies, commodities, hedge fund managers, etc. If the investment opportunities do

not comply with the investment philosophy or are unfavorable in some kind of fashion, they
are excluded from the investment universe. As the investment strategy, the investment
analysis has to be reviewed at a reasonable frequency. This is symbolized by the middle
feedback loop in Figure 2.1.
After the investment analysis, the definitive investment universe is defined and the
actual portfolio construction can be conducted. This part of the asset allocation process
is called tactical asset allocation. It has to comply with the constraints and rules of the
strategic asset allocation. If the strategic asset allocation and the investment analysis
are carried out accordingly, the tactical asset allocation solely consist of the statistical
modeling and the mathematical optimization problem. Investment analysis and tactical
asset allocation are often combined in the same step. The portfolio construction may be
altered at a predefined frequency, usually defined in the strategic asset allocation. This
is the innermost feedback loop in Figure 2.1. It has the highest frequency of the three
feedback loops.
The last step of the asset allocation process is the monitoring of the portfolio and its
single positions. The new information about the evolvement of the prices of the different
assets is incorporated in the optimization problem, i.e., the model parameters are up-
dated. In addition, the performance in comparison to the benchmark is analyzed. If the
risk tolerance is violated, the portfolio composition has to be altered. If the expected,
additional gains by changing the portfolio positions are lower than the transaction costs,
the portfolio should be left unchanged.
2.3 Risk Management and Risk Measures
There are many examples where improper risk management led to huge losses. Some
examples are Metallgesellschaft in 1993, Barings Bank in 1995, and Long Term Capital
Management (LTCM) in 1998. In each case, catastrophic losses occurred. These cases
highlight the importance of proper risk management.
Obviously, we first need an understanding of risk before the topics of risk management
and risk measures can be addressed. The main problem is that there is no universal
definition of risk and neither are there generally accepted definitions for risk in specific
environments. There is a close relation between risk and uncertainty. Because of the above
2.3 Risk Management and Risk Measures 15
mentioned points we do not state a rigorous definition of risk. For our purposes we may
define risk as follows:
Definition 2.1 (Risk).

Risk is the exposure to some uncertain future event. The probabilities of the different
outcomes of this future event are assumed to be known or estimable.
The mathematical tool to describe problems including uncertainty is probability theory.

The term exposure in Definition 2.1 states that a certain system only contains the risks
of the uncertain events it is exposed to. In a financial context, these uncertain events are
often called risk factors. Therefore, only events which have a dependence on the considered
system may influence its risk. In a financial model with risk factors, the return of an asset
only depends on the considered risk factors. It is common to model stocks with two risk
factors. The first factor represents market risk, the second risk factor is the idiosyncratic
risk of the company. We are only considering risks involved in the realm of investing.
Mathematically speaking, risk is a random variable, mapping the future states of the
world into monetary gains or losses.
The key for every successful investment strategy is a sound risk management. From this
statement the question arises what good risk management is. The two main components
of financial risk management are the modeling of the assets and the definition of the risk
measure. Once these two elements are defined, risk management becomes a formal, logical
process. The first key factor, i.e., the modeling of the assets, is the subject of Chapter 3.
The topic of risk measures is discussed in the following.
2.3.1 The Concept of Utility
In economics, the concept of utility has been introduced centuries ago. Utility is a measure
of the happiness or satisfaction gained from goods or services in an economic context. For
financial problems, the argument of utility function usually is money (consumption). The
first systematic description of risk for financial problems is the concept of risk aversion. It
is introduced in Morgenstern and Neumann (1944) which contains an axiomatic extension
of the ordinal concept of utility to uncertain payoffs. We therefore consider the concept
of risk aversion as the first form of a risk measure. For a risk averse investor, a utility
function U must fulfill certain properties:
• A utility function must be an increasing continuous function: U 0 > 0.

• A utility function must be concave: U 00 < 0.
The first property makes sure that an investor prefers always more wealth to less wealth.
The second property captures the principle of risk aversion. Some commonly used utility
functions include
1. the exponential function (a > 0): U (x) = −e−ax .

2. the logarithmic function: U (x) = ln(x).
3. the power functions (b < 1 and b 6= 0): U (x) = 1b (x)b .
a
4. the quadratic functions (x < 2b
): U (x) = ax − bx2 .
All of these utility functions capture the principle of risk aversion. This is accomplished
whenever the utility function is concave. We will not get into the details of utility the-
ory, for more details the reader is referred to Luenberger (1998), Cvitanić and Zapatero
(2004), and Panjer (1998). Since we are usually not interested in the absolute values of
utility functions but rather in its shape, Pratt and Arrow have independently developed
measures for risk aversion. Let U (x) be a utility function, then the Arrow-Pratt measures
for absolute and relative risk aversion are defined as follows:
00
• the Arrow-Pratt measure of absolute risk aversion: a(x) = − UU 0 (x)
(x)
.
U 00 (x)
• the Arrow-Pratt measure of relative risk aversion: b(x) = −x U 0 (x)
.
The main critique on utility theory is that humans are not always rational. We do not
discuss this topic since we do not derive economic or financial models based on this
assumption. Here, we investigate the performance of rational investment strategies.
2.3.2 Financial Risk
The actual return of every security is always uncertain and therefore full information of the
underlying risks in a portfolio means knowing the exact distribution of the portfolio return.
In addition, one wants to know how the portfolio return distribution is affected by altering
the positions in the portfolio. This is very difficult when dealing in a complex stochastic
environment. Even for single securities it may be hard to find a suitable distribution, e.g.,
for illiquid securities. Therefore, different risk-measures as a single quantity have been
established. These risk measures are characteristic quantities of a probability density
function.
In the realm of financial markets, risk describes the uncertainty of the future outcome
of a current decision or situation. This is put in a more formal manner by introducing the
random variable X, defined on a probability space (Ω, F, P), which denotes the profit or
loss of a financial position. Therefore, X is a real-valued function on the set Ω of possible
scenarios. By L0 we denote the set of all random variables X : Ω → R, which are almost
surely finite. A quantitative measure of risk is given by a mapping % from the set L 0 to
the real line. Formally, the definition of a quantitative risk measure is given as:
Definition 2.2 (Risk measure).

A risk measure is a function % : L0 → R.
The Bank for International Settlements (BIS) is an international organization fostering

the cooperation of central banks and international financial institutions. Its classification
of financial risks is summarized in Table 2.2.
Table 2.2. Financial risks
Market Risk The risk associated with the uncertainty of the value of traded assets
Credit Risk The risk associated with the uncertainty of the default of debtors.
Operational Risk The risk of direct or indirect loss resulting from inadequate or
failed internal processes, people and systems, or from external events.
Liquidity Risk The risk that positions cannot be liquidated quickly enough at critical times.
Model Risk The risk of using inaccurate or wrong models for risk budgeting.
Event Risk The risk of extreme event.
Reputational Risk The risk of losing ones reputation as investment manager.
In this work, the main emphasis will be on dealing with market risk.
Single Period Risk Measures
The systematic treatment of risk measures was introduced in the seminal paper of Artzner,
Delbaen, Eber and Heath (1998), where the properties of good risk measures are described
by some axioms. A risk measure fulfilling these axioms is called a coherent risk measure.
Let the two random variables X and Y denote the profit or loss of two assets. The axioms
for a coherent risk measure % are (r denotes the risk-free rate of interest):
• Subadditivity: ∀X, Y : %(X + Y ) ≤ %(X) + %(Y )

• Positive-homogeneity: ∀X : c ≥ 0 : %(cX) = c%(X)
• Translation invariance: ∀X : c ∈ R : %(X + cr) = %(X) − c

• Monotonicity: ∀X, Y : X ≤ Y : %(X) ≥ %(Y )
The subadditivity property ensures that diversification reduces risk. The positive-
homogeneity property, together with subadditivity, implies that the risk measure is convex.
A risk measure which is translation invariant and monotone is called monetary. Ziemba
and Rockafellar (2000) and Föllmer and Schied (2002) introduce the concept of convex
monetary risk measures. This concept is a generalization of the more restrictive concept
of coherent risk measures. The axioms for convex monetary risk measures are
• Convexity: ∀X, Y : %(cX + (1 − c)Y ) ≤ c%(X) + (1 − c)%(Y ), c ∈ [0, 1]

• Translation invariance: ∀X : c ∈ R : %(X + cr) = %(X) − c
• Monotonicity: ∀X, Y : X ≤ Y : %(X) ≥ %(Y )
In most of the cases it is no loss of generality to assume that a given monetary risk
measure satisfies %(0) = 0. In Ziemba and Rockafellar (2000), modified risk measures are
described as convex monetary risk measures including the properties %(0) = 0 and for
X < 0: %(X) > 0. Some examples of single period risk measures are
• Maximum Loss (ML)

The maximum loss risk measure is intuitive and needs no further explanation. Note
that the maximum loss is unbounded and therefore useless when the return distribution
is neither truncated nor discrete. Sufficient historical data has to be available for the
use of this risk measure.
• Shortfall Probability (SP)
A shortfall is the event when the return of a portfolio drops below a given threshold.
A portfolio manager may not be allowed to drop below a certain performance level;
therefore the manager is interested in minimizing the probability to perform below this
level. Formally speaking:
%SP (a) = P (X ≤ a).
• Method of Moments (MM)

Since the introduction of mean-variance portfolio theory, moments of return distribu-
tions are used as risk measures. The variance is still the most widely used measure to
quantify risk. This has obvious disadvantages, e.g., the sign of the return is not taken
into account. The method of partial moments overcomes the problem of symmetry. As
an example, the partial variance for a given threshold a is formally
%PV (a) = E[X 2 |X < a].
• Value at Risk (VaR)

Value at risk is, besides variance, the most-used quantitative analysis tool in risk man-
agement today. The reason for this is because the BIS has introduced VaR as standard
risk measure for banks in the new Basel Capital Accord (Basel II). It is intuitively
understood and characterized by a confidence level α and the time period considered.
This leads to the following formal expression
%VaR (α) = inf{x ∈ R|P (X ≥ x) ≥ α},
where X denotes the return of a financial position. The VaR-quantity is the maximum
loss over the next time period that will not be exceeded with probability α. The ma-
jor drawback of VaR is that it does not state what the outcome is once an extreme
event has happened, i.e., it contains no information about the tail of the distribution.
Furthermore, VaR is not a coherent measure because it is not subadditive, i.e., di-
versification does not necessarily reduce risk, see Embrechts (2004) for an illustrative
example.
• Conditional Value at Risk (CVaR)
A possible, coherent extension to VaR is the conditional value at risk (CVaR). CVaR
is also known as expected shortfall (ES) and is defined as
%CVaR (α) = E[X|X ≤ %VaR (α)].
Again, a confidence level α is specified and the returns a characterized for a given time
period. CVaR is the expected loss once a return below the VaRα occurs. Informally,
CVaR states “how bad is bad?”. CVaR has the appealing property that it is coherent
in a single-period setting.
Note that, from a regulatory point of view, coherent risk measures should be the
preferred choice. From the point of view of an investment manager it is more comfortable
to work with convex monetary risk measures in order to more accurately model the
investment problem.
Dynamic Risk Measures
The area of dynamic risk measures is still immature and there is no generally accepted
standard. A dynamic risk measure is necessarily a stochastic process. One of the first
publications on this subject is Cvitanić and Karatzas (1999). Formal treatments are found
in Balbas, Garrido and Mayoral (2002), Riedel (2004), and Boda and Filar (2005). In these
publications, coherent risk measures within a dynamic environment are presented. The
axioms for the dynamic case resemble those of the static case. In Cheridito, Delbaen and
Kupper (2004), dynamic risk measures are investigated for processes which are right-
continuous with left limits. The connection between Bellman’s principle and dynamic
risk measures is also found in these publications. Riedel (2004) introduces the concept of
dynamic consistency, which is an important concept in connection with active portfolio
management. A dynamically consistent risk measure rules out contradictory investment
decisions over time. Therefore, if two portfolios have the same risk tomorrow in every
scenario, then these portfolios should have the same risk today. Note that CVaR needs
not to be time consistent in a dynamic environment, as shown in Boda and Filar (2005).
For more details on the subject of dynamic risk measures, the reader is referred to the
publications mentioned above.
3
Modeling of Financial Assets and

Financial Optimization
Young man, in mathematics you don’t understand

things, you just get used to them.
John von Neumann
The choice of asset models is an important success factor of a quantitative investment

strategy. The more realistic the asset prices are modeled, the better the investment strat-
egy performs. In addition, the more accurately the asset returns are reflect by the chosen
distribution, the better the actual risk exposure can be calculated. Therefore, we are in-
terested in distributions which can take the stylized facts of asset returns into account.
Obviously, we do not want to underestimate the taken risks. However, the overestimation
of risk is also unfavorable because this reduces the risk capacity and therefore results in
lower returns. We are interested in models for the financial assets discussed in Chapter 2.
We provide a short overview of the economic and financial models developed so far. We
attribute the first analytic and systematic treatment to Harry Markowitz. In his seminal
publication, Markowitz (1952) models asset returns as multivariate random variables.
Asset returns are modeled as multivariate Gaussian random variables and the investor’s
utility function is quadratic. Therefore, it is often referred to as mean-variance model. The
reader is referred to Panjer (1998) for more details on the mean-variance model. Sharpe,
Lintner, and Mossin have, based on the assumptions of Markowitz, derived the capital
asset pricing model (CAPM), see Sharpe (1964). The CAPM is one of the first factor
models. The importance of the CAPM stems also from its terminology, i.e., the use of the
Greek letters α and β, which are widely used in portfolio management contexts today.
The reader is referred to Sharpe et al. (1998) for more details on the CAPM.
22 3 Modeling of Financial Assets and Financial Optimization
A further milestone in financial modeling is the arbitrage pricing theory (APT) of Ross
(1976). The APT framework is essentially a multifactor model which rules out arbitrage
possibilities. Fama and French (1993) was one of the first publications, giving empirical
evidence that factors explain average returns of stocks and bonds. Treynor and Black
(1973) pioneered the area of systematic active portfolio management. Their ideas have
been refined in Black and Litterman (1991, 1992) by introducing uncertainty about the
model parameters.
Besides the single-period models mentioned above, there is the branch of continuous-
time finance. The breakthroughs of continuous-time finance are the seminal publications
of Black and Scholes (1973) and Merton (1973b). These papers consider the problem of
pricing contingent claims. The continuous-time extension of the CAPM is found in Merton
(1973a). The models of Black, Scholes, and Merton are based on Brownian motion which
implies that returns are normally distributed. The concept of risk-neutral valuation was
introduced by Cox and Ross (1976). Short-rate models are frequently used for modeling
fixed-income securities, see Vasicek (1977) for an example. Concerning the modeling of the
whole term structure, the pioneering work of Ho and Lee (1986) considers the discrete-time
case. The continuous-time case is studied in Heath, Jarrow and Morton (1992).
Besides the just mentioned economic and financial models, a major advance in volatility
modeling is called autoregressive conditional heteroskedasticity (ARCH), introduced by
Engle (1982). This topic is discussed in Section 3.2. The drawbacks of the continuous-
time models of Black, Scholes, and Merton are that returns are normally distributed. This
deficiency is overcome by replacing the Brownian motion with a Lévy process. A Lévy
process is a continuous-time process with independent and stationary increments, based
on a more general distribution than the normal distribution. However, in order to define
such a stochastic process with independent and stationary increments, the distribution
has to be infinitely divisible. Lévy processes take the stylized facts of asset returns much
better into account than Brownian motion. The reader is referred to Schoutens (2003) for
details on Lévy processes in finance.
Of course, this short overview is far from complete. It should serve the reader as an
overview of the models and methods used in this work.
3.1 Statistical Properties of Asset Returns 23
3.1 Statistical Properties of Asset Returns
In Chapter 2, the rate of return is defined as the monetary gain or loss of the investment
divided by the initial value of the investment. This concept is called arithmetic return,
sometimes also denoted as simple return. The return of an asset may also be defined
as the continuous-compounded or log-return. The numerical differences between simple
and log-returns are usually small for high frequencies of data. Both concepts have their
advantages and disadvantages in terms of portfolio and time aggregation. If not stated
otherwise, we usually work with the log-return. The reader is referred to Tsay (2001) for
details.
In order to describe asset returns, the distribution of the asset returns has to be
specified. The distribution can either be parametric, semi-parametric, or non-parametric.
Whilst the fully parametric models are most vulnerable to modeling errors, their mathe-
matical use for further calculations is far richer. For instance, portfolio optimizations are
by far easier with parametric models than with semi- or non-parametric models. Figure
3.1 gives an overview of important parametric models in finance.
Elliptical Stable
Distributions Distributions
Normal Mean-
Variance Mixture
Distributions
Fig. 3.1. Classes of distributions in finance
Elliptical distributions are often reasonably good models for financial return data and
have very pleasing properties. For instance, taking linear combinations of elliptical ran-
dom vectors results in an elliptical random vector of the same type. The marginal and
conditional distributions of elliptical distributions are again elliptical. Popular elliptical
distributions are the normal and the t distribution. For more details on elliptical distri-
butions, the reader is referred to McNeil, Frey and Embrechts (2005).
Stable distributions were introduced by Paul Lévy in 1925. Note that stable distribu-
tions are also called α-stable, stable Paretian, or Lévy stable distributions. The sum of
two independent random variables having the same stable distribution is again a random
variable with the same stable distribution. Note that, in general, there exists no closed
form formula for the density of the the stable distribution. This makes the maximum
likelihood estimation computationally tedious because numerical approximations have to
be used. Stable distributions have infinite variance, in general, which is also an unpleasant
property.
A normal mean-variance mixture distribution is a generalization of the normal distri-
bution. The generalization stems from a positive mixing variable, introducing randomness
into the mean vector and the covariance matrix of a multivariate normal random variable.
Let U be a random variable on [0, ∞), Σ ∈ Rn×n a covariance matrix, and µ, γ ∈ Rn two
arbitrary vectors. The random variable
X| U = u ∼ N (µ + uγ, uΣ)
is said to have a normal mean-variance mixture distribution. This distribution is elliptical

for γ = 0 and is called normal variance mixture in this case. The most important normal
mean-variance mixture distribution we consider in this context is the generalized hyper-
bolic distribution (GH). The mixing variable for the GH distribution is the generalized
inverse Gaussian (GIG) random variable. The reader is referred to Appendix A for the
technical details on normal mean-variance mixture distribution.
Having described the important classes of distributions found in Figure 3.1, the role
of the normal distribution, denoted by N , becomes apparent. It is the only distribution
which is found in every of the three classes. Therefore, the normal distribution is usually
considered as benchmark for the modeling of financial assets. In the sequel of this chapter,
the univariate and the multivariate properties of asset returns are explored. The data
in this chapter is obtained from the Datastream database of Thomson Financial. The
datasets range from 1990 to 2005.
3.1.1 Stylized Facts
There are many publications on the subject of the stylized facts of asset returns. Since
theses stylized facts are observed empirically, they are now more or less accepted. We list
the most important stylized facts.
• Equity returns show little or no serial correlation although they are not independent.
• Equity returns are fat-tailed and skewed.
• Squared or absolute equity returns are serially correlated.
• Volatility is time-varying and appears in clusters.
For high frequency data and their properties see Cont (2001) and the references therein.
A standard reference on high frequency finance is Dacorogna, Gencay, Muller, Olsen and
Pictet (2001). For more details on the stylized facts of asset returns the reader is referred
to McNeil et al. (2005), Ziemba (2003), Campbell et al. (1997), and Campbell and Viceira
(2002).
3.1.2 Univariate Properties
We explore the (unconditional) univariate properties of asset returns. Therefore, we con-

sider the set of univariate distributions. The starting point is the normal distribution,
which is the most popular in portfolio construction since Markowitz (1952). For finance
in general, the normality assumption is found in most models. The first appearance of the
normal distribution in finance dates back to Bachelier (1900).
Another reason for the popularity of the normal distribution is because of the use of
Brownian motion in finance. Although Brownian motion has been mathematically rig-
orously introduced in 1923 by Norbert Wiener, the Brownian motion first shows up in
finance in Osborne (1959). A lot of continuous-time finance results have emerged from
Samuelson (1969) and Merton (1969). The central limit theorem makes the normal dis-
tribution the most important distribution in probability. Some similar phenomenon may
also be observed for equity returns. The lower the frequency of the returns, the more
the distribution of the returns resembles a normal distribution. This means that we may
reasonably model yearly returns as normal. However, daily returns cannot be assumed
normal, statistically.
One of the first published doubts about the normality assumption of asset returns are
Mandelbrot (1963) and Fama (1965). Since then, many more publications on this subject
have appeared. Motivated by the fact that financial returns are skewed and leptokurtic
(fat-tailed), we want to investigate suitable extensions of the normal distribution. Figure
3.1 shows promising extensions of the normality assumption proposed so far.
Standard references for continuous distributions are Johnson, Kotz and Balakrishnan
(1995a, 1995b). Many distributions are not considered because of their unpleasant prop-
erties. The Laplace and the exponential distribution have not been considered because
of their shape, the Cauchy distribution has not been considered because its mean is not
defined. We consider the log-normal, gamma, generalized inverse Gaussian, chi-square,
Weibull, beta, and F distributions as candidates for price distributions, but not for return
distributions.
There are many publications treating skewness and kurtosis values of asset returns.
All of them report that real-world return series are leptokurtic and skewed. Therefore,
we are interested in distributions which are skewed, have fat tails, or both. A possible
extension of the normal distribution is its skewed version, introduced by Azzalini (1985).
The estimation in its original form is inconvenient, we therefore use the methods described
in Pewsey (2000). The results for the skewed normal distribution are rather disappointing
since the skewed normal distribution does not account for fat tails. Therefore, it is not
investigated any further. We may state, as a rule of thumb, that the inclusion of heavy-tails
in return distributions is more important than the skewness aspect.
A fat-tailed extension of the normal distribution is the t distribution. The t distribution
converges to the normal distribution as the parameter ν tends to infinity, see (A.2) for
details. Therefore, a large value of ν indicates that the considered random variable may
also be considered normal. A further extension would be the skewed t distribution. We
use the method of Fernandez and Steel (1998) to extend the t distribution to be skewed,
see (A.1) for details. The skewness is measured by the parameter γ ∈ (0, ∞). We have no
skewness for γ = 1 which results in the ordinary t distribution. The skewed t distribution
obviously has the properties of being leptokurtic and skewed. Note that Hansen (1994)
also introduces a skewed version of the t distribution.
The generalized hyperbolic (GH) distribution is introduced by Barndorff-Nielsen
(1977), although not in a financial context. Eberlein and Keller (1995) use the GH dis-
tribution to describe financial return data and also suggest a hyperbolic Lévy motion.
The GH distribution is a very flexible distribution and is well suited for describing return
data. It contains many important special and limiting cases. Among these are the hyper-
bolic, normal inverse Gaussian (NIG), a version of the skewed t, variance gamma, t, and
the normal distribution. All these distributions are proposed as financial return models
in the literature. For more details on the GH distribution in finance see McNeil et al.
(2005), Knight and Satchell (2000), Prause (1999), Raible (2000), Rydberg (1998), and
Barndorff-Nielsen and Shepard (2001). The density functions of the GH family are found
in Appendix A.2.3.
In his publication, Mandelbrot (1963) finds that the stable distribution is well suited
for describing asset returns. As their name suggests, these distributions have the pleasing
property of being stable. That is, the sum of two independent random variables character-
ized by the same stable distribution is itself characterized by the same stable distribution.
Besides this appealing property, the problem with the stable distribution is that it has
infinite second and higher moments. This is in contrast with empirical observations which
have finite second moments.
Madan and Seneta (1987) introduce the variance gamma distribution. A financial ap-
plication of the variance gamma distribution is found in Madan and Seneta (1990). Note
that Eberlein and von Hammerstein (2004) show that the variance gamma distribution
is a limiting case of the generalized hyperbolic distribution. Carr, Gemna, Madan and
Yor (2002) give a generalization of the variance gamma distribution, called CGMY. The
CGMY distribution is infinitely divisible and therefore also suited for building a corre-
sponding Lévy process. Geman (2002) shows that the GH- and CGMY distribution are
well suited for describing asset returns.
We distinguish between two main classes to model asset returns more realistically.
These classes are the GH class and the class of stable distributions. We investigate further
models of the GH class. The reasons for this are manifold. One important reason is that,
using multivariate distributions of the GH class, the distribution of the portfolio is easily
calculated. Another reason is that for the stable distribution, there exists, in general, no
closed-form of its density. Therefore, the GH distribution is much more convenient to
work with. The most important reason is that various empirical studies, e.g., Akgiray
and Booth (1988), rule out infinite variance of asset returns and therefore also stable
distributions.
We investigate the following univariate distributions: normal, t, normal inverse Gaus-
sian (NIG), skewed t, and generalized hyperbolic (GH). Apart from these parametric
distributions we also consider kernel density estimates. The corresponding kernels are al-
ways chosen to be Gaussian, the bandwidth is optimized with the leave-one-out method,
Normal
70 GH
Kernel density
60
50
density
40
30
PSfrag replacements
20
10
0
−0.06 −0.04 −0.02 0 0.02 0.04 0.06
return
Fig. 3.2. Density estimates for the daily Dow Jones returns.
see Härdle (1992) for details. Figure 3.2 shows the density estimates for the daily Dow
Jones log-returns from 1990 to 2005. The GH distribution gives the best parametric fit in
terms of the log-likelihood value. In this case, the deficiency of the normal distribution is
that it does not account for the fat tails and the thin middle.
−5
log(density)
−10
PSfrag replacements
−15
Normal
GH
−20 Kernel density
−0.06 −0.04 −0.02 0 0.02 0.04

return
Fig. 3.3. Logarithmic density estimates for the daily Dow Jones returns.
In order to analyze the tails, the logarithmic density estimates are plotted in Figure
3.3. Obviously, the normal distribution fits very poorly in the tails, therefore considerably
underestimating the events of extreme losses.
3.1.3 Methodology and Results for the Univariate Case
The distributions are fitted to the return time series by a maximum likelihood approach.
For the model selection part, we use the method of information criteria. In this work, we
use the concept of Akaike (1974). An alternative approach is suggested in Schwarz (1978),
which is more restrictive with respect to higher order models. Accordingly, we chose the
distribution with the lowest information criterion as the best model. By y we denote the
geometric returns of the price data. The parameters of the distribution are assembled in
the vector θ, the estimated parameters are denoted by θ̂. The log-likelihood value of the
estimation is denoted by l(θ̂|y). The Akaike information criterion is defined as
AIC = −2l(θ̂|y) + 2q, (3.1)
where q is the number of parameters of the distribution. The distribution which minimizes
the Akaike information criterion is considered as the best model. As an example, we give
the detailed results for the Dow Jones Industrials index. The results from the maximum
likelihood estimation for a daily frequency are shown in Table 3.1, the best results are
shown in bold numbers. Note that the normal distribution gives the worst fit for daily
returns. Having inspected Figure 3.2 this result is expected.
Table 3.1. Distributions for daily Dow Jones returns.
Distribution AIC value log-likelihood value

GH -25496.33 12753.17
NIG -25482.79 12745.39
t -25468.92 12737.46
Skewed t -25467.84 12737.92
Normal -24914.26 12459.13
In Table 3.1, the GH density has the highest log-likelihood value and therefore fits the
data best. If the number of parameters is taken into account, i.e., we use the AIC criterion
for model selection, the GH distribution still is the best model in this particular case.
Table 3.2 reports the results for different equity indices with data from 1990 to 2005.
The GH, NIG, and the skewed t (s-t) fit the data best in terms of the maximum likelihood
value. In addition, the skewness γ1 and the kurtosis γ2 are given. The normal distribution
is the best model for monthly Nikkei 225 return data. This result is supported by the
values of γ1 and γ2 for the monthly Nikkei 225 returns. The considered stock indices,
in general, have fat tails and are skewed to the left. This is seen from the values of γ 1 ,
which are all negative, and from the values of γ2 , which are all larger than three. For daily
returns, the GH and the NIG distribution are the best models in terms of the AIC value.
In terms of the maximum likelihood value, the GH distribution fits best.
Table 3.2. Distributions for equity index returns.
monthly weekly daily

Equity index min(AIC) γ1 γ2 min(AIC) γ1 γ2 min(AIC) γ1 γ2
S&P 500 NIG -0.36 3.43 NIG -0.41 5.83 GH -0.10 6.89
Dow Jones s-t -0.27 3.71 s-t -0.40 6.34 GH -0.23 7.69
Nasdaq GH -0.53 4.22 NIG -0.45 6.35 GH -0.02 8.74
FTSE 100 NIG -0.38 3.75 NIG -0.33 5.97 NIG -0.09 6.14
CAC 40 s-t -0.46 3.50 t -0.23 4.70 NIG -0.09 5.83
DAX 30 s-t -0.76 4.33 NIG -0.47 5.86 NIG -0.21 6.87
SMI s-t -0.71 5.47 NIG -0.69 7.34 GH -0.25 8.21
Nikkei 225 N -0.13 3.43 t 0.02 4.71 GH 0.20 6.35
S&P Global 1200 s-t -0.41 3.57 NIG -0.46 4.81 NIG -0.19 6.96
Table 3.3 reports the results for some commodities. The results for the daily returns
are similar to the ones in Table 3.2, the GH and the NIG distribution are the best models.
For monthly and weekly returns, the t distribution is often the best choice. Note that the
t distribution is fat-tailed whereas the GH distribution has semi-heavy tails, see Prause
(1999) for details. Commodity returns, in contrary to equity index returns, may be signif-
icantly skewed to the right. The high values of the kurtosis give evidence that commodity
returns have fatter tails than the equity indices in Table 3.2 and the bond indices in Ta-
ble 3.4. Daily returns on oil are significantly more non-normal than the returns on gold,
indicated by the corresponding values of the skewness and kurtosis.
Table 3.4 reports the results for fixed income indices. We consider US Government Bond
indices with different maturities. The indices are total return indices and are calculated
by Thomson Financial. These data sets seem to have thinner tails than the asset returns
Table 3.3. Distributions for commodity returns.

Commodity (index) min(AIC) γ1 γ2 min(AIC) γ1 γ2 min(AIC) γ1 γ2
Gold t 0.60 6.46 t 0.31 8.39 GH -0.08 14.34
Oil (West Texas Int.) t 0.07 3.85 s-t -0.45 8.72 GH -1.47 29.40
Platinum (London) t -0.1 3.75 t -0.02 6.78 NIG -0.24 11.19
Moody’s Commodities Index N 0.30 3.64 t 0.12 4.00 GH 0.04 11.82
GS Commodities Index t 0.14 3.56 t -0.59 8.67 GH -1.02 19.95
GS Energy Index t 0.26 3.80 t -0.04 7.43 GH -0.16 6.42
considered so far. For monthly returns with a maturity of less than seven years, the normal
distribution is the best model in terms of the AIC value. We observe that the longer the
maturity of the bond index, the more the return distribution deviates from the normal
distribution. The NIG distribution is particularly well suited for describing daily bond
index returns. Besides the normal and the NIG distribution, the skewed t distribution
gives the best fits.
Table 3.4. Distributions for bond total return index returns.

FI index min(AIC) γ1 γ2 min(AIC) γ1 γ2 min(AIC) γ1 γ2
US Govt. 1-3 years N 0.008 3.18 t -0.04 3.88 NIG 0.06 7.05
US Govt. 3-5 years N -0.26 3.32 NIG -0.28 3.66 NIG -0.22 5.67
US Govt. 5-7 years N -0.26 3.32 s-t -0.39 3.78 NIG -0.29 5.17
US Govt. 7-10 years s-t -0.38 3.71 s-t -0.45 3.88 NIG -0.36 5.23
US Govt. >10 years s-t -0.49 3.83 s-t -0.41 3.84 NIG -0.33 4.67
US Govt. all mat. s-t -0.40 3.56 s-t -0.42 3.73 NIG -0.32 4.88
For the sake of brevity, we only analyzed the univariate properties of some selected
equities. However, the results for other assets in these classes are similar. Summarizing,
we find that the GH class with its limiting cases offers a fairly good choice for modeling
univariate distributions for asset returns.
3.1.4 Multivariate Properties and Dependence
A portfolio, by definition, consists of more than one asset. Therefore, asset returns must
be modeled as multivariate random variables. The previous section investigated the (un-
conditional) marginal distributions of different kinds of assets. A portfolio is the linear
combination of the components of a multivariate random variable or a random vector,

respectively. As a consequence, the dependencies among the different components signifi-
cantly influence the properties of the portfolio distribution.
The dependence concept used most commonly is correlation, i.e., the linear dependence
of multivariate random variables. If we are considering the mean-variance framework, cor-
relation suffices since the correlation matrix of a multivariate normal distribution fully
describes its dependence. A standard reference on dependence is Joe (1997). It is doc-
umented that correlation is a questionable dependence measure when distributions are
not elliptical, see Embrechts, McNeil and Straumann (2002) and Embrechts, Lindskog
and McNeil (2003) for more details. Therefore, we investigate for dependence measures
beyond correlation.
Most of the distributions introduced in the previous section have a multivariate ver-
sion, see Appendix A.2.3. However, instead of introducing a multivariate distribution
function, there exists another approach to construct a multivariate distribution: a copula
is a function which ties together univariate distributions to a fully multivariate distribu-
tion. Therefore, copulas provide a wide range of possible dependence structures. Copulas
allow for constructing a dependence structure among totally different kinds of margins.
This is not possible with multivariate distributions whose margins usually are of the same
type.
Copulas
In the area of finance, risk management and diversification play central roles. Obviously,
reasonable risk management is not possible without a sound knowledge of the dependen-
cies of the risky assets. Without this knowledge, good diversification cannot be achieved.
The copula approach allows us to separate the modeling of the univariate margins and
their dependencies. A comprehensive introductory paper for copulas in finance is Bouye,
Durrleman, Nikeghbali, Riboulet and Roncalli (2000). We briefly review the most impor-
tant concepts of copulas used in this context. The reader is referred to the literature for
details. A standard reference on copulas is Nelsen (1998), more recent publications are
Mari and Kotz (2004) and McNeil et al. (2005).
A copula is a function C that links the univariate margins with the cumulative distribu-
tion functions Fi of the random variables X1 , X2 , ..., Xn to a full multivariate distribution
F . Therefore, an n-copula is a function C from [0, 1]n to [0, 1] with the properties
• C is grounded and n-increasing.

• C has margins Cn which satisfy Cn (u) = C(1, ..., 1, u, 1, ..., 1) = u, ∀u ∈ [0, 1].
Sklar proved in 1959 that the copula C is unique for a multivariate distribution function F
with continuous margins. Its importance stems from the fact that marginal distributions
and their dependence can be separated.
Theorem 3.1 (Sklar’s Theorem).

Let F be an n-dimensional distribution function with continuous margins F 1 , . . . , Fn .
Then, F has a unique copula representation
F (x1 , . . . , xn ) = C(F1 (x1 ), . . . , Fn (xn )).
Proof. See Nelsen (1998).
With the assumptions of Sklar’s theorem we may also state that
C(u1 , . . . , un ) = F (F1−1 (u1 ), . . . , Fn−1 (un )).
The modeling process within the copula framework has two levels. The first level consists of
modeling the marginal distributions. The second level consists of modeling the dependence
of the margins, i.e, of choosing the appropriate copula. In both levels we may either use
parametric or non-parametric models. The marginal densities of the random variables X i
are denoted by fi . The density f of the multivariate distribution function F is given by
n
Y
f (x1 , . . . , xn ) = c(F1 (x1 ), . . . , Fn (xn )) fi (xi ), (3.2)
i=1
where c is the density of the copula given by
∂C(u1 , . . . , un )
c(u1 , . . . , un ) = .
∂u1 · · · ∂un
We only consider elliptical copulas. Of course, there are other classes of copulas such
as Archimedean copulas, extreme value copulas, or Marshall-Olkin copulas which are not
further investigated. Elliptical copulas are simply the copulas of elliptic distributions.
Archimedean copulas are also popular in finance. The Gumbel copula is an Archimedean
copula which is often found in financial studies. Other popular Archimedean copulas are
the Frank and the Clayton copula. See Schmidt, Hrycej and Stützle (2003) for the GH
copula.
As mentioned in the previous section, the multivariate normal distribution is still the
most popular distribution when modeling asset returns. This makes the Gaussian copula
the most used copula in finance. The multivariate normal or Gaussian copula is given by
CRGa (u1 , . . . , un ) = ΦR (Φ−1 (u1 ), . . . , Φ−1 (un )),
where Φ denotes the standard normal distribution and ΦR the n-dimensional normal
distribution with correlation matrix R. The corresponding density is (ζ i = Φ−1 (ui ))
1 1 T
(R−1 −I
c(u1 , . . . , un ) = p e− 2 ζ n )ζ
,
det(R)
where In denotes the n-dimensional identity matrix. Another copula frequently found in
financial applications is the multivariate t copula,
t
CR,ν (u1 , . . . , un ) = tR,ν (t−1 −1
ν (u1 ), . . . , tν (un )),
where tR,ν denotes the standardized multivariate t distribution with ν degrees of freedom
and shape matrix R. Additionally, tν denotes the standard univariate t distribution with
ν degrees of freedom. The corresponding density is
Qn ζi2 ν+1
t fR,ν (ζ1 , . . . , ζn ) Γ ( ν+n
2
)[Γ ( ν2 )]n−1 i=1 (1 + ν )
2
cR,ν (u1 , . . . , un ) = Qn =p ν+1 ν+n , (3.3)
i=1 f1,ν (ζi ) det(R)[Γ ( 2 )]n (1 + ν1 ζ T R−1 ζ) 2
where ζi = t−1
ν (ui ) and fR,ν denotes the density of a tn (ν, 0, R) distributed random vari-
able, see Appendix A.2.3. The properties of the t copula and related copulas are extensively
studied in Demarta and McNeil (2005). Malevergne and Sornette (2003) investigate ellip-
tical copulas for financial assets. They consider the Gaussian and the t copula and find
that it may be dangerous to blindly assume a Gaussian copula. Breymann, Dias and Em-
brechts (2003) and Dias and Embrechts (2004) analyze elliptical as well as Archimedean
copulas for their use in modeling of financial data. We will investigate the normal and
the t copula. The normal copula is considered because of its importance in finance. The
t copula is investigated because it is a natural extension of the normal copula, i.e., the
normal copula is a limiting case of the t copula. Furthermore, Malevergne and Sornette
(2003) and Dias and Embrechts (2004) find very promising results for the t copula also
in comparison to Archimedean copulas.
Finally, we examine the statistical inference of copulas. For the non-parametric case
we may use the concept of empirical copulas, see Bouye et al. (2000) for details. For
non-parametric margins we may either use empirical distributions or kernel regression
techniques. For details on the method of kernel regression see Härdle (1992). The two
main concepts for statistical inference are maximum likelihood and method of moments.
We will use the maximum likelihood approach since, in general, it is more accurate than
the method of moments. Suppose we have sample of size N , denoted by X . By θ we denote
parameters of the model, θc denotes the parameters of the copula, and θi corresponds to
the parameters of the i-th margin. From (3.2) we immediately obtain the log-likelihood
function l(θ) as
N h ³ ¡
X (t ) ¢´ X
n
¡ (t ) ¢i
l(θ|X ) = log c F1 (x1 i |θ1 ), . . . , Fn (xn(ti ) |θn )|θc + log fj (xj i |θj ) . (3.4)
i=1 j=1
If we have a parametric model for the margins and for the copula, (3.4) has to be
maximized with respect to all of the elements in θ. However, one could also, in a first
step, estimate the parameters of the margins. After having estimated the parameters
θ̂i (i = 1, . . . , n) of the margins, the parameters of the copula are estimated separately.
This procedure could also be applied to a non-parametric estimation of the margins. In
this case we call the procedure a pseudo-maximum-likelihood estimation or inference func-
tions for margins method (IFM). In both ways, the second term in (3.4) does not affect
the estimation of the copula parameters. Therefore it is often omitted in the literature.
By using the IFM method, the inference of the marginal properties and the dependence
properties are separated.
Dependence Measures
We give a brief overview of measures of dependence. For more details on the topic depen-
dence measures, the reader is referred to McNeil et al. (2005), Embrechts et al. (2003), and
Embrechts et al. (2002). In the following, we make use the concept of concordance. Infor-
mally speaking, the concordance of two random variables is the property that large and
(t ) (t ) (t ) (t )
small outcomes of two random processes occur together. Let (x1 i , x2 i ) and (x1 j , x2 j )
be two observations of a random vector (X1 , X2 ) of continuous random variables. We
(t ) (t ) (t ) (t ) (t ) (t ) (t ) (t )
say that (x1 i , x2 i ) and (x1 j , x2 j ) are concordant if (x1 i − x1 j )(x2 i − x2 j ) > 0, and
(t ) (t ) (t ) (t )
discordant if (x1 i − x1 j )(x2 i − x2 j ) < 0.
• Correlation
The most used dependence measure in practice is the correlation. Note that zero cor-
relation is a necessary but not a sufficient condition for independence.
• Kendall’s tau
Kendall’s tau is defined as the difference between the probability of concordance mi-
nus the probability of discordance. Note that Kendall’s tau is a copula property and
therefore independent of the margins, see Nelsen (1998) for details.
• Spearman’s rho
Spearman’s rho is defined to be proportional to the probability of concordance minus
the probability of discordance. As Kendall’s tau, Spearman’s rho is a copula property
and therefore independent of the margins, see Nelsen (1998) for details.
• Tail Dependence
The concept of tail dependence describes the dependence for extreme values. Loosely
speaking, tail dependence describes the limiting proportion of exceeding one margin
over a certain threshold given that the other margin has already exceeded that thresh-
old. We differentiate between lower and upper tail dependence. For elliptical distribu-
tions, these two measures are the same. In a financial context we are mainly interested
in the lower tail dependence since this means concurrent extreme losses.
Definition 3.2 (Lower Tail Dependence).

C(u,u)
If, for a bivariate copula C, the limit λl = limu→+ 0 u
exists, then C has lower tail
dependence for λl ∈ (0, 1] and no lower tail dependence for λl = 0.
As Kendall’s tau and Spearman’s rho, tail dependence is a copula property and there-
fore independent of the margins. The Gaussian copula has no tail dependence. This
is the main deficiency of the Gaussian copula since we know from the empirical prop-
erties of asset returns that asset prices may have concurrent extreme losses. The tail
t
dependence of a bivariate t copula CR,ν is
s
³ (ν + 1)(1 − ρ) ´
λ = 2 tν+1 − , (3.5)
1+ρ
where ρ is the off-diagonal element of R and tν+1 denotes the t distribution with ν + 1
degrees of freedom. For a proof see Embrechts et al. (2002). Note that we can compute
the tail dependence coefficients in any dimension of the t copula in an analogous way.
For the proof see Appendix C.1.
(t ) (t ) (i) (j) (t ) (t )
Let {(x1 i , x2 i )}N
i=1 denote a sample of size N and R1 , R2 the rank of x1
i
and x2 i ,
respectively. Empirically, the tail dependencies can be calculated as
n
1X
λ̂l = 1 (i) (i) .
k i=1 {R1 ≤k,R2 ≤k}
The parameter k has to be defined. It reasonable the set k = αn, where α describes
the percentage of the area under the distribution that is considered as tail.
3.1.5 Results for the Multivariate Case
We fit the considered multivariate models to various typical combinations of assets by

maximum likelihood and analyze the multivariate properties of the asset returns. First,
we analyze the results of different multivariate distributions of asset returns. In a second
step, we elaborate the tail dependencies among several asset classes.
Multivariate Parametric Distributions
As in Section 3.1.3, we aim to select the most suitable model for asset returns. We consider
the multivariate versions of the normal, t, skewed t, NIG, and the GH distribution. The
distribution functions are given in Appendix A.2.3. Again, we make use of the Akaike
information criterion as defined in (3.1). We fit the equity indices of Table 3.2 to the
multivariate distributions mentioned above. The results are shown in Table 3.5; the best
results are shown in bold numbers. The GH distribution gives the best fit in terms of
the log-likelihood value. Surprisingly, the multivariate t distribution is the best model in
terms of the AIC criterion, although it is not frequently chosen for the univariate case in
Table 3.2. We find that the normal distribution fits the data significantly worse than the
other distributions.
Table 3.5. Multivariate distributions for equity indices returns.

Distribution log-l AIC log-l AIC log-l AIC
Normal 2835.5 -5583 16274.8 -32462 106129 -212170
t 2866.7 -5643 16607.6 -33125 108279 -216467
Skewed t 2871.5 -5637 16614.6 -33123 108285 -216464
NIG 2871.4 -5637 16612.3 -33119 108286 -216467
GH 2871.6 -5635 16615.0 -33122 108291 -216474
Next, we fit the commodities found in Table 3.5 to the parametric multivariate distribu-
tions considered. Table 3.6 shows the results; the best results are shown in bold numbers.
As for the equity indices returns, the multivariate t distribution offers a good fit in terms
of the AIC value. This time, the choice of the multivariate t distribution is less surprising
since the t distribution is also frequently chosen in the univariate case. The best fits for
the log-likelihood value are the multivariate skewed t and the GH distribution.
Table 3.6. Multivariate distributions for commodity returns.

Normal 2127.0 -4200 11918.4 -23783 76832 -153609
t 2147.9 -4240 12332.0 -24608 80443 -160829
Skewed t 2149.7 -4231 12334.0 -24600 80447 -160825
NIG 2149.7 -4231 12319.1 -24570 80414 -160761
GH 2149.8 -4230 12333.9 -24598 80445 -160821
We do not give the detailed results of the bond indices of Table 3.4. However, the
results are similar to those obtained so far. Again, the multivariate t distribution offers the
best fit in terms of the AIC value. Although that the univariate distributions for monthly
returns are reasonably modeled with the normal distribution, this is no longer the case for
multivariate distributions. We interpret this finding as the lack of the multivariate normal
distribution to model the dependence structure of bond index returns. In addition to
the deficiencies of the univariate normal distribution, the multivariate normal has further
disadvantages because of its dependence structure.
So far we have only considered multivariate distributions of asset returns belonging
to the same asset class. We consider the portfolio of an US investor. The portfolio of
this investor consists of the S&P 500, Nasdaq, S&P Global 1200, GS Commodities Index,
GS Energy Index, and the DS US Government all maturities index. In this example,
there are no foreign exchange or real estate assets in the portfolio. Neither are there any
alternative investments. The results are shown in Table 3.7, the best results are shown
in bold numbers. Again, the results are similar to the multivariate examples analyzed so
far. The GH and the skewed t distribution offer good fits for the considered multivariate
asset returns. The results for the portfolio substantiate the fact that assuming a normal
Table 3.7. Multivariate distributions for a typical portfolio.

Normal 2351.4 -4649 13147.2 -26241 84841 -169628
t 2376.6 -4697 13532.7 -27009 87751 -175447
Skewed t 2377.7 -4687 13536.4 -27005 87759 -175450
NIG 2377.4 -4687 13518.0 -26968 87724 -175381
GH 2377.7 -4685 13536.3 -27003 87758 -175447
distribution for portfolio construction can underestimate the probability of extreme losses
severely.
For the sake of brevity, we have only analyzed some selected groups of equities. As
expected, the GH family and its limiting cases offer a considerable improvement to the
normal distribution.
Multivariate Semi-Parametric Distributions
In the previous section, we have analyzed the goodness-of-fit of parametric distribu-

tion models. In this section, we consider semi-parametric models. The models are semi-
parametric because we chose non-parametric distributions for the margins. These are tied
together with a copula function in order to have a multivariate distribution function. We
either choose the empirical distribution or the kernel density for the estimates of the mar-
gins. The main advantage of the empirical distribution is that it is trivial to compute. The
main deficiency of using empirical distributions is that the tails may not reflect the true
tails of the underlying distribution. One possibility to overcome this problem is to use
kernel densities. Another possibility would be having parametric tails with models from
extreme value theory and using the empirical distribution for the body of the distribution.
We investigate the Gaussian copula and make comparisons with the t copula. The copulas
are fitted to the same groups of assets as in the previous section. We consider the equities
studied in Table 3.5, the commodities of Table 3.6, and the portfolio of the US investor
found in Table 3.7.
Only the copula parameters are estimated. For the margins, either the empirical dis-
tribution or the kernel density is used, i.e., we only consider the left term in (3.4) for
the maximum likelihood estimation. We find that the log-likelihood values for kernel den-
sity estimates are significantly higher than for the empirical estimates. Therefore, we use
kernel density estimates for the margins.
Table 3.8 shows the result for the three considered cases. The rather low estimates
for the degree of freedom parameter ν indicate that there is considerable tail dependence
for the correlated assets. The higher the frequency of the data, the lower the degree of
the freedom parameter of the t copula becomes. Therefore, a high frequency of return
data implies more tail dependence. By comparing the log-likelihood values of the semi-
Table 3.8. Copula estimations for asset returns with kernel estimations for the margins.

log-likelihood Gaussian t Gaussian t Gaussian t
Equity indices 2876 2889 (ν=15) 16556 16710 (ν=8) 107891 108706 (ν=6)
Commodities 2156 2163 (ν=12) 12296 12441 (ν=11) 80604 81263 (ν=9)
Portfolio 2382 2395 (ν=11) 13497 13638 (ν=9) 87425 88152 (ν=7)
parametric models with the parametric models, we find that the semi-parametric models
with the t-copula give the best fit in every case. The results for the Gaussian copula
are mixed. For monthly returns, the semi-parametric Gaussian model is superior to the
parametric models. This is not the case for weekly and daily data.
The previous section showed that univariate margins, in general, cannot reasonably
assumed to be normal. This section indicates that the Gaussian copula is usually not
suitable for describing multivariate asset returns as well. The interpretation of the results
in Table 3.8 is that the Gaussian copula cannot account for tail dependence, although the
low values of ν indicate significant tail dependence. As the multivariate normal distribu-
tion, the Gaussian copula underestimates extreme losses in a portfolio because it does not
account for concurrent extreme losses of assets in a portfolio.
Tail Dependencies
In the previous section, several alternative dependence measures have been introduced.
Although these dependence measures are found in many scientific texts, they are hardly
found in practice. Nevertheless, Spearman’s rho and Kendall’s tau can easily be calculated.
In addition, the interpretation of these measures is rather simple and resembles the one
of correlation. In contrast to Spearman’s rho and Kendall’s tau, the tail dependence is
not easily calculated. However, we consider tail dependence important since it measures
the degree of diversification in extreme situations. An investor is especially interested in

good diversification once extreme losses occur.
We investigate the tail dependence among different asset classes. This is done by fitting
a t copula to the data and then calculating the tail dependence coefficients accordingly,
as in (3.5). We do not make any modeling assumptions about the margins. Therefore,
the kernel density is used. Note that the results for the tail dependence do not differ
significantly when the empirical distribution is used instead of the kernel density. At first,
we analyze global equity indices, i.e., S&P 500, Dow Jones, Nasdaq, FTSE 100, CAC 40,
DAX 30, SMI, and Nikkei 225.
Table 3.9. Tail dependence coefficients of weekly world equity indices returns. S&P 500 (S&P), Dow Jones (DJI),
NASDAQ (Nas), FTSE 100 (FSE), CAC 40 (CAC), DAX 30 (DAX), SMI (SMI), Nikkei 225 (Nik)
S&P DJI Nas FSE CAC DAX SMI Nik

S&P 1 0.61 0.42 0.21 0.22 0.22 0.20 0.08
DJI 1 0.27 0.21 0.21 0.21 0.21 0.07
Nas 1 0.16 0.17 0.18 0.14 0.08
FSE 1 0.30 0.26 0.27 0.08
CAC 1 0.37 0.30 0.08
DAX 1 0.30 0.08
SMI 1 0.08
Nik 1
From Table 3.9 we observe strong tail dependence between the S&P 500 and the Dow
Jones. Surprisingly, the S&P 500 and the Nasdaq are not as tail dependent as one would
expect. The other numbers are moderate except for the Nikkei, which makes the Nikkei
very suitable for global diversification. If we chose a daily frequency for the returns, the
tail dependencies become much higher. The tail dependence of the S&P 500 and the Dow
Jones for daily returns is 0.93. The Nikkei, for daily returns, has a tail dependence of
approximately 0.2 with the other indices. The low tail dependence of the Nikkei with the
other indices for daily data may be caused by asynchronous returns, see Audrino and
Bühlmann (2003) for details.
We analyze the tail dependencies of the commodities found in Table 3.3. The Goldman
Sachs (GS) indices show considerable tail dependence with oil. The commodities index
and the energy index have a high tail dependence coefficient, indicating that energy prices
are considerably influenced by commodity prices. The other tail dependencies are rather
small. The bond indices found in Table 3.4 are very tail dependent. We interpret this
result as the fact that the duration does not diversify with respect to extreme losses.
Again, we consider the portfolio of an US investor. Recall that this portfolio consists
of the S&P 500, Nasdaq, S&P Global 1200, GS Commodities Index, GS Energy Index,
and the DS US Government all maturities index. The results for this portfolio are shown
in Table 3.10.
Table 3.10. Tail dependence coefficients in a typical portfolio. S&P 500 (S&P5), Nasdaq (Nasd), S&P Global 1200
(S&PG), GS Commodities Index (GSCI), GS Energy Index (GSEI), and the DS US Government all maturities
index (USFI).
S&P5 Nasd S&PG GSCI GSEI USFI

S&P5 1 0.39 0.52 0.01 0.01 0.02
Nasd 1 0.03 0.01 0.01 0.01
S&PG 1 0.01 0.01 0.02
GSCI 1 0.70 0.01
GSEI 1 0.01
USFI 1
We observe that the S&P 500 and the S&P Global 1200 have considerable tail depen-
dence, indicating the global importance of the US economy. However, the Nasdaq and
the S&P Global 1200 have almost no tail dependence. The large tail dependence between
the commodities index and the energy index has already been mentioned. The other tail
dependencies are very small. Therefore, the basic portfolio containing stocks and bonds
makes extreme losses less severe. The US Government all maturities index has low tail
dependence to all other assets, making it very suitable for diversification.
3.2 Dynamic Models of Financial Assets
Having investigated static asset return models in detail, the dynamic models of financial
assets used in this work are briefly discussed. We do not give technical details about the
models. They are either found in the literature or in the corresponding applications later
on. In Section 3.1, the statistical properties of financial assets are studied. These properties
are inherently static and unconditional. However, by inspection of the evolution of asset
prices, it is natural to model them as stochastic processes.
3.2 Dynamic Models of Financial Assets 43
The autoregressive moving average (ARMA) model is popular for financial time series
in discrete time. From the stylized facts of asset returns, we know that returns, in gen-
eral, are not autoregressive. Therefore, we do not aim to model asset returns as ARMA
processes. For more details on ARMA models, the reader is referred to Hamilton (1994).
The stylized facts of asset returns show that squared returns are autocorrelated. In
the introduction of this chapter we mentioned the concept of autoregressive conditional
heteroskedasticity (ARCH). Often, we encounter processes of a generalized ARCH type,
abbreviated by GARCH. There exists a wide range of possible extensions of GARCH
models such as threshold GARCH, denoted by TARCH, and many others. The TARCH
model is particularly well suited for modeling equity returns. For more details on ARMA
and GARCH models in finance the reader is referred to Alexander (2001), Tsay (2001), or
McNeil et al. (2005). A good comparison of different volatility models is found in Sadorsky
(2004). The univariate case for GARCH models is usually not sufficient for interesting
applications. Therefore, we are interested in multivariate models. Popular multivariate
models are the vector GARCH model (VEC) and the BEKK model of Baba, Engle,
Kroner, and Kraft. In this work we will make use of the constant conditional correlation
(CCC) and the dynamic conditional correlation (DCC) GARCH model. The CCC model
was proposed by Bollerslev (1990). The DCC model was introduced in Engle and Sheppard
(2001) and Engle (2002). In these models, as for the copula model, the univariate models
are separated from the dependence structure. Therefore, the univariate time series are
modeled by individual GARCH models and then combined by a dynamic correlation
matrix. The DCC GARCH model offers a good tradeoff between model complexity and
convenience of the estimation of the parameters, see Engle and Sheppard (2001) for details.
We only consider GARCH models in a discrete-time context. For a continuous-time version
see Klüppelberg, Lindner and Maller (2004). Cointegration is a popular model for the
dependence of asset return prices and introduced by Engle and Granger (1987). However,
it is not further investigated in this context.
In general, continuous-time models are mathematically more profound than discrete-
time models. Stochastic differential equations, driven by Brownian motions, are the most
popular continuous-time models. In this type of model, asset returns are assumed to be
(conditional) normally distributed. We have seen in this chapter that this is not always
appropriate. Brownian motion belongs to the family of Lévy processes which offers much
more degrees of freedom to model asset returns. A Lévy process is a continuous-time

stochastic process which is continuous in probability and has stationary, independent
increments. Therefore, the increments of a Lévy process have an infinitely divisible distri-
bution. In a Lévy process framework, we may model asset return distributions as members
of the GH family. This chapter indicates that this type of distribution is well suited for
describing asset returns.
Since the introduction of the APT by Ross (1976), factor models are popular for
describing asset returns. This often results in a linear regression or in an ARMA model.
Factor models represent the thought that asset returns are driven by underlying economic
factors such as dividend yields, price-earnings ratios etc. In addition, the use of technical
factors for forecasting asset returns is popular, e.g., the momentum. Therefore, we consider
the use of factors for two reasons. The first usage of factors is to elaborate the systematic
risks of asset returns. By knowing the return drivers of an asset, the investor obtains
valuable insights with respect to risk management. This is particularly interesting if an
investor is inspecting a financial product. The second purpose of factors is to predict asset
returns. The biggest problem thereby is an in-sample overfitting of the model which has
no out-of sample prediction ability. To overcome this problem, model selection techniques
are necessary. The reader is referred to Burnham and Anderson (1998) for more details
on this topic.
3.3 Financial Optimization Techniques
As mentioned in the introduction, we attribute the first systematic treatment of the port-
folio selection problem to Markowitz (1952). It is still the most popular single-period
financial optimization although its deficiencies are widely documented. We already know
that the normal distribution is not a suitable model for describing univariate or multi-
variate asset returns. Further drawbacks of the mean-variance model are that the risk
criterion is not coherent and that it is only a single period optimization.
Some alternative risk measures to variance in a single-period context are semi-variance
(see, e.g., Markowitz (1959)), mean-absolute deviation (see Konno and Yamazaki (1991)),
expected regret (see Dembo and King (1992)), and conditional value at risk (see Rock-
afellar and Uryasev (2000)). In these models, the actual optimization problem becomes
either a linear or a quadratic program. These can be solved in very large dimensions.
3.3 Financial Optimization Techniques 45
The single period optimization lacks many important properties which are encountered
in real-world investment processes. First of all, it does not account for transaction costs.
Second, the possibility of altering the portfolio at different times in the future is not
taken into account. In a single period optimization problem, the investment decisions are
inherently static.
The deficiencies of single period optimizations can only be taken care of if a dynamic
optimization approach is used. For deterministic systems as well as stochastic systems,
Bellman’s optimality principle and Pontryagin’s minimum principle are often used to
find optimal solutions, see Fleming and Rishel (1975) for details. Bellman’s optimality
principle is also called dynamic programming and is popular in financial optimization.
Some early publications on multi-stage portfolio selection problems are Samuelson (1969),
Fama (1970b), and Dantzig and Infanger (1993).
When the decision or control variables of the optimization problem are constrained,
dynamic optimization problems become very hard to solve. A technique for overcoming
this problem is called model predictive control (MPC). The use of MPC in deterministic
problems is popular, see Bemporad and Morari (1999) for a survey. This is not the case
for stochastic MPC for which many important results have only been found recently, the
reader is referred to Herzog (2005) for details.
Definition of the Estimation of the Implementation of

Computation of
model, constraints, r - model parameters - - of the optimal solu-
the optimal
investment horizon, 6 based on all tion and monitoring
solution.
optimization criterion. available data. of the portfolio.
Evolution of the asset prices P (t) → P (t + ∆t)
Fig. 3.4. The model predictive control concept in finance
Figure 3.4 shows the MPC strategy conceptually. The crucial idea is that in each step,
we solve the whole multi-stage optimization problem but then only apply the current
decision variable. The future decision variables are calculated but are not actually imple-
mented since the current decisions variable is recalculated in each decision step. We can
either have a fixed or a receding horizon.
Besides dynamic programming, there exists a different approach to solving dynamic
stochastic optimization problems, called stochastic programming. For introductory text-
books on stochastic programming, the reader is referred to Louveaux and Birge (1997)
and Kall and Wallace (1994). For applications of stochastic programming see Ziemba and
Mulvey (2001) and Wallace and Ziemba (2005). Further case studies and details on the
interplay between dynamic programming and stochastic programming are found in Her-
zog (2005). For a detailed case study of a stochastic programming approach for the asset
and liability management of a Swiss pension fund see Dondi (2005).
Finally, we give an important result concerning the interplay between the modeling
and optimization of a portfolio. We consider the class of elliptical distributions such as
the multivariate normal, t, and symmetric NIG distribution. Suppose we use an arbi-
trary positive-homogeneous, translation-invariant measure of risk to determine the risk-
minimizing portfolio with a desired return. Then the portfolio weights are the same as if
we used the variance as risk measure. The reader is referred to McNeil et al. (2005) for
the proof. This means that, in an elliptical world, the mean-variance efficient portfolio is
the same as the mean-VaR efficient portfolio.
This section serves as a very brief introduction on the topic of financial optimization.
As a matter of fact it is far from complete. However, the literature on this topic is very
rich. The reader is referred to Deng, Wang and Xia (2000) for nice overview on models
and strategies in portfolio selection. The technical details on the optimization methods
used in this work are provided in the applications.
4
Alternative Investments
We must believe in luck. For how else can we

explain the success of those we don’t like?
Jean Cocteau
4.1 Introduction
The traditional portfolio consists of fixed-income securities, stocks, real estate, and cash.
In Chapter 2, further types of assets have been introduced, called alternative investments.
Alternative assets give investors a further degree of freedom to manage the risk-return
characteristics of their portfolios. We call hedge funds, managed futures, private equity,
physical assets (e.g. commodities), and securitized products (e.g. mortgages) alternative
investments. The statistical properties of some commodities have been studied in Chap-
ter 3. The main emphasis of this chapter is on hedge funds. The inherent properties of
hedge funds significantly differ from those of private equity and securitized products.
Therefore, the results of this chapter cannot be generalized to private equity investments
and securitized products.
The first hedge fund is usually credited to Alfred Winslow Jones in 1949. However,
Ziemba (2003) finds that already John M. Keynes was using hedge fund techniques in an
endowment portfolio in the 1920s. Since these early stages of hedge funds, the hedge fund
industry has developed a wide range of different strategies to exploit market inefficiencies.
The legal environment for hedge funds differs from the legal environment of traditional
investments. Hedge funds are usually not allowed to make public advertisements. Also,
hedge funds are often domiciliated in off-shore regions, i.e., in regions which are favorable
for tax and legal reasons. Popular off-shore locations are Caribbean islands such as the
48 4 Alternative Investments
British Virgin Islands or the Cayman Islands. Having discussed some issues about hedge
funds, we finally give a formal definition of a hedge fund.
Definition 4.1 (Hedge Fund).

A Hedge Fund is a generally pooled private investment vehicle, often in the form of part-
nerships or limited companies. It is loosely regulated and not required to have a particular
performance objective or fee structure. Hedge Funds are not widely available to the public
and may have a limited number of investors. They do not prohibit the use of leverage,
short selling, or the use of derivatives.
From this definition, the differences of hedge funds compared to mutual funds are
obvious. Mutual funds are highly regulated, are neither allowed to use leverage, nor to
sell short, or to hold derivatives, and have a given free structure. The differences between
hedge funds and mutual funds are discussed in Fung and Hsieh (1997, 1999). Often,
high minimum investments are required for investing in hedge funds. In addition, lockup
periods prevent investors from withdrawing money quickly.
As of December 2005, the hedge fund industry consists of some 8000 funds and manages
about US$ 1.1 trillion of assets, according to Hedge Fund Research, a provider of hedge
fund data. By considering the evolution of the assets under management in Figure 4.1,
we observe a steady growth of the industry. The assets under management have consid-
erably increased since 2002. However, according to the Investment Company Institute, a
mutual fund data provider, there are currently US$ 16.1 trillion invested in mutual funds
worldwide. This makes hedge fund investments rather small in comparison to mutual fund
investments. Seen under the caveat that hedge funds are not open to the public, the figure
of US$ 1.1 trillion is still impressive.
Because of fraud scandals and their loose regulation, hedge funds are often discussed,
in the press as well as in politics. This means that investment managers may commit
themselves to a considerable amount of reputational risk by including hedge funds in
their portfolio. One of the biggest hedge fund disasters in history, as briefly discussed
next, has forced the management of financial institutions to leave the company because
of the huge losses incurred.
The best known hedge fund disaster is the case of Long Term Capital Management
(LTCM), which occurred in 1998. This major event is also observable in Figure 4.1. The
literature on LTCM is vast, we only give a few references. A very detailed description of
4.1 Introduction 49
1200
1000
Total Assets [$bn]

800
600
400
200
PSfrag replacements
0
1994 1996 1998 2000 2002 2004
year
(Source: Hedge Fund Research)
Fig. 4.1. Assets under management by the hedge fund industry.
the LTCM story is found in Lowenstein (2000). Jorion (2000) analyzes risk management
aspects of the LTCM disaster. Because of the legal structure of hedge funds, investors
take on more risk of fraud with hedge funds than with mutual funds.
The legal environment of hedge funds is most probably subject to changes in the near
future. Important issues are transparency and the obligation to register. As the emphasis
of this work is not on the legal aspects of hedge funds, although it is an important issue,
we will not discuss this topic any further. The reader is referred to Lhabitant (2002) or
Cottier (1997) for details on legal and regional aspects.
The question whether hedge funds as such are “good” or “bad” is a debate which has
been ongoing for years. Opponents of hedge funds blame them for several reasons. One
argument is that hedge funds are driving asset prices away from their equilibria because
of speculation. Another is that hedge funds are causing financial crises or at least making
them worse once they occur. The opposite side claims making markets more efficient,
effectively stabilizing markets. Fung and Hsieh (2000a) make an attempt to analyze the
market impact of hedge funds. We do not cover this interesting topic in this work because
it is less important for portfolio construction and risk management.
It is not obvious whether hedge funds are a distinct asset class or not, i.e., a set of assets
with stable and homogeneous characteristics. From a conceptual point of view, hedge funds
are just a mix of different assets which are actively traded. This does not make hedge funds
an asset class of its own. For regulatory and reporting reasons, however, institutional
investors often consider hedge funds as a distinct asset class. The investment process for
hedge funds differs considerably from the case of traditional assets. Additionally, hedge
funds have a different risk-return profile than most other assets. This makes them a
distinct asset class for portfolio construction. The statistical properties of hedge fund
returns demand more sophisticated models than traditional assets. This topic is discussed
in more detail later in this chapter.
Note that all financial data used in the sequel of this chapter is obtained from the
Datastream database of Thomson Financial. The hedge fund data is only available on a
monthly basis. All data ranges from 1994 to 2005.
4.1.1 Hedge Fund Fee Structure
Hedge funds usually charge a management fee and an incentive fee, whereas mutual funds
only charge a management fee. In addition, there is a high watermark included in the fee
structure of a hedge fund. This means that the manager will only receive incentive fees if
the cumulative returns can make up for previous losses.
The incentive fee rewards the hedge fund manager for high absolute returns. In ad-
dition, hedge fund managers usually have a considerable amount of their own money
invested in the fund. This should motivate the manager to produce high risk-adjusted
returns. Kouwenberg and Ziemba (2004) find that incentive fees increase the risk ap-
petite of managers considerably. Only if the manager has a substantial amount of his
own money in the fund, the risk taking is reduced. Kouwenberg and Ziemba (2004) also
give empirical evidence that hedge funds with high incentive fees have significantly lower
mean returns (net of fees) and worse risk-adjusted performance. Liang (1999) finds that a
high watermark is very effective in aligning the manager’s interest with the fund perfor-
mance. Goetzmann, Ingersoll and Ross (2003) find a closed-form expression for the value
of a hedge fund manager contract. They state that the value of a hedge fund contract
is increased with the variance of the portfolio under certain conditions and provide a
discussion of the compensation structure of hedge funds. Hedge fund fee structures are
also discussed in Ackermann, McEnally and Ravenscraft (1999). Brown, Goetzmann and
Park (2001) find that the risk choice of managers is motivated by industry benchmarks
and not by high watermarks.
4.1 Introduction 51
Summarizing, the academic literature on performance fees of hedge funds suggests that
high watermarks and a considerable amount of the fund managers own money in the fund
are favorable for the investor’s interest.
4.1.2 Hedge Fund Terminology
When dealing with alternative investments, we always find the Greek letters α and β. The
terminology stems from the capital asset pricing theory (CAPM), introduced by Sharpe
(1964). In the CAPM, beta refers to the market risk. This concept has been generalized
and is now often found in the literature as
n
X
r(t) = α(t) + βi (t)Fi (t) + ξ(t), (4.1)
i=1
where r(t) refers to the return of the hedge fund, α(t) its intercept, F i (t) an arbitrary
factor, βi (t) the factor loading, and ξ(t) is a white noise process. Often, α(t) and β(t)
are assumed to be constant. The estimation of the alpha and betas then reduces to a
simple linear regression. One of the key questions in hedge fund research is actually the
search of alpha and the detection of the betas. However, these goals are either difficult or
impossible to achieve. In order to find the manager’s real alpha and the actual betas, one
has to know the hedge fund’s investment universe and the financial products used therein.
As hedge funds are, in general, reluctant to give the investor insights into these topics, the
investor has to use a simplified, hypothetical investment universe of the hedge fund. By
introducing the hypothetical investment universe we are speaking of systematic returns
of hedge funds and not of the actual sources of returns. However, systematic risk is often
found as the term sources of returns in the literature. But without an exact knowledge
of the investment positions of a hedge fund over time, the determination of the return
drivers of hedge funds is virtually impossible. Note that the estimation of alpha and its
significance also depends considerably on the underlying model, see Amenc, Curtis and
Martellini (2003) for a detailed study.
4.1.3 Hedge Fund Styles
There exists a huge variety of different styles by which hedge fund managers actively
manage their portfolios. However, there is neither a generally accepted definition for hedge
fund styles, nor is there a general classification of these. Nevertheless, many participants
in the industry made attempts to identify and classify hedge fund styles. In Table 4.1, a
broad overview of common hedge fund styles is shown. Note that the directional style is
often described as opportunistic.
Table 4.1. Hedge fund styles
Directional Relative Value Event Driven Others

Global Macro Convertible Arbitrage Risk (Merger) Arbitrage Funds of Hedge Funds
Long/Short Equity Equity Market Neutral Distressed Securities Equity Market Timing
Dedicated Short Bias Fixed Income Regulations D Equity non Hedge
Emerging Markets Relative Value Arbitrage Multi-Strategy Multi-Strategy
The long/short equity style was already used by Alfred Winslow Jones in 1949. It
hedges market risk and derives its returns from equity selection skills. The return sources
of the common directional style are the correct predictions the movements of security
prices. Leverage is sometimes used to increase returns. The relative value style seeks
out relative pricing discrepancies between related instruments in equity and fixed income
markets. An event driven manager invests in corporations involved in special situations
such as mergers and acquisitions. Multi-strategy funds do not have a pure style but rather
have a mixture of several styles. Funds of hedge funds invest in several hedge funds and
are therefore very different to the styles described so far. Funds of hedge funds will be
discussed later in this section. A detailed description of the different hedge styles is found
in Cottier (1997), Lhabitant (2002, 2004), and Jaeger (2002).
An important topic in the realm of hedge funds is style analysis. Investors are interested
in which strategy a hedge fund is following in order to allocate their money or to assess
risk. The manager’s investment strategy and the investment universe determine the major
part of the risk profile of the hedge fund. Note that hedge funds are classified by styles,
however, this does not necessarily describe their strategy. The strategy, in contrary to
the style, is described by the investor’s degree of freedom to invest in the hedge funds
investment universe. Nevertheless, investors are interested whether a hedge fund applies
its reported style and whether this style is consistent over time. Bares, Gibson and Gyger
(2004) find that style consistency can significantly affect the survival probability of a
hedge fund. This corroborates the style analysis for hedge funds.
Style analysis for investment funds and traditional portfolios was pioneered by Sharpe
(1992). This style analysis is basically a factor model with the constraint that the factors
4.1 Introduction 53
are returns on asset classes. Since hedge funds make use of dynamic trading strategies,
the concept of Sharpe may not be applied to hedge funds as such. Not only do we not
know what the exact investment universe of the hedge fund is; we also do not know how
the investment positions change over time. Obviously, hedge fund mangers are reluctant
to give this kind of information since it would reduce their edge. Because of their dynamic
behavior, hedge funds returns may have a non-linear relationship to the returns of other
asset classes.
The classical style analysis is usually extended by more factors than just the returns on
asset classes in order to account for the special properties of hedge funds. These additional
factors are supposed to explain the trading style and the leverage decisions of hedge fund
managers. These factors are discussed in detail later in this chapter.
Fung and Hsieh (1997) state that managers having the same style will generate corre-
lated returns. They use principal components and factor analysis to extract style factors.
By this, they circumvent the linear structure of classical style analysis by introducing these
new factors. Fung and Hsieh essentially find five dominant investment styles. Brown and
Goetzmann (2003) use a generalized least squares procedure to identify different hedge
fund styles. They find eight different hedge fund styles. However, from Table 4.1, we find
much more conceptual hedge fund styles, which are obviously not all distinguishable by
numerical analysis. These findings show that there are probably more qualitative styles
than quantitative styles.
Another approach to analyze the styles of hedge funds is described in Lhabitant (2002).
The main idea in this kind of style analysis is to apply classical style analysis with the
nine Tremont hedge fund indices as asset class substitutes; see Table 4.3 (page 66) for the
list of the Tremont hedge fund indices. This also circumvents the non-linear exposure of
hedge fund returns to traditional asset classes.
4.1.4 Funds of Hedge Funds
Funds of hedge funds, as their name suggests, allocate money among several hedge funds.
In the sequel, we use the terminology fund of funds instead of fund of hedge funds. A
fund of funds may either use a top-down or a bottom-up approach to select different
hedge funds. In the top-down approach, the style diversification is established first. In a
second step, hedge fund managers from the corresponding style classes are chosen. The
problem of the top-down approach is that there may not be sufficiently many good hedge
fund managers for a particular style available. In the bottom-up approach, the hedge
fund universe is screened for the best managers and then the fund of funds portfolio is
constructed accordingly. This may result in a significant exposure to a specific risk factor
or group of risk factors, i.e., a clustering of risks. The importance of style diversification
is also documented in Brown and Goetzmann (2003).
The main advantages of fund of funds are the diversification of risk, the lower minimum
investment requirement, and the access to closed funds. Fund of funds can, at least to
some extent, reduce the idiosyncratic risk of hedge funds by diversification, making the
hedge fund investment less risky. Due to minimum investment requirements for single
hedge funds, it may be difficult for a single investor to hold a diversified hedge fund
portfolio by himself. In addition, the managers of the fund of funds usually have a better
understanding of the industry and a broader manager network than the investor. Because
of the larger size of the fund of funds, the managers get more insight into the single hedge
funds, sometimes even privileged access.
Having described the advantages of fund of funds, one might wonder why someone
would invest in single hedge funds at all. Unfortunately, there is also the flip side of the
coin. We list some severe disadvantages of investing in fund of funds: the most important
disadvantage is the second layer of fees. Brown, Goetzmann and Liang (2004) and Amin
and Kat (2003) find that the fees on fees in fund of some funds are too high and therefore
offer the investor no added value. The second disadvantage lies in liquidity. Fund of funds
usually offer better liquidity than the funds. This may lead to severe problems when too
many investors want to withdraw their money at the same time. As a last disadvantage
we mention the lack of control of the investor. If the investor disagrees with the inclusion
of new hedge fund in the fund of funds, the only possibility for the investor is to sell all
his shares in the fund of funds.
4.1.5 Hedge Fund Performance
Besides the risk, the performance of an asset class is a crucial input for the strategic asset
allocation. Measuring the performance of traditional asset classes is conceptually not
difficult, because traditional investments are sufficiently regulated and are well studied.
In addition, there are several de facto benchmarks. For equities, the MSCI World Index
4.1 Introduction 55
is often considered as benchmark for world wide equities. The S&P 500 index is often
considered as benchmark for US equities.
In contrast to the performance measurement for traditional assets, the performance of
hedge funds is very difficult to measure. The main reasons for this is that hedge funds are
not obliged to report. Nevertheless, the hedge fund industry has launched several indices
to meet investors’ demand for benchmarks. The basis for the calculation of these indices
are hedge fund databases which include style and performance information. Since there
is no generally accepted definition for hedge fund styles, the categorization of hedge fund
performance figures is difficult. Therefore, the comparison of hedge fund indices among
various hedge fund data providers leads to confusion because of the lack of standardization.
For a list of various hedge fund data providers see Lhabitant (2002).
Since hedge fund managers do not have to report, all hedge fund databases have the
same problem of not being complete. Whether these databases are still representative for
the whole industry is, again, a difficult question and is not addressed in this context. The
reporting of hedge fund performance data is usually not audited. This leads to several
biases in hedge fund databases; see Liang (2003) for a discussion on the importance of
audited hedge fund data. We list the most important systematic biases which are present
in hedge fund databases.
• Survivorship Bias
In some databases, funds which do no longer report their performance figures are ex-
cluded from the database. Poor performance is one reason for hedge fund managers to
stop reporting. However, if a manager closes the fund for new investors because the
optimal size of assets under management has been reached, the manager may also stop
reporting performance figures. Since the reasons for a manager to stop reporting are
manifold, survivorship bias is hard to quantify. See Ibbotson and Chen (2005), Bares
et al. (2004), Liang (2000), Fung and Hsieh (2000b), Ackermann et al. (1999) for esti-
mations of the survivorship bias. However, the estimated numbers differ significantly
because of the already mentioned discrepancies in different hedge fund databases. Es-
timated numbers of survivorship bias range from 1.5% to 3%. Survivorship bias is
considerably easier to estimate for mutual funds.
• Selection Bias
Every database can only consist of a subset of all existing hedge funds. The first type
of selection bias stems from the fact that hedge fund managers do not have to report.
This is the same mechanism that also causes survivorship bias. The reasons for hedge
fund managers to report have already been discussed in the topic of survivorship bias.
The second type of selection bias arises from data vendors having additional selection
criteria to add hedge funds to their databases.
• Backfill (Instant History) Bias
Hedge funds usually undergo an incubation period with seed money before they are
offered to a broader audience. Once they are included in a database, their previous
returns are included into the database as well. Obviously, only successful funds survive
the incubation phase. Therefore, the database gives a too optimistic picture of the
hedge fund universe. Fung and Hsieh (2000b) estimate the backfill bias by 1.4% on
major hedge fund databases. Ibbotson and Chen (2005) find a backfill bias of 4.8%.
These biases are just an excerpt of the most important biases. Another bias is reporting
bias. Reporting bias originates from hedge funds which report the performance manner
not in an objective fashion but favorable for their track record. This may be the case
when a hedge fund is invested in instruments which are hard to price, e.g., illiquid assets.
These biases may also affect the statistical properties of hedge funds. Ackermann et al.
(1999) show that survivorship bias can effect the first two moments and the correlations
of hedge fund returns.
As mentioned, hedge fund indices are calculated from hedge fund databases. Since these
databases are biased, hedge fund indices inhere these biases by construction. Amenc and
Martellini (2003) discuss the problem of hedge fund indices and construct pure style
indices using either a Kalman filter or a principal component approach. A detailed per-
formance measurement for various different models is conducted. They find a wide range
of different alpha estimates for different models. This underlines the inherent problems of
accurate performance measurement of hedge funds. Nevertheless, performance measure-
ment remains an important topic for hedge funds. An interesting aspect of performance
measurement is performance persistence. The investor is only interested in hedge funds
which persistently deliver good performance. Gibson, Bares and Gyger (2003) find short-
term performance persistence but no significant long-term persistence. See also Amin and
Kat (2003), Agarwal and Naik (2000), and Lochoff (2002) for more details on performance
persistence.
4.2 Systematic Risks of Hedge Funds and Risk Management 57
The actual performance of hedge funds should be measured by risk-adjusted perfor-

mance measures. The most popular risk-adjusted performance measure for traditional
investments in the Sharpe ratio, introduced by Sharpe (1966). Having its origins in the
CAPM, the Sharpe ratio relies on variance as a risk measure, whose deficiencies are well
known. Nevertheless, the Sharpe ratio is also the most widely used risk adjusted perfor-
mance measure for alternative investments, as found in Amenc, Martellini and Vaissie
(2002). Because of the non-normality of at least some hedge fund styles, several further
risk adjusted performance measures have been developed. These risk measures are usually
based on the left-hand side of the distribution, therefore called downside risk measures.
Popular risk measures based on downside risk are the Sortino, the Sterling, and the Burke
ratio. Also popular are the return-on-VaR measure and the Omega performance measure.
The reader is referred to Amenc, Malaise and Vaissie (2005) for details on these risk
measures and how to use them in practice.
Note that these measures are closely related to the ones used in active portfolio man-
agement, where the benchmark plays a central role. Obviously, the returns of the active
portfolio are compared to the returns of the benchmark. The comparison between the
active portfolio and the benchmark is usually done by considering the differences between
the corresponding returns. The mean of this difference is the average outperformance and
often called alpha. The standard deviation of the difference is called tracking error. The
ratio between alpha and tracking error is a revised Sharpe ratio, often called information
ratio. The problem with all these risk-adjusted performance measures is that the inherent
risk measures are all not coherent. Therefore, extreme risks are not sufficiently taken into
account. The considered performance measures cannot protect the portfolio against large
losses in market stress. Therefore, a conditional risk measure such as CVaR should also
be considered for risk-adjusted performance measures.
4.2 Systematic Risks of Hedge Funds and Risk Management
We aim to discuss two closely related topics in this section. First, we discuss the topic
of systematic risks of hedge funds. Second, important topics for the risk management of
hedge funds are discussed. The connection between these two topics stem from the fact
that the systematic risks determine an important part of the risk profile of a hedge fund
or a fund of funds. It is always possible to analyze unconditional hedge fund returns, but
knowing the underlying risk exposures gives the investor more insight. Consequently, the
knowledge of the risk exposures of all assets in a portfolio allows the investor to analyze
the behavior of a combination of different assets.
As for traditional assets, we differentiate between systematic and idiosyncratic (non-
systematic) risks. Systematic risk is defined as the part of risk which is not diversifiable.
The other part of risk is called idiosyncratic risk. It is standard in finance to assume that
the investor is only compensated for systematic risk and not for idiosyncratic risk. The
most prominent model for this theory is the CAPM of Sharpe (1964). Whilst systematic
risks for traditional assets, e.g., stocks, are well understood, this is not the case for hedge
funds. From the classification of hedge fund styles, we know the conceptual return drivers
of the corresponding funds. As mentioned, hedge funds usually give no details about
their investment positions. However, this information would be needed in order to exactly
identify the specific risks of a hedge fund. This problem worsens once we combine several
hedge funds of different styles in a portfolio of hedge funds. Idiosyncratic risks of hedge
funds are risks such as operational risk, model risk, or the risk of fraud. We do not discuss
idiosyncratic risk of hedge funds in detail. It is a very difficult question how idiosyncratic
risk of hedge funds is to be quantified. Therefore, due diligence is as important as a
quantitative analysis when assessing idiosyncratic risk of hedge funds.
Having introduced the concept of separating risk into systematic and idiosyncratic risk,
we are interested whether this concept is also found empirically. A straight-forward idea
to measure the idiosyncratic risk of hedge funds would be to use the same approach as for
stocks, i.e., to analyze the combination of different assets. Fung and Hsieh (2002) build
randomly selected portfolios of hedge funds and analyze the variance for an ever larger
number of hedge funds. They confirm that risks of hedge funds may be separated into an
idiosyncratic and systematic part. However, it takes a lot of hedge funds (more than 120)
for the idiosyncratic risk to finally diminish. Therefore, Fung and Hsieh suggest considering
systematic risk style by style, which does make sense. Similar results for systematic risk are
also found in Patel, Krishnan and Meziani (2002). However, there are also disadvantages
when building portfolios of hedge funds. Lhabitant and Learned (2003) find that the more
funds are assembled into a portfolio, the higher the correlation with the equity market
becomes. In addition, the kurtosis rises with the number of funds combined. Because of
this finding, extreme losses cannot be reduced through diversification of idiosyncratic risks.
The contrary is the case, the higher kurtosis even indicates that extreme losses actually
become worse through diversification. Lhabitant and Learned suggest not to have a too
high number of funds combined (5-10), because the added value in the overall portfolio is
successively decreased otherwise.
By isolating the systematic risk through a combination of a large number of hedge
funds, we can examine the properties of systematic hedge fund risk. We want to know
whether an investor is exchanging idiosyncratic hedge fund risk for systematic exposure
to traditional risks by diversifying among hedge funds. This is a very crucial question
because the investor is certainly not interested in paying hedge fund managers fees for
risk exposures already present in the original portfolio.
We have already discussed the topic of the sources of returns of hedge funds. Recall that
this terminology may lead to confusion. If we knew the sources of returns, the exact risk
profile of the hedge fund in connection with the portfolio would be known. Unfortunately,
this is not feasible because we virtually never have full information about the positions of
a hedge fund. However, for portfolio construction, we are interested in the systematic risks
of hedge funds and not in the actual underlying sources of returns. Of course, systematic
risks do only reflect an abstract part of the real sources of returns. Nevertheless, knowing
the systematic returns of hedge funds allows the investor to more accurately identify the
risk profile of the portfolio. This is of special importance when hedge funds are combined
with different types of assets.
4.2.1 Systematic Risks of Hedge Funds
We have argued previously in this chapter that hedge funds are conceptually not a dis-
tinct asset class but rather a dynamic combination of traditional assets and derivatives.
However, by inspection of hedge fund returns, we observe that the statistical properties
of hedge fund strategies are different from those of traditional assets. In addition, the
legal environment of hedge funds is way different from the one of traditional assets. In
contrast to mutual funds, the returns of hedge funds do not only depend on the invest-
ment universe of the fund. The returns of hedge funds do also depend on the dynamic
trading strategy of the fund, which also includes the leverage decisions of the manager.
Once the idiosyncratic risk of hedge funds is eliminated by constructing a fund of funds
with sufficiently many hedge funds, only the systematic risk remains. We are interested
in the nature and the profile of systematic risk. One way to explore the systematic risks
of hedge funds is to consider hedge fund indices. Conceptually, hedge fund indices are the
same as a large fund of hedge funds. Therefore, the idiosyncratic part of risk in hedge
fund indices is considered negligible.
We are particularly interested if these systematic risks have an exposure to other risks.
The literature on propositions of risk factors explaining systematic hedge fund risk is
vast. We review some of the literature and give a collection of the most common risk
factors. In particular see Chan, Getmansky, Haas and Lo (2005), Schneeweis and Spurgin
(1998, 1999), Amenc, Bied and Martellini (2002), Agarwal and Naik (2004), and Jaeger
(2003). Table 4.2 gives a summary of the risk factors found in these publications.
Table 4.2. Common risk factors of hedge funds
Equity markets Fixed income related Commodities Various

US equity index Term spread Oil Volatility
World equity index Credit spread Gold Currency factor
Emerging markets index US government bond index GS Com. Index Momentum factors
Value minus growth US corporate bond index Moving averages of indices
Small cap minus large cap Treasury bills Lagged returns of equity indices
Bank index Treasury bills minus LIBOR Absolute returns of indices
Dividend yields High yield bonds Option based risk factors
We give the economic interpretation for some of the factors: Treasury bills stand for
future economic activity, the credit spread for the default premium, the oil price for
short-term business cycles, and the bank index for the supply of liquidity for hedge funds.
Option-based risk factors are essentially non-linear dependence properties of hedge fund
returns to returns of traditional assets. For more details on the factors of Table 4.2 and
their explanatory power, the reader is referred to the literature.
The risk factors for explaining hedge fund returns are also found as asset-based style
factors in the literature. In the realm of hedge funds, asset-based style factors are rule-
based replications of hedge fund styles using traditional assets and derivatives. The reader
is referred to Fung and Hsieh (2004) for asset-based style factors for different hedge
fund styles. The option-like pay-off structure to traditional asset classes is documented in
Agarwal and Naik (2004), Lhabitant (2004) and many other publications. For instance,
Fung and Hsieh (2001) model trend-following strategies as lookback straddles.
4.2.2 Risk Management for Hedge Funds
We have argued that mean-variance optimization cannot capture the statistical proper-
ties of traditional assets for portfolio construction. If hedge funds are included in the
investment universe, the notorious weaknesses of the mean-variance approach become
even more apparent. This is also widely documented in the literature, e.g., see Lhabitant
(2004), Lo (2001), or Fung and Hsieh (1998). The main reason for this is that correlation
is no longer sufficient to measure diversification. Hedge funds have usually low correla-
tions with traditional assets and a better Sharpe ratio than traditional assets, making
them very favorable in terms of the mean-variance framework. This, however, leads to
over-allocation of money to hedge funds in a mean-variance framework. The problem lies
in the fact that hedge funds incur extreme losses when other assets have extreme losses
as well. Therefore, when diversification is needed most, it essentially vanishes.
Lo (2001) may be considered as a primer for the risk management for hedge funds. The
problems of the use of classical risk management tools for hedge funds are highlighted.
Additionally, the need for the special consideration of risk management for extreme events,
i.e., tail risk, is stressed and illustrated in an example. Lo also discusses the problems of
the use of value at risk in the realm of hedge funds. The ease of building an impressive
track record with options is highlighted. This can be done by using derivative securities
to mimic dynamic trading strategies. This subject is extensively discussed in Haugh and
Lo (2001). An example of such a strategy would be the shorting of out-of-the-money put
options. This strategy gives small positive returns most of the time. However, if a negative
return of this strategy once in a while occurs, this loss is extreme. The additional danger
with this type of strategy is that it is hardly revealed from the hedge funds balance sheet,
even with full position transparency. Anson and Ho (2003) find that event driven strategies
actually have this type of risk exposure to the equity market. Because of this behavior,
hedge funds are sometimes classified as short-volatility strategies. Therefore, the investor
has to take these extreme events into special consideration when managing risk of hedge
funds.
A major source of risks for hedge funds are the credit and liquidity risks. Illiquid
assets are known to be hard to price, giving the hedge fund manager some degrees of
freedom for the reporting of the performance. Calculated or even manipulated prices are
an explanation for the sometimes smooth and persistent hedge fund returns, as reported in
Kat and Brooks (2001) and Agarwal and Naik (2000). Asness, Krail and Liew (2001) find
that hedge funds probably price their securities at a lag. One possibility for this are illiquid
or otherwise hard to price assets. After eliminating the serial correlation in the considered
return series, Asness et al. (2001) find that the broad hedge fund universe and many
subcategories no longer offer return and diversification benefits. Kat and Brooks (2001)
analyze the statistical properties of asset returns and their implications for investors.
Among other findings they find that hedge fund returns are significantly autocorrelated
and that returns of hedge funds are smoothed.
We know from the stylized facts of asset returns that returns do not have serial corre-
lation. In an efficient market, serial correlation of asset returns is not possible. However,
market frictions such as transaction costs, borrowing constraints, restrictions on trading,
and costs of information do exist. These frictions all contribute to the possibility of serial
correlation in asset returns, which cannot by exploited because of the presence of these
frictions. If these frictions would not exist, traders would immediately make use of the
serial correlation, which in turn would eliminate this phenomenon. Getmansky, Lo and
Makarov (2004) suggest that the serial correlation of hedge fund returns is most probably
caused by illiquid assets.
1
0.8
0.6
Serial correlation
0.4
0.2
PSfrag replacements 0
−0.2
−0.4
0 5 10 15 20
Lag
Fig. 4.2. Serial correlation of the Tremont convertible arbitrage index.
Therefore, the Tremont hedge fund indices found in Table 4.3 (page 66) are analyzed for
serial correlation. Figure 4.2 shows the sample serial correlation of the Tremont convertible
arbitrage index. The convertible arbitrage index shows significant serial correlation for the
first two lags. Besides this hedge fund index, the event driven, the emerging market, the
equity market neutral, and the fixed-income arbitrage indices also show significant serial
correlation. This indicates that many hedge fund managers have illiquid assets in their
portfolios.
From the stylized facts of traditional asset returns it is known that volatility appears
in clusters. We are interested if this is also the case for hedge funds. We investigate
for GARCH effects in the Tremont hedge fund indices of Table 4.3. The technical de-
tails for GARCH processes are found in Appendix B. There are highly significant (99%)
GARCH effects for the styles emerging markets, equity market neutral, global macro, and
long/short equity. A possible explanation for this would be that the manager is increasing
the risk tolerance because of incurred losses. A high watermark will compensate the man-
ager with incentive fees only if the cumulative returns can make up for previous losses.
This is comparable to the St. Petersburg concept of betting, see Weisman (2002) for de-
tails. Figure 4.3 shows the dynamic standard deviation of the Tremont long/short equity
index, resulting from a GARCH model with t distributed innovations. Note that the re-
sults from Table 4.3 indicate that the t distribution is suitable for describing Tremont
long/short equity index returns. We observe considerable volatility clustering in the year
2000. In addition, the hedge fund crisis of 1998 is clearly seen in Figure 4.3, where the
0.06
Standard deviation
0.05
0.04
0.03
0.02
PSfrag replacements
Jun94 Oct95 Mar97 Jul98 Dec99 Apr01 Sep02 Jan04 May05
Fig. 4.3. Dynamic standard deviation of the Tremont long/short equity index.
volatility more than doubles in one month.

Hedge fund styles play an important role for the risk management of hedge funds.
The use of style information is manifold. As mentioned, Bares et al. (2004) find that the
survival probability of a hedge fund is significantly affected by style consistency. Therefore,
hedge funds should be constantly monitored whether they keep following their reported
style or not. This can be either done be the approach suggested by Lhabitant (2002) or
the approach found in Fung and Hsieh. Concerning styles, Brown and Goetzmann (2003)
discuss the importance of style diversification for risk management. Their finding makes
the top-down portfolio construction superior to the bottom-up approach.
Having mentioned the importance of style diversification, the reader has to be aware
of the fact these results are only of indicative nature. Obviously, the style of a hedge fund
only gives a very limited description of how the fund actually makes profit. However,
what determines the risk-return profile of a hedge fund are the investment universe and
the strategies implemented in these. The investment universe defines the opportunity
sets of the hedge fund manager, the strategy defines the degrees of freedom therein.
Therefore, styles are a classification scheme for hedge funds, hedge fund strategies describe
the degrees of freedom of a manager.
4.2.3 Non-linearities in Hedge Fund Returns
Since hedge funds use dynamic strategies, their exposure to traditional assets is unlikely
to be linear. The returns of hedge fund styles in comparison to the equity market are
analyzed. Therefore, the scatter plot of various hedge fund styles versus the the S&P 500
are considered. Mitchell and Pulvino (2001) find that risk arbitrage has a similar return
profile to the S&P 500 as the one of the short position of a naked put option on the S&P
500. This result is confirmed by performing a kernel regression on the S&P 500 returns
versus the Tremont event driven index returns, as seen in Figure 4.4 (b).
(a) (b) (c)

0.2 0.05 0.04
Fixed Inc. Arbitrage returns
Emerging Markets returns
Sfrag replacements
0.02
Event Driven returns
0.1
0
0
0
−0.05 −0.02
−0.1
−0.04
−0.1
−0.2 −0.06
−0.3 −0.15 −0.08

−0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2 −0.2 −0.1 0 0.1 0.2
S&P500 returns S&P500 returns S&P500 returns
Fig. 4.4. Non-linearities of hedge fund returns. Kernel regressions of S&P 500 returns vs. different Tremont hedge
fund indices returns.
The value of R2 for this regression is 77%, i.e., 77% of the variation of Tremont event
driven index returns are explained by the kernel regression. Note that R 2 denotes the
4.3 Statistical Properties of Hedge Funds 65
percentage of variation explained by the predictor variables, see Hamilton (1994) for
more details on linear regression.
By performing a kernel regression on the S&P 500 returns versus the Tremont emerging
market index returns, as seen in Figure 4.4 (a), the relationship is similar to the event-
driven case. In this case, 86% of the variations may be explained by the regression function.
It would be tempting to state that the Tremont fixed income arbitrage index has the shape
of a short call option, as shown in Figure 4.4 (c). However, the R 2 of this regression is
only 1%, making this statement insignificant.
Nevertheless, if the relationship of the fixed income arbitrage index returns is analyzed
with respect to the one month lagged S&P 500 returns, the picture changes dramatically.
Instead of a short call option profile as in Figure 4.4 (c), we again observe a short put
option profile for the one-month lagged S&P 500 returns, see Figure 4.5. This regression
function explains 66% of the variations of the Tremont fixed income arbitrage index.
0.04
Fixed Income Arbitrage returns
0.02
−0.02
−0.04
−0.06
PSfrag replacements
−0.08
−0.2 −0.1 0 0.1 0.2
1 month lagged S&P500 returns
Fig. 4.5. Kernel regression of lagged S&P 500 returns vs. Tremont fixed income arbitrage returns.
4.3 Statistical Properties of Hedge Funds
The statistical properties of hedge fund returns are analyzed and the implications of the
results discussed. Obviously, the quality of the data is crucial for a statistical analysis of
hedge fund returns. Liang (2003) finds that the data quality of audited funds is of much
better quality than of non-audited funds. Therefore, audited funds should be preferred to
non-audited funds. First, the univariate properties of hedge funds are analyzed. Second,
the multivariate properties are discussed.
4.3.1 Univariate Properties of Hedge Fund Returns
Two important properties of univariate hedge fund returns have already been discussed.
These are the serial correlation and the volatility clustering of hedge fund returns, ex-
amples are shown in Figures 4.2 and 4.3. In this section, the (unconditional) properties
of univariate hedge fund returns are examined. The methodology is as in Chapter 3, the
reader is referred to Appendix A.2.3 for the technical details about the fitted distributions.
Table 4.3. Distributions for monthly Tremont hedge fund indices returns.
Tremont Hedge Fund Indices min(AIC) γ1 γ2

Hedge Fund Index GH -0.03 5.22
Convertible Arbitrage GH -1.39 6.08
Dedicated Short Bias GH 0.61 4.08
Emerging Markets GH -1.12 9.19
Equity Market Neutral Normal 0.31 3.27
Event Driven GH -3.83 30.70
Fixed Income Arbitrage NIG -3.23 20.12
Global Macro GH -0.20 5.79
Long/Short Equity t -0.02 6.88
Managed Futures Normal -0.10 3.44
Multi-Strategy NIG -1.28 6.58
Table 4.3 shows the detailed results for the Tremont hedge fund index and its subindices
including the sample skewness γ1 and kurtosis γ2 . We find that the GH model fits the data
best in terms of the log-likelihood value. Table 4.3 shows how the statistical properties
hugely differ among the different styles. This is seen from diversely selected distributions
according to the AIC value and the very diverse values of γ1 and γ2 . By inspection of
Table 4.3, it is seen that the normal distribution is well suited for the case of equity
market neutral and managed futures returns. In contrary to this, the normal distribution
is very bad for describing returns of the styles event driven and fixed income arbitrage.
Figure 4.6 shows the detailed results for the Tremont convertible arbitrage index. The
return distribution is considerably skewed to the left, also extreme returns are present
in the lower tail. The normal distribution is by far not able to model these observed
properties. The GH distribution handles the asymmetry of the hedge fund index returns
fairly well and can also account for the fat tails.
60 Normal
GH
Kernel density
50
40
density
30
PSfrag replacements 20
10
0
−0.05 −0.04 −0.03 −0.02 −0.01 0 0.01 0.02 0.03
return
Fig. 4.6. Density estimates for the monthly Tremont convertible arbitrage index returns.
The literature is vast on descriptions of the (unconditional) hedge fund returns. They
confirm the findings of this section, see Kat and Brooks (2001) for instance. In the previous
section it has been found that GARCH effects may occur for hedge fund returns. Threshold
ARCH (TARCH) processes are an extension of GARCH processes and are well suited for
describing volatility clustering in declining markets. Therefore, the hedge fund indices of
Table 4.3 are tested for significant (99%) TARCH effects. There are significant TARCH
effects for the convertible arbitrage and the fixed-income arbitrage index. The univariate
properties of hedge fund returns may summarized as follows:
• The results vary considerably among the different styles.

• The returns may have a high excess kurtosis and negative skewness.
• The GH distributions usually is the best model for monthly hedge fund returns, but
some styles may even be reasonably modeled as normal.
• Some styles have significant serial correlation, indicating illiquid assets.
• Some styles show volatility clustering, possibly caused by an increased risk tolerance
of the manager because of performance fees.
We conclude this section with the following remarks. Since the univariate properties
of hedge fund returns differ considerably among the various styles, a universal treatment
of hedge fund returns as such it not possible. Every fund, in contrast to most traditional
assets, has to be analyzed in detail on its own.
4.3.2 Multivariate and Dependence Properties of Hedge Fund Returns
The first aspect of hedge funds, i.e., their claimed outperformance or alpha in comparison
to traditional assets, has been discussed already. A further aspect to include hedge funds
in a portfolio is because of their benefits for diversification.
First, the tail dependence of the different hedge fund styles is investigated. In most
cases, there is no significant tail dependence. In particular, the styles convertible arbitrage,
dedicated short bias, equity market neutral, fixed income arbitrage, managed futures,
and multi-strategy show, if at all, only little tail dependence among each other and to
the other styles. The styles which show tail dependence among each other are shown in
Table 4.4. Tail dependence coefficients for Tremont hedge fund styles, i.e., Tremont Hedge Fund Index (THFI),
Emerging Markets (EmMa), Event Driven (EvDr), Global Macro (GlMa), Long/Short Equity (LSEq).
THFI EmMa EvDr GlMa LSEq

THFI 1 0.28 0.32 0.41 0.43
EmMa 1 0.24 0.14 0.22
EvDr 1 0.15 0.31
GlMa 0.13
LSEq 1
Table 4.4. The Tremont hedge fund index has large tail dependence coefficients with the
emerging markets, the event driven, the global macro, and the long/short equity index.
This may indicate that these styles are dominating the Tremont hedge fund index. Since
the Tremont index is asset weighted, these styles may have more assets under management
than the other styles in the database which Tremont uses, i.e., TASS. However, because
this information is not publicly available, this remains a supposition. The long/short
equity style has rather high tail dependence with the event driven style. It is plausible to
state that these styles have a considerable amount of capital invested in similar equities.
Next, we are interested in the tail dependence coefficients of the different hedge fund
styles versus some of the risk factors of Table 4.2. There is no significant tail dependence
of hedge fund indices with commodities and interest rates. The other tail dependence
coefficients are shown in Table 4.5, correlations are given in brackets. The S&P 500 is
fairly tail dependent with many styles. The dedicated short bias is not tail dependent
on any of the considered risk factors except for the value minus growth index. The fixed
income arbitrage index has only considerable tail dependence with the Citigroup US
Corporate Bond index with maturities 3-7 years.
Table 4.5. Tail dependence coefficients for Tremont hedge fund styles with common risk factors. Dow Jones is
abbreviated by DJ, Citigroup is abbreviated by CG. Correlations are given in brackets.
x
nde
kets
cap
-7y
ks i
th
S
Mar
row
p. 3
ex U
rge
Ban
ue-G
ll-la
Cor
erg.
rld
US
500
Sma
US
Em
Wo
Val
E
S&P
FTS
CG
DJ
DJ
DJ
DJ
Hedge Fund Index 0.25 (0.44) 0.23 (0.42) 0.17 (0.44) 0.11 (0.26) 0.02 (-0.12) 0.37 (0.25) 0 (0.24)
Convertible Arbitrage 0.10 (0.11) 0.08 (0.07) 0.09 (0.11) 0.02 (0.15) 0.01 (0.12) 0.19 (0.15) 0 (0.19)
Dedicated Short Bias 0 (-0.70) 0 (-0.65) 0 (-0.62) 0 (-0.33) 0.16 (0.22) 0.02 (-0.41) 0 (-0.05)
Emerging Markets 0 (0.45) 0.23 (0.53) 0.27 (0.75) 0.06 (0.25) 0.06 (-0.06) 0.22 (0.33) 0 (0.02)
Equity Market Neutral 0.08 (0.39) 0.01 (0.27) 0.04 (0.30) 0.03 (-0.04) 0 (-0.01) 0.1 (0.33) 0 (0.14)
Event Driven 0.35 (0.53) 0.27 (0.56) 0.18 (0.62) 0.08 (0.30) 0.02 (0.05) 0.23 (0.44) 0 (0.09)
Fixed Income Arbitrage 0.09 (0.02) 0.02 (0.01) 0.06 (0.03) 0 (0.09) 0 (0.05) 0.02 (0.04) 0.16 (0.2)
Global Macro 0.13 (0.20) 0.02 (0.10) 0.07 (0.15) 0.04 (0.06) 0 (0) 0.20 (0.16) 0 (0.28)
Long/Short Equity 0.30 (0.54) 0.00 (0.59) 0.02 (0.54) 0.15 (0.43) 0.10 (-0.20) 0.38 (0.27) 0 (0.16)
Managed Futures 0.07 (-0.17) 0.03 (-0.05) 0.02 (-0.07) 0.00 (-0.03) 0.01 (0.12) 0.01 (-0.15) 0 (0.22)
Multi-Strategy 0.00 (0.07) 0.13 (0.09) 0.10 (-0.08) 0 (0.10) 0 (-0.01) 0.04 (-0.04) 0 (0.07)
The FTSE US Banks index has considerable tail dependence to many hedge fund styles.
In particular, the style with the highest exposure is long/short equity. This underlines the
importance of liquidity for hedge funds, provided by the banks. The emerging markets
index has no tail dependence with the US market, but a significant one with the Dow
Jones emerging markets index. However, there is considerable tail dependence between
the Dow Jones World index ex US and the emerging markets index. This indicates that
the emerging market index is only tail-independent with the US market but not with
the other developed markets. The fact that correlation does not explain the dependence
for extreme events is seen from the results for the Tremont hedge fund index versus the
FTSE US Banks index and the Citigroup US corporate bond index. The correlation is
in both cases almost the same, however, there is a huge difference in the tail dependence
coefficient.
Finally, the impact of the inclusion of hedge funds in a portfolio is discussed. We
consider a portfolio with equities, bonds, commodities, and hedge funds. As representative
for these asset classes we choose the S&P 500, the Citigroup US big corporations 3-7 years
index, the Lehman government 1-3 years index, the Goldman Sachs commodities index,
and the Tremont hedge fund index. Again, the methodology is the same as in Chapter 3.
Table 4.6. Multivariate distribution models for a portfolio including hedge funds.
Distribution log-l AIC Copula log-l

Normal 1897 -3753.9 Gaussian 1932.91
t 1916.5 -3791.1 t (ν=8.6) 1943.28
Skewed t 1922.4 -3792.9
NIG 1922 -3791.9
GH 1922.4 -3790.9
Table 4.6 gives the results, the best results are shown in bold numbers. Concerning the
parametric distributions, the skewed t distribution gives very promising results. However,
the copula models offer better log-likelihood values. As for the case with only traditional
assets, the t copula offers the best fit. However, optimal portfolio construction with the
fully parametric distributions is much more convenient than with a copula model.
4.4 Hedge Fund Investing
We distinguish between two main types of hedge fund investing problems. The first is
the problem of building a fund of hedge funds portfolio. The second is the problem of
embedding hedge funds in a traditional portfolio. These two problems may also be modeled
as dependent of each other. Nevertheless, the investor has to make sure that the hedge
fund or the hedge fund portfolio provides a significant alpha for the current portfolio. In
addition, the systematic risks of the hedge fund part have to be analyzed in order not to
interfere with the systematic risks already present in the portfolio.
4.4 Hedge Fund Investing 71
Embedding Hedge Funds in Traditional Portfolios
The reasons for including hedge funds in a traditional portfolio are manifold. Once the
decision to include hedge funds in a portfolio has been made, the next problem is to de-
cide how much of the portfolio should consist of alternative investments. We have already
encountered the problems when trying to answer this question with the mean-variance
approach. Kat and Brooks (2001) and Fung and Hsieh (1998) find that mean-variance
portfolio construction with hedge funds is not suitable as well. Cvitanić, Lazrak, Martellini
and Zapatero (2003) solve the problem of hedge fund allocation in a dynamic framework
and with model uncertainty. They find that the presence of model risk significantly de-
creases the amount of wealth invested in hedge funds. Therefore, the over-allocation to
hedge funds can be eliminated by introducing model uncertainty. For instance, if the al-
pha of hedge funds is modeled as random variable rather than a deterministic value, the
amount of capital allocated to hedge funds is reduced.
The topics of risk and performance measurement have already been discussed. Also,
dynamic and static possibilities to model asset returns have been sketched. Once the
investor has determined a hedge fund which provides alpha for the existing portfolio, the
investor then has to make sure that the hedge fund has no undesirable systematic risk
exposures. There exists a huge variety of different approaches to construct a portfolio, e.g.,
the core-satellite strategy. However, all these different methods of portfolio construction
lead to the same optimization problem if the models for the assets and the risk measure
are the same. The resulting optimization problems then only differ in the constraints on
the decision variables.
The term portable alpha is often encountered in the context of alternative assets in
traditional portfolios. Concerning hedge funds, the portable alpha is closely connected to
the systematic risk of hedge funds. The systematic risks of hedge funds have already been
discussed in detail. These risks may also contain traditional systematic risks which are
unfavorable for the investor because these are already present in the traditional portfolio.
However, these exposures should be small since the investor is not interested in paying
fees for traditional risks. One way to dispose the systematic risk exposures to traditional
risks is by hedging these risks. Recall the hedge fund terminology of (4.1). By hedging the
beta-exposures, what remains is the pure alpha. Of course, the isolation of alpha comes
at a cost, i.e., the cost of hedging the unpleasant beta-exposures. Because the alpha is
now isolated from the risks of the investors portfolio, it is called portable. The investor
will not alter the risk profile of the portfolio by introducing such a portable alpha. The
return of the portfolio, in contrast to the risk of the portfolio which remains the same, is
increased by the portable alpha.
We have emphasized the importance of tail dependence for risk measurement. However,
this does not make the correlation of hedge funds with traditional assets less important.
The correlation is of importance because of the return maximization in normal market
situations. Since hedge funds make use of dynamic trading strategies, the correlation
properties with traditional asset classes may be dynamic as well. The correlation properties
of hedge fund indices versus stocks and bonds are calculated. The dynamic conditional
correlation (DCC) GARCH model is used to find the dynamic correlations. The technical
details can be found in Appendix B.
Tremont Hedge Fund Index Tremont Equity Market Neutral Index

1 1
0.8 0.8
0.6 0.6
Correlation with bonds
Correlation with bonds
0.4 0.4
0.2 0.2
0 0
−0.2 −0.2
Sfrag replacements −0.4 −0.4
−0.6 −0.6
−0.8 −0.8
−1 −1
−1 −0.5 0 0.5 1 −1 −0.5 0 0.5 1
Correlation with stocks Correlation with stocks
Fig. 4.7. Correlation of Tremont Hedge Fund Indices with stocks and bonds.
Figure 4.7 shows the dynamic correlations of the Tremont hedge fund index and the
Tremont equity market neutral index with stocks and bonds. The stock returns are substi-
tuted by the S&P 500 index, the bond returns by the Lehman government bond 1-3 years
index. The Tremont hedge fund index shows rather stable correlation with the equity
market (around 50 %), the correlation with the bond market is not stable and varies
between ± 40 %. The Tremont equity market neutral index correlation is unstable with
respect to stocks and bonds. The results for all other Tremont hedge fund indices are
similar to the results shown in Figure 4.7. This essentially means that the correlation
properties of hedge fund indices are not always stable with respect to traditional assets.
This underlines the advantage of active portfolio management, also when hedge funds are
part of a portfolio.
Hedge Fund Selection
What remains is the selection of appropriate hedge funds once the investor has decided
how much capital of the portfolio is allocated to hedge funds. However, the engagement
in a hedge fund differs enormously from an engagement in a traditional asset. We have
argued that risk management is systematic and rational. The same should also apply for
the construction of the alternative part of a portfolio. In Section 4.1.4, the topic of funds
of hedge funds has been discussed and these results also apply for the hedge fund selection
problem. The two main approaches are the top-down and the bottom-up approach. These
Hedge Fund
Top-down Styles Hedge Fund
Approach Universe
Style
Composition
Risk- and Portfolio Management
Manager
Selection
Bottom-up
Approach Hedge Fund
Managers
Fig. 4.8. Hedge fund portfolio construction
two concepts are shown graphically in Figure 4.8. The advantages and disadvantages
have been discussed in Section 4.1.4. Therefore, the three main elements for hedge fund
investing are:
• Style Diversification
• Hedge Fund Selection
• Risk Monitoring
In general, the asset allocation process of Figure 2.1 still applies. In the strategic asset
allocation, the hedge fund styles used for diversification have to be defined. The selection
of the hedge fund or managers is performed in the investment analysis and the tactical
asset allocation. The risk monitoring is performed in connection with the risk management
for the other assets.
Style diversification has been discussed in Section 4.2. The style diversification is con-
ceptually not different from diversification for traditional investments. What differentiates
hedge fund engagements from those in traditional investments is the hedge fund selection
process. Figure 4.9 gives a schematic overview. In the first step, potential candidates have
Hedge Fund
Initial Potential Qual. Analysis Due Hedge Fund
Universe - - Short-list -
Candidates Selection
(Database) Filtering Quant. Analysis Dilligence
Fig. 4.9. The hedge fund selection process
to be found by screening the hedge fund universe. For this, several commercial hedge fund
databases should be filtered for funds with adequate properties. The elaboration of the list
with potential candidates usually depends heavily on the investor’s preferences and less
on subjective quantitative criteria. The next step is the qualitative and the quantitative
analysis of the funds. This results in a short list of suitable funds. The steps performed
thus far can be performed in an automated fashion. The next step, i.e., the due diligence
of the funds, analyzes the fund in more details. Due diligence is in a sense a qualitative
analysis, but much more comprehensive than the one of the previous step. The due dili-
gence usually includes a visit to the fund managers by experienced professionals. Among
other things, the strategy of the fund, the people involved, the infrastructure, and the
processes are reviewed and analyzed in detail. Therefore, it is often called operational and
structural due diligence.
After the individual funds have been selected, the hedge fund portfolio has to be
constructed accordingly. We have argued that the mean-variance approach is not appro-
priate for solving this problem. Some alternative approaches to solve this task are found
in the literature. Krokhmal, Uryasev and Zrazhevsky (2002) analyze linear rebalancing
strategies for hedge fund portfolios using different risk measures such as CVaR and condi-
tional drawdown-at-risk. Agarwal and Naik (2004) build mean-CVaR optimal portfolios
and compare these with mean-variance portfolios. Agarwal and Naik find that the mean-
variance significantly underestimates the tail risk of the portfolio. Amenc and Martellini
(2002) present an improved estimator for the out-of-sample covariance matrix of hedge
fund index returns.
Summarizing, in the realm of hedge funds, qualitative aspects play a much more im-
portant role than for traditional investments. However, this does not make quantitative
aspects less important. Hedge fund portfolio construction asks for coherent risk measures
which take into account the tails of the return distributions.
5
Optimal Portfolio Construction with

Brownian Motions
Opportunity is missed by most people because

it is dressed in overalls and looks like work.
Thomas Edison
In Section 3.3, the optimization techniques in finance have been reviewed. In this chapter,
dynamic asset allocation strategies are developed for asset prices, modeled as continuous-
time stochastic differential equations (SDEs) driven by Brownian motion. In this type
of model, the conditional distribution of asset returns is normal. Therefore, asset prices
are log-normally distributed. Note that the unconditional distribution of returns in this
framework is not necessarily the normal distribution. The main advantage of using the
continuous-time framework is that the optimal control problem can be solved analyti-
cally to a high degree. In some cases, even closed-form solutions may be derived. This
gives more insight into the mechanics of an optimal asset allocation strategy than a nu-
merical approximation thereof. However, the modeling properties are rather limited for
continuous-time stochastic processes with Brownian motion.
We will make use of factors for explaining expected returns of assets. Two types of
problems are considered in this chapter. We consider the case were all factors which are
explaining the returns of assets are known, i.e., measurable. The second case considers
the situation where not all of the factors explaining returns are observable. This problem
is called optimal asset allocation under partial information. The optimal asset alloca-
tion strategies are derived with a stochastic dynamic programming approach. Therefore,
the Hamilton-Jacobi-Bellman (HJB) equation has to be solved. The HJB equation is a
non-linear partial differential equation, which is very hard to solve if the control vari-
able is constrained. For problems in higher dimensions, it is virtually impossible to find
78 5 Optimal Portfolio Construction with Brownian Motions
analytical solutions for the constrained case. This fact and the limited possibilities to
model asset returns are the main disadvantages of modeling assets in continuous-time
stochastic differential framework with Brownian motion. In this chapter, when we speak
of continuous-time finance, we actually refer to a continuous-time stochastic differential
framework with Brownian motion.
After having introduced the dynamics of the considered assets, we are able to define
the wealth dynamics of our investor. The investor’s portfolio is self-financing, i.e., there
are no external in- or outflows of money. We are considering two types of investors in this
chapter. They are characterized by their corresponding utility functions. On the one hand,
we consider the popular constant relative risk aversion (CRRA) case. On the other hand,
we consider the constant absolute risk aversion case (CARA). The problems are solved
by using Bellman’s optimality principle. For the partial information case, we show that
the separation theorem is not valid anymore, i.e., we cannot separate the estimation from
the optimization. This means that we cannot simply estimate the unobservable quantities
and treat them afterwards as if they were known exactly.
The asset allocation strategies are all backtested with real market data. The data in
this chapter is obtained from the Datastream database of Thomson Financial.
5.1 The Full Information Case
The cornerstones of continuous-time finance are the publications of Samuelson (1969)

and Merton (1969, 1971). Since then, these results have been extended to a wide range
of improved models and applications. The most popular application of continuous-time
finance is the pricing of contingent claims by Black and Scholes (1973). The modeling of
fixed-income securities is also popular in the continuous-time framework. The reader is
referred to Shreve (2004) and Björk (1998) for a detailed treatment of various topics in
continuous-time finance.
We are less interested in solely modeling in continuous time but rather in the solution
of optimal asset allocation problems resulting thereof. The solutions of optimal asset allo-
cation problems can be used either for asset pricing or for optimal portfolio construction.
In the developments of Samuelson and Merton, the optimization problem is solved under
full information. For the full-information case, several closed-form solutions have been de-
rived. Since the literature on this topic is vast, we can only mention a few. Among them
5.1 The Full Information Case 79
are Kim and Omberg (1996), Browne (1999), Korn and Kraft (2001), Herzog, Dondi,
Geering and Schumann (2004), Wachter (2002), Keel, Herzog and Geering (2004), and
Munk and Sorensen (2004). A recent publication on this subject is Schroder and Skiadas
(2005).
Kim and Omberg (1996) find a closed-form solution for a single risky asset with stochas-
tic risk premium. In addition, conditions for the solvability of the problems are discussed,
although not in sufficient detail. Browne (1999) gives the analytical solution for the prob-
lem of beating a stochastic benchmark. Thereby, the problem of maximizing the expected
discounted reward of outperforming the benchmark, as well as the minimization of the
discounted penalty paid by being outperformed by the benchmark is discussed. Wachter
(2002) solves the optimal portfolio choice problem for an investor with utility over con-
sumption under mean-reverting returns in closed form. The asset allocation problem for
investing among stocks, bonds, and cash is solved for a power-utility investor with mean-
reverting returns and interest rate uncertainty in Munk and Sorensen (2004). However,
the excess return is perfectly negatively correlated with the asset prices, which is a limiting
assumption.
Korn and Kraft (2001) analyze the problem of utility maximization over terminal
wealth for stochastic interest rates. The investment opportunities are a savings account,
stocks, and bonds. A verification theorem without the usual Lipschitz assumptions is
proved. Keel et al. (2004) consider the application of optimal portfolio construction with
interest rate risk, market risk, and the risks introduced by an alternative investment.
Schroder and Skiadas (2005) introduce a class of recursive utility, which includes additive
exponential utility. The solutions, including convex trading constraints, are obtained by
solving a constrained forward-backward stochastic differential equation.
Since the work of Merton, it is obvious that optimal investment strategies depend on
the investment horizon. Therefore, a long-term strategy differs usually in a significant way
from the myopic optimization. The long-term optimization problem contains, in addition
to the myopic policy, the intertemporal hedging demand. This kind of problem is also
called strategic asset allocation and is introduced in Brennan, Schwartz and Lagnado
(1997). The strategic asset allocation problem including an arbitrary number of factors
explaining mean returns of assets is described in Herzog, Dondi, Geering and Schumann
(2004). Similar results are also found in Liu (2005).
By introducing multiple factors, one has to solve a high-dimensional, non-linear par-

tial differential equation (PDE) to compute the solution. The use of numerical dynamic
programming with discrete state approximation suffers from Bellman’s curse of dimen-
sionality and is therefore restricted to very few factors. For an illustration of the problems
involved with numerical dynamic programming, the reader may refer to Peyrl, Herzog
and Geering (2004). Further advances in numerical methods for solving partial differen-
tial equations may make this approach also applicable to higher dimensions.
There are many publications on the issue of using explanatory factors for improving
the asset allocation. In Fama and French (1993), five common factors for stocks and bonds
are identified. For the stock market, an overall market factor, a factor related to the firm
size, and book-to-market equity are considered. For the bond market, two factors, related
to maturity and default risk, are considered. Some additional publications on this subject
are Moskowitz and Grinblatt (1999), Jegadeesh (1990), Bossaerts and Hillion (1999),
and Rosenberg, Reid and Lanstein (1985). These papers suggest that the momentum of
equities possesses predictive power. In Bossaerts and Hillion (1999), evidence is given
that the relation between factors and asset returns is non-stationary. This is a further
motivation for having a dynamic prediction model. In Amenc, Bied and Martellini (2003),
the predictability of hedge fund returns is discussed. In Campbell and Hamao (1992) and
Harvey (1995), possible factors for an international diversified portfolio are discussed.
There are various extensions to the standard problems discussed in the literature. The
problem of transaction costs is considered in Oksendal and Sulem (2002) and Janecek
and Shreve (2004). However, the resulting problems are no longer analytically solvable.
Bertsimas and Lo (1998) derive dynamic optimal trading strategies that minimize the
expected cost of trading a large block of equity over a fixed time horizon. Portfolio choice
problems with stochastic volatility are considered in Fleming and Hernandez-Hernandez
(2003) and Chacko and Viceira (2005). Since stochastic dynamic volatility is a stylized
fact of asset returns, these results are more realistic than the ones with deterministic
volatility.
5.1.1 The Model
The investment opportunities are modeled as stochastic differential equations. They are
assumed to behave as local geometric Brownian motions. The drift terms of the asset price
dynamics are modeled as affine functions of explanatory factors. We model the factors
via stochastic differential equations as well. The diffusions of the n risky price processes
are driven by an n-dimensional standard Brownian motion process Wp . Similarly, the
diffusions of the m factor processes are driven by an m-dimensional standard Brownian
motion process Wx . In addition to the risky asset, there is a risk-free asset (or bank
account) whose instantaneous return is deterministic. Nevertheless, the return on the
risk-free asset may be time-dependent or even stochastic. The Brownian motion Wp of
the price processes and the Brownian motion Wx of the factor processes are defined on a
fixed, filtered probability space (Ω, F, {Ft }t≥0 , P) with Ft satisfying the usual conditions.
The Brownian motions Wp and Wx do not need to be independent.
Factor Dynamics
In order to improve the asset allocation, factors are included in the asset models. We expect
the factors to have some predictive power for the returns of the investment opportunities.
The m factors x(t) ∈ Rm are modeled by the following stochastic vector process
dx(t) = [Ax (t)x(t) + a(t)]dt + σx (t)dWx (t), (5.1)
x(0) = x0 ,
where Ax (t) ∈ Rm×m , a(t) ∈ Rm , σx (t) ∈ Rm×m , and Wx (t) ∈ Rm . The matrix and vector
functions Ax (t), a(t), and σx (t) are deterministic functions. In addition, σx (t) is assumed
to have full rank for all t. The factor process allows us to model different variables affecting
the mean return of the risky assets.
Asset Price Dynamics
The set of investment opportunities of our investor consists of n ≥ 1 risky assets. The
asset price processes P = (P1 (t), P2 (t), . . . , Pn (t)) ∈ Rn of the risk-bearing investments
satisfy the stochastic differential equations, where diag(P (t)) denotes the diagonal matrix
of the vector P (t),
dP (t) = diag(P (t)) {µ(x(t), t) dt + σp (t)dWp (t)} , (5.2)
P (0) > 0 ,
where µ(x(t), t) ∈ Rn , σp (t) ∈ Rn×n , and Wp (t) ∈ Rn . The matrix function σp is assumed
to be deterministic. From the diffusion matrix σp we get the instantaneous covariance
matrix per unit time as Σ(t) = σp (t)σp (t)T . The matrix function Σ has to be invertible,
therefore σp has to have full rank. The correlation matrix ρ ∈ Rn+m×n+m of the Brownian
motion W = [WpT , WxT ]T is defined as
 
I1 ρ(t)
ρ(t) =  ,
T
ρ (t) I2
where I denotes the identity matrix and ρ ∈ Rn×m , I1 ∈ Rn×n , and I2 ∈ Rm×m . In
addition, there exists a risk-free investment opportunity B(t) with instantaneous rate of
return r(x(t), t) ∈ R:
dB(t) = B(t)r(x(t), t)dt , (5.3)
B(0) > 0 .
The scalar function r is deterministic. The drift terms of the risk-free asset and the risk-
bearing assets depend on the m factors x. Furthermore, we assume that the drift terms
in (5.2) and (5.3) are affine functions of the factor levels, as given by
µ(x(t), t) = G(t)x(t) + f (t) , (5.4)
r(x(t), t) = F0 (t)x(t) + f0 (t) , (5.5)
where G(t) ∈ Rn×m , f (t) ∈ Rn , F0 (t) ∈ R1×m , and f0 (t) ∈ R. The matrix and vector
functions G(t), f (t), F0 (t), and f0 (t) are all deterministic.
Portfolio Dynamics
We assume that the investor’s portfolio is self-financing, i.e., there are no exogenous in-
or outflows of money, e.g., consumption. The dynamics of the investor’s wealth V may be
expressed as
³ dB(t) X n
dPi (t) ´
dV (t) = V (t) u0 + ui (t) ,
B(t) i=1
Pi (t)
V (0) > 0,
where u1 (t), . . . , un (t) denotes the fraction of wealth invested in the corresponding risky
asset and u0 (t) accordingly in the risk-free asset at time t. The proof is either found
in Merton (1992) or Björk (1998). Because the portfolio is self-financing, we have the
P
constraint ni=0 ui (t) = 1. Inserting the definitions of the asset price dynamics of (5.2)
and (5.3) in (5.6), we arrive at the following wealth dynamics:
dV
= {uT [µ(x, t) − 1n r(x, t)] + r(x, t)}dt + uT σp dWp , (5.6)
V
where 1n is defined as the vector 1n = (1, 1, . . . , 1)T ∈ Rn and u(t) = [u1 (t), . . . , un (t)]T .
5.1.2 Optimal Asset Allocation
Optimal Asset Allocation with a CRRA Utility Function
The optimal asset allocation is derived for an investor having constant relative risk aver-
sion (CRRA). Therefore, the expected power utility over terminal wealth is maximized.
The definitions of µ and r, found in (5.4) and (5.5), are inserted into the wealth dynamics
of 5.6. The investor’s optimization problem under full information becomes (with time
arguments omitted for better readability)
h1 i
max1 E V (T )γ
u(·)∈Ln γ
s.t.
dV = V {uT [F x + f ] + F0 x + f0 }dt + V uT σp dWp (5.7)
dx = [Ax x + a]dt + σx dWx
dWp dWx = ρ dt,
with V (0) = V0 and x(0) = x0 . The parameter γ < 1 is the coefficient of risk aversion. The
deterministic matrix functions F ∈ Rn×n and f ∈ Rn of the investors wealth dynamics
are defined as
F = G − 1 n F0 , (5.8)
f = f − 1 n f0 . (5.9)
The deterministic matrix functions G, f , F0 , and f0 are defined in (5.4) and (5.5), the
vector 1n is defined as in (5.6). In order to solve this problem with Bellman’s optimality
principle, we introduce the value or cost-to-go function as
h1 i
J(t, V, x) = max1 E V (T )γ .
u(·)∈Ln γ
The optimal asset allocation strategy is the solution of the Hamilton-Jacobi-Bellman

equation. For a proof in the recent literature see Yong and Zhou (1999). The Hamilton-
Jacobi-Bellman partial differential equation for this problem is
h
Jt + maxn V {uT [F x + f ] + F0 (t)x(t) + f0 (t)}JV + (Ax x + a)T Jx
u∈R
1 1 i
+ V 2 uT ΣuJV V + V uT Ψ JV x + tr{Jxx σx σxT } = 0,
2 2
with Ψ = σp ρ σxT and terminal condition J(T, V (T ), θ(T )) = γ1 V (T )γ . This kind of prob-
lem is solved in Herzog, Dondi, Geering and Schumann (2004). The reader may consult
this publication for the proof. The optimal control law u∗ of this problem is given by
1 ³ ´
∗ −1
u = Σ F x + f + Ψ [K1 x + k2 ] , (5.10)
1−γ
where k2 (t) ∈ Rm and K1 (t) ∈ Rm×m are the solutions of two matrix Ricatti equations.
The differential equation for the matrix K1 (t) is given by
K̇1 + K1 σx σxT K1 + K1 A + AT K1
γ ³ T T
´
− F Σ −1 F + F Σ −1 Ψ K1 + K1 Ψ T Σ −1 F + K1 σx ρT ρσxT K1 = 0, (5.11)
(γ − 1)
with terminal condition K1 (T ) = 0. The differential equation for the vector k2 (t) is given
by
k˙2 + γF0T + K1 σx σxT k2 + AT k2 + K1 a

γ ³ T T
´
− F Σ −1 f + F Σ −1 Ψ k2 + K1 Ψ T Σ −1 f + K1 σx ρT ρσxT k2 = 0, (5.12)
(γ − 1)
with terminal condition k2 (T ) = 0. We summarize the results in the following lemma.
Lemma 5.1 (Full Information, CRRA Case).

The optimal asset allocation strategy under full information for the CRRA case (5.7) is
given by (5.10), where K1 (t) and k2 (t) are the solutions of two matrix Ricatti equations
(5.11) and (5.12), respectively.
Proof. See Herzog, Dondi, Geering and Schumann (2004).
Optimal Asset Allocation with a CARA Utility Function
The optimal asset allocation is derived for an investor having constant absolute risk aver-
sion (CARA). Therefore, the expected exponential utility over terminal wealth is max-
imized. For the problem to be solvable, we model the risk-free interest rate r(t) as a
function of time only, i.e., independent of x(t). Therefore, we set F0 ≡ 0 in (5.5). We
proceed as in the CRRA case and state the investors optimization problem as
h 1 i
max1 E − e−γV (T )
u(·)∈Ln γ
s.t.
dV = V {uT [Gx + f ] + r}dt + V uT σp dWp (5.13)
dx = [Ax x + a]dt + σx dWx
dWp dWx = ρ dt,
with V (0) = V0 and x(0) = x0 . The parameter γ > 0 is the coefficient of risk aversion, f
is as defined in (5.9). The value or cost-to-go function for this problem is
h 1 i
−γV (T )
J(t, V, θ) = max1 E − e .
u(·)∈Ln γ
This results in the following Hamilton-Jacobi-Bellman partial differential equation for this
problem
h
Jt + maxn V {uT [Gx + f ] + r}JV + (Ax x + a)T Jx
u∈R
1 2 T 1 i
+ V u ΣuJV V + V uT Ψ JV x + tr{Jxx σx σxT } = 0.
2 2
This type of HJB partial differential equation is solved in Herzog, Dondi, Geering and
Schumann (2004). The optimal solution u∗ is given by
1 ³ ´
u∗ = − Σ −1 Gx + f + Ψ [K1 x + k2 ] . (5.14)
γV k3
It remains to define the functions K1 (t), k2 (t), and k3 (t). The matrix function K1 (t) is
the solution of the following linear matrix differential equation
K̇1 + K1 σx σxT K1 + K1 A + AT K1 − F T Σ −1 F − F T Σ −1 Ψ K1
−K1 Ψ T Σ −1 F − K1 σx ρT ρσxT K1 = 0, (5.15)
with terminal condition K1 (T ) = 0. The vector function k2 (t) is the the solutions of the
following differential equation
k˙2 + K1 σx σxT k2 + AT k2 + K1 a − F T Σ −1 f − F T Σ −1 Ψ k2
−K1 Ψ T Σ −1 f − K1 σx ρT ρσxT k1 = 0, (5.16)
with terminal condition k2 (T ) = 0. Finally, the scalar function k3 (t) is the solution of the
following differential equation
k˙3 + f0 (t)k3 = 0, k3 (T ) = −γ . (5.17)
We summarize the results in the following lemma.

Lemma 5.2 (Full Information, CARA Case).

The optimal asset allocation strategy under full information for the CARA case (5.13) is
given by (5.14), where K1 (t), k2 (t), and k3 (t) are the solutions of the differential equations
(5.15), (5.16), and (5.17), respectively.
Proof. See Herzog, Dondi, Geering and Schumann (2004).
5.1.3 Case Study with Alternative Investments
We consider an investor having three risky investment opportunities. These are the stock
market, the bond market, and alternative investments. Each of the three investment op-
portunities offers a different risk-return profile. For the fixed income part, the short rate
model of Vasicek (1977) is used. As second investment opportunity, we consider the stock
market. We chose a stock market index as a proxy for the market portfolio. It is modeled
by a geometric Brownian motion. Its drift and diffusion are constant. For the hedge fund,
we use a model originating from Sharpe’s capital asset pricing model including the Greek
letters α and β. However, we only use the terminology of the CAPM but do not need
the assumptions of the CAPM. Since the model is in continuous time, the intertemporal
capital asset pricing model (ICAPM) of Merton (1973a) is used. Cvitanić et al. (2003)
use a similar model for hedge funds. As a consequence, the alternative investment does
not have a constant risk premium. This is also the case for the market portfolio since
the risk-free interest rate is not constant. The investment opportunities are modeled by
appropriate stochastic differential equations. The investor’s utility function is chosen to
have constant relative risk aversion.
The Model
In order to derive the optimal investment strategy, we first need to model the three
considered investment opportunities. The Brownian motions of the continuous-time
stochastic differential equations involved are defined on a fixed, filtered probability space
(Ω, F, {Ft }t≥0 , P) with Ft satisfying the usual conditions. As mentioned, a short rate
model is used for the fixed income part. The investor is able to put money into a bank
account. The bank account has an interest rate equivalent to the short rate. We have the
following SDE for the short rate r:
dr = κ(θ − r)dt + σr dWr , (5.18)
r(0) = r0 ,
where κ, θ, σr ∈ R are the constant parameters of the short rate. Given the short rate,
we solely need to determine the price of risk λ to determine the dynamics of the bond B
with maturity T ,
³ λσr ´ σr
dB = B r + aT dt − B aT dWr , (5.19)
κ κ
B(T ) = 1,
where the scalar function aT (t) is defined as
aT (t) = 1 − e−κ(T −t) . (5.20)
The reader is referred to Vasicek (1977) for details. The second investment opportunity
is a passive equity fund, regarded as a proxy of the market portfolio. The passive fund S
has the SDE
dS = Sµs dt + Sσs dWs , (5.21)
S(0) = S0 ,
where µs , σs ∈ R are the constant parameters of the model. Furthermore Ws is assumed

to be independent of Wr . As a last step, the model for the alternative asset remains to be
introduced. The price of the alternative asset, denoted by A, is modeled by
p
dA = A(r + β(µs − r) + α)dt + AσA (ρdWs + 1 − ρ2 dWA ),
A(0) = A0 ,
where β, α, σA , ρ ∈ R are the constant parameters of the model. Furthermore WA is

assumed to be independent of Wr and Ws . In this context, r + β(µs − r) describes the
risk adjusted return of the asset with respect to the market, whereas α denotes the
outperformance of the alternative asset. The β parameter is defined to be
cov(dS/S, dA/A) ρσA
β= 2
= , (5.22)
σS σS
where ρ denotes correlation of the return of the market portfolio and the return of the
alternative asset. We introduce a three-dimensional control vector u. The three compo-
nents of u represent the percentage of total wealth invested in the respective investment
category. In our case, the wealth equation becomes
h i
dV = V u µ(r, t) + r dt + V uT σdW,
T
where u ∈ R3 , W = [Wr , Ws , WA ]T ∈ R3 and initial condition V (0) = V0 . The vector

µ(r, t) is
 
λσr
κ T
a (t)
 
 
µ(r, t) = F r + f (t) =  µs − r ,
 
β(µs − r) + α
whereas the matrix σ(t) is defined to be

 
σr
− a (t) 0 0
 κ T 
 
σ(t) =  0 σs 0 .
 p 
0 σ A ρ σA 1 − ρ 2
The matrix σ(t)σ T (t) has to be invertible and therefore |ρ| < 1.
Solution to Asset Allocation with CRRA Utility
The portfolio choice problem is to maximize the expected power utility defined over ter-
minal wealth. Furthermore, we assume that leveraging, short-selling, and borrowing at
the risk-free rates are unrestricted. Mathematically, the problem statement is
n1 o
max E V γ (T )
u(·) γ
s.t.
h i
dV = V uT µ(r, t) + r dt + V uT σdW
dr = κ(θ − r)dt + σr dWr ,
with initial conditions V (0) = V0 and r(0) = r0 . The time horizon is denoted by T
and γ < 1 denotes the coefficient of risk aversion. The solution of this problem, given
Σ(t) = σ(t)σ(t)T and e1 = [1, 0, 0]T , is
1 ³ σ2 ´
u∗ (t, r) = Σ(t)−1 µ(t, r) − r aT (t)[k1 (t)r(t) + k2 (t)]e1 . (5.23)
1−γ κ
The two functions k1 (t) and k2 (t) are the solutions of two coupled ordinary differential
equations (ODEs). The ODE for k1 (t) is
σr2 2
k˙1 − 2κk1 + k − h1 = 0, k1 (T ) = 0 . (5.24)
1−γ 1
The only unknown in the ODE for k1 (t) is the constant h1 , which is defined by
γ
h1 = .
(γ − 1)σs2
The ODE for k1 is independent of k2 and can be therefore solved independently. Because
of the form of (5.24), there exists a closed-form solution. Define the function Υ (t) to be
s
n ³ κ ó h1 σr2
Υ (t) = tanh (T − t)δ + atanh , δ= + κ2 .
δ 1−γ
We finally have for the solution of k1
1 − γ³ ´
k1 (t) = κ − δΥ (t) .
σr2
The remaining unknown of the solution is k2 (t). From the general solution we know that
k2 (t) is the solution of an ODE which is dependent of k1 (t). The ODE for k2 (t) is, for our
specific case, given by
³ σr2 ´
˙
k2 − k2 κ − k1 + k1 h3 + h2 = 0, k2 (T ) = 0 . (5.25)
1−γ
The constants h2 and h3 are found to be
γ
h 2 = γ + h 1 µS , h3 = κθ − σr λ.
γ−1
Again, we can give an analytical solution, but the form of the solution of (5.25) is more
complicated than for k1 (t), i.e.,
p 1³1 − γ ´ 1−γ
k2 (t) = C 1− Υ (t)2 + 2
κh3 + h2 Υ (t) − h3 2 .
δ σr σr
The integration constant C has to be chosen such that the terminal condition k2 (T ) = 0
is met, therefore we get
√
δ 2 − κ2 ³ h3 (1 − γ) κh2 ´
C= − .
δ σr2 δ 2 − κ2
The conditions for existence of a solution are σr 6= 0, σs 6= 0, and γ < 0. Since we want to
optimize a portfolio with alternative investments, we are especially interested in the third
component of u∗ in (5.23). It reflects the fraction of wealth allocated to the alternative
investment and is given by
α
u∗3 = .
(1 − γ)(1 − ρ2 )σA2
The amount of capital invested in the alternative investment increases linearly with α.
The closer the variance of A is to zero, the more is invested in the alternative investment.
At first sight, it is counter-intuitive that the larger the absolute value of the correlation
ρ, the more is invested in the alternative asset. But if we take a look at u∗2 , the fraction of
wealth invested in the market, we observe that, for large absolute values of ρ, the value
of u∗2 changes significantly. The asset allocation rule exploits this correlation property
by taking much more extreme positions when a large positive or negative correlation is
present,
1 σA
u∗2 = 2
(µS − r) − u∗3 ρ.
(1 − γ)σS σS
The first term of u∗2 is seen to be the well known solution of Merton (1992), whereas the
second term depends on the amount of wealth invested in the alternative investment u∗3 . If
the correlation ρ is equal to zero, the position in the market is the same as in the standard
Merton case. If ρ is positive, the position in the market is reduced in favor of the position
in the alternative investment (assuming a positive α). The interesting property lies in the
fact that, if the correlation is negative, the optimal weight in the market is larger than in
the positively correlated case. The lower the correlation, the more the downturns of the
alternative investment are hedged by the position in the stock market.
One reason to include hedge funds in portfolios is because of their benefits of diversifi-
cation, i.e., low correlation. In the perfectly independent case, i.e., ρ = 0, the fraction of
wealth invested in the market remains unaffected in terms of the Merton solution. Because
of the lack of dependence between the bond market and the stock market and the alter-
native investment, respectively, the amount of wealth invested in the bond is independent
of the characteristics of the market and the alternative investment.
Analysis and Backtest of the Asset Allocation Strategy with US Data
The optimal control vector u(t) is computed for real market conditions. We use US stock
market data and the Tremont hedge fund index. For the equity fund, i.e., the substitute
for the market portfolio, the S&P 500 is used. As a proxy for the short rate, we use three
month Treasury bills, which have interest rates close to the ones paid on a money market
account. For the bond portfolio part, the Datastream USA Total 3-5 years bond index is
used. In order to account for the coupon payments, the total return index data is used
which is a suitable approximation for the zero coupon bond. The data is obtained on a
weekly basis except for the Tremont hedge fund index which is only available on a monthly
basis.
The three-month Treasury bills are used as a proxy for the short rate for two reasons.
The first is because of its long availability (since 1972), which is important for the esti-
mation of the short rate parameters. The second reason is that the federal fund rate is
locally deterministic and therefore not suited as proxy for the short rate. The resulting
control vector u(t) crucially depends on the parameters chosen. The parameters used for
the market portfolio can be estimated with long time series of data and are therefore
reliable long term estimates. This is also the case for the fixed income security.
The stochastic differential equation for the short rate (5.18) is discretized with the
method of Euler, see Kloeden and Platen (1999) for details. We get
√
rt+1 = κθ∆t + (1 − κ∆t)rt + σr ∆t ξr ,
where ∆t is the time increment and ξr is a standard normal white noise process. The
parameters of the short rate are estimated by doing an ordinary least squares estimation
on the discrete version of the short rate.
We assume that the bond has a fixed duration, i.e., having a roll-over bond portfolio
part in the entire portfolio. This can be achieved by changing the time-varying function
aT (t) in (5.20), to be a function of the duration τ of the bond portfolio part only. We
discretize the stochastic differential equation of the logarithmic bond prices (5.19) with
the method of Euler and get
³ σ 1 ³ σr ´2 ´ σr √
r
ln(Bt+1 ) − ln(Bt ) − rt ∆t = λ aT (τ ) + aT (τ ) ∆t + aT (τ ) ∆t ξB ,
κ 2 κ κ
where ∆t is the time increment and ξB is a standard normal random variable. The duration
τ and the price of risk λ of the bond index are estimated by estimating mean and variance
of the series above.
The drift and the diffusion of the market portfolio are computed in the same way as
the bond prices. The price process (5.21) is transformed with the natural logarithm. The
resulting stochastic differential equation is then used in its discrete version, using the
method of Euler. This gives the relationship
¡ 1 ¢ √
ln(St+1 ) − ln(St ) = µS − σS2 ∆t + σS ∆t ξS ,
2
where ∆t is the time increment and ξS is a standard normal random variable.

The drift and the diffusion of the Tremont hedge fund index are computed analogously
to the market portfolio. The correlation is estimated by calculating the correlation of
the residuals of ln(A) and ln(S). With these estimates at hand, α can be estimated by
subtracting r + β(µS − r) from the mean of the Tremont hedge fund index returns.
Table 5.1. Typical values for the estimated parameters.
Parameter value std. error t stat. Parameter value std. error t stat.
κ 0.26 0.05 4.8 µS 0.1 p.a. 0.008 11.7
θ 0.07 p.a. 0.005 13 σS 0.16 p.a. 0.004 38.8
σr 0.02 p.a. 0.0007 27.5 ρ 0.49 0.07 6.9
λ 0.56 0.04 14.8 α 0.05 p.a. 0.014 3.27
τ 3.66 years 0.4 8.9 σA 0.09 p.a. 0.006 14.1
Using the time series of the market and the short rate from 1972 to 2005, the bond
index from 1980 to 2005, and the alternative asset from 1994 to 2005, we estimate the
parameters of the stochastic processes. Table 5.1 shows the results. By considering the t
statistics of all parameters, it is seen that they are all significant.
2.5
1.5
1
Portfolio weights ui
0.5
0
PSfrag replacements
−0.5
−1 u1 : Bond
u2 : Stock market
u3 : Alternative inv.
−1.5
Short rate
−2
0 1 2 3 4 5 6 7 8 9 10
Time [years]
Fig. 5.1. Asset allocation strategy under full information for γ = −10.
Note that price of risk λ for the bond has a positive sign as in the original Vasicek
(1977) model although it is often found to be introduced with a negative sign in recent
texts. In Figure 5.1, the asset allocation for an investor with a risk aversion coefficient
γ = −10 is shown. We see that for the observed parameter values, the weight in the bond
is always the biggest. This may change by choosing different parameter values. The bigger
γ, the more aggressive the asset allocating strategy becomes. Because of our model, only
the bond part of the portfolio is time-dependent for a given parameter set.
However, in the implementation of the strategy, also the other portfolio weights vary
because the parameters are constantly updated. Finally, the asset allocation strategy is
implemented. In order to have reasonable estimates for all parameters, the investment
strategy is implemented starting in January 1997. The portfolio is adjusted every month.
2.8
Portfolio
2.6 DS bond index 3-5 years
Stock market
Alternative Investment
2.4
2.2
2
Value
1.8
PSfrag replacements
1.6
1.4
1.2
1
Mar97 Jul98 Dec99 Apr01 Sep02 Jan04 May05
Time
Fig. 5.2. Asset allocation strategy performance under full information for γ = −10.
The investment horizon of the investor ends in December 2005. As new observations are
available, the model parameters are recalculated using all past data available. The appli-
cation of the data is done as in Brennan et al. (1997) and Bielecki, Pliska and Sherris
(2000). The investment strategy is always implemented in an out-of-sample manner. Fig-
ure 5.2 shows the results for γ = −10. The investment strategy outperforms the S&P 500
and the Tremont hedge fund index by far.
Table 5.2 shows the key figures of the considered time series. The Sharpe ratio of the
equity market is rather poor compared to the others. This is due to the bear market from
2000 to 2003. It is noteworthy that the Sharpe ratio of our portfolio does not change
significantly for different γ’s. The high Sharpe ratios in Table 5.2 give evidence that the
risk adjusted returns of the investment strategy are superior to the ones of the single
assets.
Table 5.2. Key figures for the asset allocation strategy under full information
return volatility Sharpe

(p.a.) (p.a.) ratio
γ = −5 0.17 0.12 0.93
γ = −10 0.12 0.09 0.93
γ = −20 0.08 0.04 0.90
DS 3-5 years 0.06 0.04 0.62
S&P500 0.07 0.16 0.21
Tremont 0.10 0.08 0.84
In the phase of July 1998 to December 1999, the investment strategy does not show a
good performance. This because of the enormous drop of the hedge fund index in 1998
which causes the controller to significantly reduce its position in the alternative asset.
In the beginning of 2001, the controller is starting to take short positions in the market,
which is still the case at the end of the considered time period. For more details about
this case study, the reader is referred to Keel et al. (2004).
5.2 The Partial Information Case
Asset price models usually contain unknown parameters. This fact is not taken into ac-
count in general. In the application of optimal asset allocation strategies, the estimated
parameters are often treated as deterministic. This may lead to falsified investment deci-
sions when the uncertainty on the parameters is significant. In order to improve the asset
allocation, we do not only consider the problem of unknown parameters but also include
external factors in the model. By carefully choosing explanatory variables for the asset re-
turns, we expect the performance of the optimal asset allocation strategy to improve. The
dynamics of these factors are modeled as well and have to be included in the optimiza-
tion. The number and nature of the factors are crucial for the quality of the results of the
optimization. We consider two kinds of factors. On the one hand, we consider observable
factors, whose current values are known to the investor, i.e., no estimation is necessary.
On the other hand, we consider unobservable factors which are, technically speaking, not
5.2 The Partial Information Case 95
measurable with respect to the investor’s filtration. Since the values of these factors are
not known, the investor has to estimate their values. In this framework, the methods of
the Kalman filter are used. The usage of factors with predictive power is motivated by
the literature.
Linear filtering is a well-established research area since the work of Kalman (1960)
and Kalman and Bucy (1961). The Kalman filter is well-suited for the investor’s dynamic
inference problem and is used as maximum likelihood estimator of the current values
of the unobservable processes as well as predictor for their further evolvement. In order
to work with the Kalman filter, we need a priori estimates of the starting values of the
unobservable processes as well as their error covariance matrix. From the dynamics of the
Kalman filter, we may deduce the future evolvement of the expected values as well as
their error covariance matrices.
The first results for economic problems under incomplete information are found in
Detemple (1986), Dothan and Feldman (1986), and Gennotte (1986). The results in these
papers are rather specific, i.e., closed-form solutions are derived for logarithmic utility
functions. Brennan (1998) analyzes the case of one risky asset with a constant, unknown
drift parameter. The investor is assumed to have constant relative risk aversion. Numerical
results are presented for this case. Brennan (1998) also shows that the myopic investor,
having a logarithmic utility function, does not hedge against unfavorable changes of the
drift of the risky asset. Therefore, the myopic investor is not able to improve the asset
allocation strategy by inspecting asset prices over time. Xia (2001) analyzes the case of
dynamic unobservable factors and finds the opportunity costs of ignoring the predictability
of asset returns as substantial. A closed-form solution for one single risky asset is also found
in Rogers (2001). Rogers observes that the impact of parameter uncertainty is more severe
than the problem of infrequent trading, i.e., the investor cannot continuously change the
composition of the portfolio.
In Brennan and Xia (2001b), the same methodology is used to derive a general equi-
librium model for stock prices. The non-observability of the expected dividend growth
rate is used in order to derive a representative agent model with rational behavior. The
results are tested numerically as well. In Brennan and Xia (2001a), an optimal portfolio
strategy is developed for an investor who has detected a price anomaly. Cvitanić et al.
(2003) analyze the optimal asset allocation for portfolios including hedge funds, the proofs
are found in Cvitanić et al. (2004). The authors derive an analytical solution in the case
of unobservable market returns as well as unobservable abnormal or excess returns of the
hedge fund. As in the papers of Brennan and Xia, the results are applied to financial data.
The model for the problem in this chapter is similar to the model in Sekine (2001).
However, Sekine (2001) uses the convex-duality method to derive the solutions whereas we
us a dynamic programming approach. This results again in two matrix Riccati equations,
which express the solution of the primal and the dual problem. The dual optimizer defines
the equivalent martingale measure. For a comparison of the two methods, the reader may
refer to Runggaldier (2003). The infinite-time horizon problem is considered in Bielecki
and Pliska (1999) and Nagai and Peng (2002). For a survey on the topic of optimal control
under uncertainty, the reader may refer to Runggaldier (1998), who also considers the case
of discrete-time problems.
5.2.1 The Model
The investment opportunities are modeled via stochastic differential equations. They are
assumed to behave as local geometric Brownian motions. The drift terms of the asset price
dynamics are modeled as affine functions of explanatory factors. The values of these factors
are either known or unknown to the investor. We model the observable and unobservable
factors as stochastic differential equations as well. In the case of the unknown factors,
the investor has to estimate current values of the factors. Because of our model, we
may use model-based filtering, i.e., we make use of the Kalman filter. The diffusions of
the n risky price processes are driven by an n-dimensional standard Brownian motion
process Wp . Similarly, the diffusions of the m observable and the k unobservable factors
processes are driven by the m- and k-dimensional standard Brownian motion processes W x
and Wy , respectively. The drift terms of observable and unobservable factors are linearly
dependent. In addition to the risky asset, there is a risk-free asset (or bank account) whose
instantaneous return is deterministic. However, the return on the risk-free asset may be
time-dependent or even stochastic.
The Brownian motion Wp of the price processes and the Brownian motions Wx and Wy
of the factor processes are defined on a fixed, filtered probability space (Ω, F, {F t }t≥0 , P)
with Ft satisfying the usual conditions. The Brownian motions Wp , Wx , and Wy do not
need to be independent.
Factor Dynamics
In order to improve the asset allocation, factors are included in the investors model.
We expect the factors to have some predictive power for the returns of the investment
opportunities. We consider two kinds of factors. On the one hand, there are observable
factors whose values are known to the investor. On the other hand, there are unobservable
factors whose values are unknown to the investor. The m observable factors x(t) ∈ R m
are modeled as the following stochastic vector process
dx(t) = [Ax (t)x(t) + Ay (t)y(t) + a(t)]dt + σx (t)dWx (t) (5.26)
x(0) = x0 ,
where Ax (t) ∈ Rm×m , Ay (t) ∈ Rm×k , a(t) ∈ Rm , σx (t) ∈ Rm×m , and Wx (t) ∈ Rm . The
matrix and vector functions Ax (t), Ay (t), a(t), and σx (t) are all deterministic functions.
In addition, σx (t) is assumed to have full rank. The k unobservable factors y(t) ∈ Rk are
modeled similarly as
dy(t) = [Cx (t)x(t) + Cy (t)y(t) + c(t)]dt + σy (t)dWy (t) (5.27)
y(0) = y0 ,
where Cx (t) ∈ Rk×m , Cy (t) ∈ Rk×k , c(t) ∈ Rk , σy (t) ∈ Rk×k , and Wy (t) ∈ Rk . The matrix
and vector functions Cx (t), Cy (t), c(t), and σy (t) are deterministic functions. Since y(0)
is not known, we need an a priori estimate of y(0), denoted by m(0). The error variance
of this estimation is denoted by the covariance matrix ν(0).
Asset Price Dynamics
The set of investment opportunities of our investor consists of n ≥ 1 risky assets. The
asset price processes P = (P1 (t), P2 (t), . . . , Pn (t)) ∈ Rn of the risk-bearing investments
satisfy the stochastic differential equations, where diag(P (t)) denotes the diagonal matrix
of the vector P (t),
dP (t) = diag(P (t)) {µ(x(t), y(t), t) dt + σp (t)dWp (t)} (5.28)
P (0) > 0 ,
where µ(x(t), y(t)) ∈ Rn , σp (t) ∈ Rn×n , and Wp (t) ∈ Rn . The matrix function σp is
assumed to be deterministic. The drift vector µ contains the relative expected instanta-
neous changes of the prices P . From the diffusion matrix σp , we get the instantaneous
covariance matrix per unit time as Σ(t) = σp (t)σp (t)T . The matrix function Σ has to be
invertible, therefore σp has to have full rank. In addition, there exists a risk-free investment
opportunity B(t) with instantaneous rate of return r(x(t)):
dB(t) = B(t)r(x(t), t)dt (5.29)
B(0) > 0 .
The scalar function r is deterministic. The drift terms of the risk-free asset and the risk-
bearing assets depend on the m observable factors x. In addition, the drift terms of the
risk-bearing assets depend on the k unobservable factors y. Furthermore, we assume that
the drift terms in (5.28) and (5.29) are affine functions of the factor levels, as given by
µ(x(t), y(t), t) = G(t)x(t) + H(t)y(t) + f (t) (5.30)
r(x(t), t) = F0 (t)x(t) + f0 (t) , (5.31)
where G(t) ∈ Rn×m , H(t) ∈ Rn×k , f (t) ∈ Rn , F0 (t) ∈ R1×m , and f0 (t) ∈ R. The matrix
and vector functions G(t), H(t), f (t), F0 (t), and f0 (t) are all deterministic.
5.2.2 Estimation of the Unobservable Factors
Since the investor cannot observe the values of y, some kind of estimation (filtering) of
the values of y is needed. The estimation with the introduced dynamics is a standard
filtering problem and can be solved with the methods of the Kalman filter. The asset
prices depend on the unknown values of y(t). Because of this, we cannot derive the optimal
asset allocation strategy based on these asset price dynamics. This would not result in
an admissible investment process, see Bielecki and Pliska (1999) for details. Therefore,
the asset price dynamics need to be transformed as well. The main idea to overcome
this problem is to transform the factor and the asset price dynamics such that they are
independent of y.
For notational convenience, we introduce the vector ξ = [log(P T ), xT ]T ∈ Rn+m , con-
taining the logarithmic prices and the observable factors. We define the Brownian motion
Wξ = [WpT , WxT ]T ∈ Rn+m , where Wp is as in (5.28) and Wx as in (5.26). The diffusion
term σξ ∈ Rn+m×n+m and the matrix Dy ∈ Rn+m×k are defined as
   
σp 0 H
σξ =  , Dy =   .
0 σx Ay
The Brownian motions Wp , Wx , and Wy need not be independent. The correlation matrix
of the n + m + k dimensional Brownian motion W = [WyT , WpT , WxT ]T ∈ Rn+m+k is defined
as
 
I ρyp (t) ρyx (t)  
 1  I1 ρyξ (t)
 
ρ(t) =  ρTyp (t) I2 ρpx (t)  =  ,
  T
ρyξ (t) ρξ (t)
ρTyx (t) ρTpx (t) I3
where I denotes the identity matrix and ρyp ∈ Rk×n , ρyx ∈ Rk×m , ρpx ∈ Rn×m , I1 ∈ Rk×k ,
I2 ∈ Rn×n , and I3 ∈ Rm×m . In order to be regular, the correlation matrix ρ needs to be
symmetric and positive-definite for all t. We summarize the result in the following lemma.
Lemma 5.3 (Transformation of the Price Dynamics).

Let the price dynamics evolve as introduced in (5.28) and the factors as in (5.26) and
(5.27). The function µ(x, y) is defined in (5.30). Summarized,
dP = diag(P ) {µ(x, y) dt + σp dWp }
dx = [Ax x + Ay y + a]dt + σx dWx
dy = [Cx x + Cy y + c]dt + σy dWy .
Then, there exists a Brownian motion Wξ0 ∈ Rn+m which generates the same information
as [WpT , WxT ]T . The estimate of y with the Kalman filter is denoted by m, the estimation
error by ν. The transformed dynamics with the new Brownian motion Wξ0 are
dP = diag(P ){µ(x, m)dt + σ p dWξ0 }
dx = [Ax x + Ay m + a]dt + σ x dWξ0
dm = [Cx x + Cy m + c]dt + [B1 + νDyT ]B2 σ ξ dWξ0
ν̇ = Cy ν + νCyT + B3 − [B1 + νDyT ]B2 [B1 + νDyT ]T
ν(0) = E[(y(0) − m(0))(y(0) − m(0))T ].
where B1 = σy ρyξ σξT , B2 = [σξ ρξ σξT ]−1 , and B3 = σy σyT . The volatility matrices are
obtained from (5.32).
Proof. See Appendix C.2.
The volatility matrices σ ξ ∈ Rn+m×n+m , σ p ∈ Rn×n+m , and σ x ∈ Rm×n+m are obtained

by the relationship for the following block matrices
     
σ y σ yξ σy 0 σp
 =  ρ 12 , σξ =  . (5.32)
0 σξ 0 σξ σx
1 1
The Cholesky factorization of ρ is a good choice for ρ 2 , i.e., ρ 2 is an upper triangu-
lar matrix. The transformation of the price dynamics of the investment opportunities is
necessary to transform the partial-information problem into a full-information problem.
5.2.3 Portfolio Dynamics and Problem Transformation
We assume that the investor’s portfolio is self-financing, i.e., there are no exogenous in-
or outflows of money, e.g., consumption. The dynamics of the investor’s wealth V may be
expressed as
³ dB(t) X n
dPi (t) ´
dV (t) = V (t) u0 + ui (t) , (5.33)
B(t) i=1
P i (t)
V (0) > 0,
asset and u0 (t) accordingly in the risk-free asset at time t. The proof is either found
in Merton (1992) or Björk (1998). Because the portfolio is self-financing, we have the
P
constraint ni=0 ui (t) = 1. By using Lemma 5.3, we can transform the investor’s wealth
dynamics into a full information process.
Theorem 5.4 (Transformation of the Wealth Dynamics).

Let the price dynamics evolve as in (5.28), where the factors evolve as in (5.26) and (5.27).
Define 1n as the vector 1n = (1, 1, . . . , 1)T ∈ Rn . Then the investors wealth dynamics
under partial information evolve like
dV
= {uT [µ(x, y, t) − 1n r(x, t)] + r(x, t)}dt + uT σp dWp
V
dx = [Ax x + Ay y + a]dt + σx dWx
dy = [Cx x + Cy y + c]dt + σy dWy
V (0) > 0.
The investors wealth dynamics under full information, written in terms of W ξ0 , are iden-
tical to those under partial information. The same notation and definitions apply as in
Lemma 5.3. The wealth dynamics under full information are
dV
= {uT [µ(x, m, t) − 1n r(x, t)] + r(x, t)}dt + uT σ p dWξ0
V
V (0) > 0.
Proof. The proof is straightforward. The results of Lemma 5.3 are applied to the self-
financing portfolio dynamics introduced in (5.33).
By using Theorem 5.4 we may transform a partial-information problem into a full-

information problem as shown in the next section.
5.2.4 Optimal Asset Allocation
Optimal Asset Allocation with a CRRA Utility Function
The optimal asset allocation is derived for an investor having constant relative risk aver-
sion (CRRA). The expected power utility over terminal wealth is maximized. We may
state the investor’s optimization problem under full information by using Theorem 5.4.
Therefore, the problem is formulated in terms of the Wiener process Wξ0 , the time argu-
ments are omitted for better readability, as
h1 i
γ
max E V (T )
u(·)∈L1n γ
s.t.
dV = V {uT [µ(x, m, t) − 1n r(x, t)] + r(x, t)}dt + V uT σ p dWξ0 (5.34)
V (0) > 0.
The parameter γ < 1 is the coefficient of risk aversion. The covariance matrix of the
estimation error ν is also present in the optimization problem. Since ν is the solution
of the ordinary differential equation (see Lemma 5.3), it is a deterministic function.
The matrices B1 and B2 are also defined in Lemma 5.3. For convenience, we introduce
θ = [xT , mT ]T ∈ Rm+k and rewrite the problem above as
h1 i
max1 E V (T )γ
u(·)∈Ln γ
s.t.
dV
= {uT [F θ + f ] + F 0 θ + f0 }dt + uT σ p dWξ0 , (5.35)
V
dθ = [Aθ + b]dt + σθ dWξ0 ,
V (0) > 0.
The deterministic matrix functions F ∈ Rn×m+k , F 0 ∈ R1×m+k , and f ∈ Rn of the

investors wealth dynamics are defined as
h i
F = G − 1 n F0 , H (5.36)
h i
F 0 = F0 , 0 (5.37)
f = f − 1 n f0 . (5.38)
The deterministic matric functions G, F0 , f , f0 , and H are defined in (5.30) and (5.31),
for the vector 1n we have 1n = (1, 1, . . . , 1)T ∈ Rn . Additionally, the deterministic matrix
functions A ∈ Rm+k×m+k and b ∈ Rm+k of the dynamics of θ are
   
Ax Ay a
A= , b =  . (5.39)
Cx Cy c
The components of A and b are defined in (5.26) and (5.27). The diffusion matrix of θ,
denoted by σθ ∈ Rm+k×n+m , is only used in this form for the proof and is defined as
 
σx
σθ =  . (5.40)
(B1 + νDyT )B2 σ ξ
In order to solve this problem with Bellman’s optimality principle, we introduce the value
or cost-to-go function as
h1 i
J(t, V, θ) = max1 E V (T )γ . (5.41)
u(·)∈Ln γ
The optimal asset allocation strategy is the solution of the Hamilton-Jacobi-Bellman

equation, which for this problem is
h
Jt + maxn V (uT [F θ + f ] + F 0 θ + f0 )JV + (Aθ + b)T Jθ
u∈R
1 1 i
+ V 2 uT ΣuJV V + V uT σ p σθT JV θ + tr{Jθθ σθ σθT } = 0, (5.42)
2 2
with terminal condition J(T, V (T ), θ(T )) = γ1 V (T )γ . The optimal control law u∗ of this
problem is given by
1 ³ ´
∗ −1 T
u = Σ F θ + f + σ p σθ [K1 θ + k2 ] . (5.43)
1−γ
We want to eliminate the parameters introduced by the filtering. Therefore, we introduce
two new matrices Ψ ∈ Rn×m+k and Γ ∈ Rm+k×m+k with the following definitions
Ψ = σ p σθT = [σp ρpx σxT , σp ρTyp σyT + Hν T ] (5.44)

 
T T T T
σx σx σx ρyx σy + Ay ν
Γ = σθ σθT =  , (5.45)
T T T T T
σy ρyx σx + νAy (B1 + νDy )B2 (B1 + νDy )
where B1 are B2 are defined as in Lemma 5.3. We can finally give the solution of the
optimal asset allocation strategy (θ = [xT , mT ]T ∈ Rm+k ),
1 ³ ´
u∗ = Σ −1 F θ + f + Ψ [K1 θ + k2 ] , (5.46)
1−γ
where K1 (t) ∈ Rm+k×m+k and k2 (t) ∈ Rm+k are the solutions of two matrix Ricatti
equations. The differential equation for the matrix K1 (t) is given by
1
K̇1 + K1 Γ K 1 + K 1 A + A T K1
1−γ
γ ³ ´
− F T Σ −1 F + F T Σ −1 Ψ K1 + K1 Ψ T Σ −1 F = 0, (5.47)
γ−1
with terminal condition K1 (T ) = 0. The differential equation for the vector k2 (t) is given
by
T 1
k˙2 + γF 0 + K1 Γ k2 + AT k2 + K1 b
1−γ
γ ³ ´
− F T Σ −1 f + F T Σ −1 Ψ k2 + K1 Ψ T Σ −1 f = 0, (5.48)
γ−1
with terminal condition k2 (T ) = 0. We summarize the results in the following theorem.
Theorem 5.5 (Partial Information, CRRA Case).

The optimal asset allocation strategy under partial information for the CRRA case (5.34)
is given by (5.46), where K1 (t) and k2 (t) are the solutions of two matrix Ricatti equations
(5.47) and (5.48), respectively.
Proof. The problem in (5.34) is the full-information representation of the partial-information

problem. The transformation is based on Theorem 5.4. The solution of the full-information
problem is found in Lemma 5.1.
Note that (5.47) is a well-known Riccati type equation. In the case where all the
parameters are constant, the Riccati equation (5.47) possesses a positive-definite and
finite solution for T → ∞, if the following two conditions are met:
h³ γ ´ ³ 1 ´ 12 i
Ψ T Σ −1 F − A , Γ (5.49)
γ−1 1−γ
is controllable, and
h³ γ ´ 12 ³ γ í
T −1 T −1
F Σ F , Ψ Σ F −A (5.50)
γ−1 γ−1
1 1
is observable in the control engineering sense, see Xu and Lu (1995). The matrix ( 1−γ Γ )2
1 γ 1
is a full rank factorization of ( 1−γ Γ ) and the matrix ( γ−1 F T Σ −1 F ) 2 is a full rank factor-
γ γ 1
ization of ( γ−1 F T Σ −1 F ). Additionally, the matrix ( γ−1 F T Σ −1 F ) and the matrix ( 1−γ Γ)
must be positive-definite. The conditions for solving matrix Riccati equations are well-
known in control engineering. For further details the reader may refer to Anderson and
1 γ
Moore (1990). If the matrix ( 1−γ K1 Γ + A T − γ−1
F T Σ −1 Ψ ) is invertible and (5.47) pos-
sesses a positive-definite finite solution, then (5.48) possesses a finite solution for T → ∞.
Note that for γ > 0, the Riccati equation (5.47) possesses no finite solution, Kim and
Omberg (1996) call the solution for this case nirvana solution.
Optimal Asset Allocation with a CARA Utility Function
The optimal asset allocation is derived for an investor having constant absolute risk aver-
sion (CARA). The expected exponential utility over terminal wealth is maximized. For
the problem to be solvable, we model the risk-free interest rate r(t) only as a function of
time and independent of x(t). Therefore, we set F0 ≡ 0 in (5.31). We proceed as in the
CRRA case and therefore state the investors optimization problem as
h 1 i
−γV (T )
max E − e
u(·)∈L1n γ
s.t.
dV = V {uT [µ(x, m, t) − 1n r] + r}dt + V uT σ p dWξ0 (5.51)
V (0) > 0.
The parameter γ > 0 is the coefficient of risk aversion. We introduce θ = [xT , mT ]T ∈ Rm+k
for convenience and rewrite the problem above as
h 1 i
max1 E − e−γV (T )
u(·)∈Ln γ
s.t.
dV = V {uT [F θ + f ] + f0 }dt + V uT σ p dWξ0 (5.52)
dθ = [Aθ + b]dt + σθ dWξ0
V (0) > 0.
The deterministic matrix function F ∈ Rn×m+k is defined as

h i
F = G, H , (5.53)
f = f − 1 n f0 . (5.54)
The deterministic matrix functions A ∈ Rm+k×m+k and b ∈ Rm+k are defined in (5.39).
The diffusion matrix σθ ∈ Rm+k×n+m is, again, only used for the proof and is defined as
in (5.40). The value or cost-to-go function for this problem is defined as
h 1 i
J(t, V, θ) = max1 E − e−γV (T ) . (5.55)
u(·)∈Ln γ
The Hamilton-Jacobi-Bellman partial differential equation for this problem is

h
Jt + maxn V {uT [F θ + f ] + f0 }JV + (Aθ + b)T Jθ
u∈R
1 2 T 1 i
T T T
+ V u ΣuJV V + V u σ p σθ JV θ + tr{Jθθ σθ σθ } = 0. (5.56)
2 2
The optimal solution u∗ is given by
1 ³ ´
u∗ = − Σ −1 F θ + f + Ψ [K1 θ + k2 ] , (5.57)
γV k3
where Ψ is defined in (5.44). What remains to be done is to derive the functions K1 (t),
k2 (t), and k3 (t). The matrix function K1 (t) is the solution of the following linear matrix
differential equation
K̇1 + K1 A + AT K1 − F T Σ −1 F − F T Σ −1 Ψ K1 − K1 Ψ T Σ −1 F = 0 (5.58)
K1 (T ) = 0 .
The vector function k2 (t) is the the solutions of the following differential equation
k˙2 + AT k2 + K1 b + F T Σ −1 f − F T Σ −1 Ψ k2 + K1 Ψ T Σ −1 f = 0 (5.59)
k2 (T )= 0 .
Finally, the scalar function k3 (t) is the solution of the following differential equation
k˙3 + f0 (t)k3 = 0, k3 (T ) = −γ . (5.60)
We summarize the results in the following theorem.
Theorem 5.6 (Partial Information, CARA Case).

The optimal asset allocation strategy under partial information for the CARA case (5.51)
is given by (5.57), where K1 (t), k2 (t) and k3 (t) are the solutions of the differential equa-
tions (5.58), (5.59), and (5.60), respectively.
Proof. The proof is analogous to the proof of Theorem 5.5.
For the conditions for solvability of the CARA problem, the reader may use the same
methodology as for the CRRA case.
5.2.5 Case Study with a Balanced Fund
The previously obtained results are applied in a balanced fund example. The balanced
fund consists of cash, bonds, stocks, and an absolute return product, which is deemed to
be a hedge fund. The investment opportunities are modeled similarly to the ones in the
case study for the full information case. However, the model is improved in some aspects.
The drift of the equity market is stochastic and not known exactly to the investor. We
model the excess return α of the absolute return product as an unknown constant.
Asset Models
We first introduce the dynamics of the short rate (or money market interest rate), denoted
by r. Let r be a mean-reverting process,
dr = κ(θ − r)dt + σr dWr , (5.61)
r(0) = r0 ,
where κ, θ, σr ∈ R are the constant parameters of the short rate. This process can be
observed in continuous-time. The dynamics of the fixed income security is derived from
the short rate, based on the methods of Vasicek (1977). We therefore get for the zero-
coupon bond dynamics
³ λσr ´ σr
dB = B r + aT dt − B aT dWr , (5.62)
κ κ
B(T ) = 1,
where the scalar function aT (t) is defined as
aT (t) = 1 − e−κ(T −t) . (5.63)
The dynamics of the bond price B(t) are derived from the short rate by no-arbitrage
reasoning. As already mentioned in the introduction, we do not consider a single bond
but rather a bond index.
We model the equity market index by its stochastic differential equation as given by
dS = Sµdt + Sσs dWs , (5.64)
S(0) = S0 ,
where σs ∈ R is the constant parameter of the model. The drift of the equity market
is assumed to be stochastic. It is modeled as mean-reverting process and satisfies the
following stochastic differential equation, µ(0) = µ0 ,
dµ = ζ(η − µ)dt + σµ dWµ , (5.65)
dWs dWµ = ρ̃dt,
where ζ, η, σµ ∈ R are the constant parameters of the model. The correlation of the two
Brownian motions Ws and Wµ is denoted by ρ̃ ∈ R. Note that we have an incomplete
market model for |ρ̃| 6= 1. Since we do not deal with the problem of pricing contingent
claims, this is not a limiting assumption.
It remains to model the alternative asset in order to analyze the balanced fund. As
mentioned above, we use a model resembling to Merton’s intertemporal capital asset
pricing model (ICAPM). Therefore, the price of the alternative asset, denoted by A(t),
evolves like
p
dA = A(r + β(µ − r) + α)dt + A σA (ρdWs + 1 − ρ2 dWA ), (5.66)
A(0) = A0 ,
where β, σA , ρ ∈ R are the constant parameters of the model. The excess return of the
alternative investment, denoted by α ∈ R, is assumed to be an unknown constant.
The excess return is unknown to the investor, i.e., not measurable by the investor. The
value of α describes the ability of hedge fund managers to outperform the market. In order
to comply with the general model, the Brownian motion Wα ∈ R is introduced. Since Wα
does not influence α, it does not affect the solution of the problem. It is therefore assumed
to be independent of the other dynamic processes. The main reason to model α as unknown
constant is the lack of available data for alternative investments. We do not want to build
a model for which we cannot obtain reasonable parameter estimates. Furthermore, the
Brownian motions Wr , Ws , Wµ , WA , and Wα are assumed to be mutually independent
except that Ws and Wµ are correlated with ρ̃. Therefore, the correlation matrix ρyx is a
zero matrix for this case study.
Again, r + β(µs − r) describes the risk adjusted return of the asset with respect to the
market, whereas α denotes the outperformance of the alternative asset. The β parameter
is defined to be
cov(dS/S, dA/A) ρσA

β= 2
= , (5.67)
σs σs
where ρ denotes correlation between the diffusions of the equity market index and the
diffusion of the alternative asset. We introduce a three-dimensional control vector u. The
three components of u represent the percentage of total wealth invested in the correspond-
ing investment category.
Optimization Problem
The observable factors consist of r, defined in (5.61). Therefore we set x = r. This results
for the matrices Ax , Ay , a, and σx in the model of (5.26) in
h i h i h i h i
Ax = −κ , Ay = 0 0 , a(t) = κθ , σ x = σr . (5.68)
The driving Brownian motion Wx of the observable factors is defined as Wx = Wr . The

unobservable factors consist of µ, as defined in (5.65), and α, which is an unknown con-
stant. The vector y is thus defined as y = [µ, α]T , and the matrices Cx , Cy , c, and σy in
(5.27) are
       
0 −ζ 0 ζη σµ 0
Cx =   , Cy =  , c= , σy =  . (5.69)
0 0 0 0 0 0
The Brownian motion Wy is defined as Wy = [Wµ , Wα ]T .

The vector of asset price processes of (5.28) is P = [B, S, A]T . The drift terms of
the risky investment opportunities are defined in (5.30). We therefore need to define the
matrices G, H, and f in this equation, which are
     
λσr
1 0 0 κ T
a
     
     
G =  0 , H = 1 0 , f = 0 . (5.70)
     
1−β β 1 0
The drift term of the risk-free asset is defined in (5.31). For its determination we need to
define the terms F0 and f0 , which are
F0 = 1, f0 = 0. (5.71)
The diffusion of the risky investment opportunities of (5.28) are determined by the
covariance matrix σp . From the asset price dynamics of (5.62), (5.64), and (5.66) we get
 
σr
− a (t) 0 0
 κ T 
 
σp (t) =  0 σs 0 . (5.72)
 p 
0 σ A ρ σA 1 − ρ 2
The Brownian motion Wp is defined as Wp = [Wr , Ws , WA ]T . The correlation matrix is

defined as a block matrix. The three block matrices in this case are
 
    1
0 ρ̃ 0 0  
 
ρyp =  , ρyx =   , ρpx =  0  . (5.73)
0 0 0 0  
0
Recall that m(t) denotes the expected values of the unobservable factors. We may now
use Theorem 5.5 to derive the optimal solution for this problem, where θ = [xT , mT ]T , as
1 ³ ´
∗ −1
u = Σ F θ + Ψ [K1 θ + k2 ] .
1−γ
The matrix function F in the equation above is defined in (5.36). The deterministic matrix
functions Ψ and Γ are defined in (5.44) and (5.45), respectively. The matrix and vector
function K1 and k2 are the solutions of the matrix Riccati equations, as given in (5.47)
and (5.48).
Backtest with Historical Data
We finish the case study by applying the derived results to historical US data. The data
is the same as in the case study for the full information case. Therefore, the three-month
Treasury bills are chosen as a substitute for the short rate, the S&P 500 for the market
portfolio, the Datastream USA Total 3-5 years for the bond index, and the Tremont hedge
fund index for the alternative part of the portfolio. Again, we assume that the bond has
a fixed duration. Therefore, the time dependent function aT (t) is redefined as a function
of the duration of the bond τ only.
The parameters of the fixed-income model are estimated by using regression techniques
with the discrete versions of the stochastic differential equations. The parameters of the
short rate are estimated by doing an ordinary least squares estimation on the discrete-
time version of the short rate. We discretize the stochastic differential equation for the
short rate,
√
rt+1 = κθ∆t + (1 − κ∆t)rt + σr ∆t ξr ,
where ∆t is the time increment and ξr is a Gaussian white noise process. With the same
procedure we arrive at the parameters of the bond index.
³ σ 1 ³ σr ´2 ´ σr √
r
ln(Bt+1 ) − ln(Bt ) − rt ∆t = λ aT (τ ) + aT (τ ) ∆t + aT (τ ) ∆t ξr .
κ 2 κ κ
The duration τ and the price of risk λ of the bond index are estimated by estimating
mean and variance of the series above.
The problem of parameter estimation for the equity market index is more involved
than for the bond index because of the unobservable drift process µ of (5.65). We use
the Kalman filter as a tool for parameter identification. The methodology of using the
Kalman filter for parameter identification is discussed in Hamilton (1994). For parameter
identification in financial problems, the reader may consult Kellerhals (2001). We do not
give full details of the parameter estimation but, nevertheless, give the problem statement.
Define p to be the logarithmic stock prices, i.e., p = log(S). The discrete dynamics with
sampling time ∆t then are
         
pk+1 1 ∆t pk − 21 σs2 ∆t √ σs 0 ξ
 =   +   + ∆t  p  s,
µk+1 0 1 − ζ∆t µk ζη∆t ρ̃σµ 1 − ρ̃2 σµ ξµ
where ξs and ξµ are two independent Gaussian white noise processes. We observe a large
negative correlation of the equity index S and its drift µ, denoted by ρ̃. This behavior is
also found in Wachter (2002) and the references therein.
Having estimated the parameters of the equity market index, the parameters for the
alternative investment may be estimated. The parameters are not estimated altogether
because only monthly data is available for the hedge fund index. We estimate the excess
or abnormal return α and the correlation coefficient ρ again with the methods of the
Kalman filter. Define φ to be the logarithmic prices of the alternative investment, i.e.,
φ = log(A). The discrete dynamics with sampling time ∆t are
      
φk+1 1 β∆t (1 − β)∆t ∆t φk − 12 σA2 ∆t
      
      
 µk+1   0 1 − ζ∆t 0 0   µk   ζη∆t 
 =   +  
      
 rk+1   0 0 1 − κ∆t 0   rk   κθ∆t 
      
αk+1 0 0 0 1 αk 0
 p  
ρσ 1 − ρ 2 σA 0 0 ξ
 A p  s 
   
√  ρ̃σµ 0 1 − ρ̃2 σµ 0   ξA 
+ ∆t 
 ,
 
 0 0 0 σ r   ξµ 
  
0 0 0 0 ξr
where ξs , ξA , ξµ , and ξr are independent Gaussian white noise processes. In order to have
accurate parameters, the parameter estimation is conducted before every adjustment of
the portfolio. Figure 5.3 shows the estimated trajectories of α and µ. The time ranges from
January 1994 to June 1999 with a monthly sampling frequency. We observe a very strong
stock market in this time period. We interpret this as high confidence of the investors
that the stock market would rise constantly, as it did in this time period.
0.2
0.18
0.16
0.14
0.12
Market drift µ(t)

0.1 Short rate r(t)
Excess return α(t)
PSfrag replacements
0.08
0.06
0.04
Jun94 Oct95 Mar97 Jul98

Time
Fig. 5.3. Estimations of the short rate and the unobservable factors α and µ.
The estimated α is a little bit less than 4% for this time period. In Figure 5.4, the
optimal asset allocation strategy is plotted for a rather aggressive investor, i.e., γ = −10.
Because the involved Riccati equations, the resulting strategy is a non-linear function
of time. The investment horizon is a little bit less than twelve years. The strategy of
Figure 5.4 would be applied if the investor would not use any further information until
the end of the problem at time T . The position in the bond index is highly leveraged
and is slowly decreasing in time. The proportion of wealth invested in the stock market
is more or less constant, only in the beginning and in the end, minor non-linearities are
observed. The position in the hedge fund is increasing with time. The reason for this
the high uncertainty of α. The estimated variance of the Kalman filter is decreasing
over time and therefore the position in the hedge fund is accordingly increased. Because
of the uncertainty of α, the optimal asset allocation strategy allocates less capital to
the alternative investment. We generally state that the asset allocation strategy is less
aggressive under partial information than under full information.
1.5
1
Portfolio weights ui
0.5
PSfrag replacements
−0.5 u1 : Bond
u2 : Stock market
u3 : Alternative inv.
−1 Short rate
−1.5
−2
0 2 4 6 8 10
Time [years]
Fig. 5.4. Asset allocation strategy under partial information for γ = −10.
Table 5.3 gives the key figures of the different strategies. The asset allocation is per-
formed for three risk aversion coefficients, i.e., γ = −5, γ = −10, and γ = −20. The
return, volatility, and Sharpe ratio are reported for the different time series. The bond
index, denoted by DS 3–5 years, has the lowest return but still an attractive Sharpe ratio
because of its low volatility. The equity index, in this case the S&P 500, has a poor per-
formance in terms of the Sharpe ratio. The actively managed portfolio has a much better
performance than the single investment opportunities. We also observe that the Sharpe
ratios differ slightly for the actively managed portfolios. This difference stems from the
fact that the Riccati equations depend on the risk aversion coefficient. This causes the
relative portfolio weights to differ for different risk aversion coefficients γ. The wealth
Table 5.3. Key figures for the asset allocation strategy under partial information.
return volatility Sharpe

(p.a.) (p.a.) ratio
γ = −5 0.25 0.17 1.30
γ = −10 0.17 0.10 1.32
γ = −20 0.12 0.07 1.29
DS 3-5 years 0.06 0.02 0.74
S&P 500 0.06 0.16 0.15
Tremont 0.10 0.08 0.81
evolution for an investor with risk aversion γ = −10 is shown in Figure 5.5. We observe a
steady growth with some minor drawdowns. This gives evidence that the dynamic trading
strategy is superior to the passive investments. After the year 2000, the stock market has
Portfolio
3.5 DS bond index 3-5 years
Stock market
Alternative Investment
3
Value
2.5
PSfrag replacements
2
1.5
1
Mar97 Jul98 Dec99 Apr01 Sep02 Jan04
Time
Fig. 5.5. Asset allocation strategy performance under partial information for γ = −10.
long time of severe decline in value. The Kalman filter and the investment strategy do
correctly identify the directions of market movements and also their degree of uncertainty.
If the unobservable factors were modeled as observable, the Sharpe ratio would drop
considerably, in the case of γ = −10 to 0.67. The return of the actively managed portfolio
is still reasonably good (15% p.a.), however, the variance increases tremendously because
the strategy is much more aggressive.
6
Active Portfolio Management
Successful investing is anticipating the anticipations of others.

John Maynard Keynes
The reasons for active portfolio management are manifold, as highlighted in Chapter 1.
The most important reasons are that the market behavior is non-stationary and investors
are constrained by liabilities and consumption. These constraints may also be dynamic
and stochastic. The growing demand for absolute return products also gives evidence that
many investors are no longer willing to be fully exposed to traditional risks. This chapter
introduces the main concepts of active portfolio management and its instruments. We
begin with the definition of active portfolio management
Definition 6.1 (Active Portfolio Management).

Active portfolio management is the implementation of a dynamic investment strategy in
order to beat a predefined benchmark at a predefined time in the future.
From this definition, the importance of the benchmark for active portfolio manage-
ment is evident, in terms of risk as well as performance measurement. Not all active
managers give a benchmark, making the risk and performance measurement of an invest-
ment strategy ambiguous. We denote the residual returns as the portfolio returns minus
the corresponding benchmark returns. The mean of the residual returns is usually called
alpha, the standard deviation tracking error. The quotient of alpha divided by the track-
ing error is called information ratio. As for ordinary returns, the variance may not be an
appropriate risk measure for analyzing residual returns. Coherent or convex risk measures
should be used for analyzing the realized returns. The benchmark can either be stochastic
or deterministic. In addition, the benchmark returns may be strictly positive. In this case,
the strategy is usually termed an absolute return strategy.
116 6 Active Portfolio Management
The returns of an actively managed portfolio stem from two sources, the systematic
risk of the involved assets and the investment strategy. Investment strategies are crudely
categorized into security selection and market timing. Summarizing, the key components
of active portfolio management are:
• The Investment universe

• The Investment strategy
– Security selection
– Market timing
In order to be representative, the benchmark should consist of all investment opportunities

present in the investment universe. In addition, the benchmark should be investable, i.e.,
the investment positions of the benchmark at time t are non-anticipating. Mathematically
speaking, the investment positions at time t are measurable with respect to the investor’s
filtration Ft . The exposure to the single securities in the investment universe is usually
constrained within the investment strategy. In general, the actual investment strategy
is not known by the investor since the active manager is reluctant to give insights into
the production of alpha. In some cases, the investor does not even know the investment
universe as such, which is the case for some hedge funds.
Obviously, the outperformance of the active portfolio stems for the under-weighting of
poorly performing assets and over-weighting of well performing assets. The security se-
lection approach, in its simplest form, only identifies the forthcoming winners and losers.
Correspondingly, the manager takes long positions in the winners, may be also short
position in the losers. The amount of capital allocated to each asset needs not be sophisti-
cated, e.g., equally weighted. However, if the mean of the residual returns is positive, the
manager has actually beaten the benchmark. Whether this outperformance is significant
or not is reflected by the information ratio. Therefore, the information ratio should rather
be seen as an indicator of the manager’s skill than as performance measure. There are
other risk measures than variance which are much better choices for measuring risk, as
already discussed.
We aim to put the above statements into a more mathematical framework. Let the
benchmark returns r (B) and the returns of the actively managed portfolio r (P ) be defined
by the following factor models:
6 Active Portfolio Management 117
n
X n
X
(B) (B) (P ) (P )
r (t) = βi (t)ri (t), r (t) = βi (t)ri (t).
i=1 i=1
Therefore, the investment universe consists of n investment opportunities and ri denotes

the return of the i-th investment opportunity. Additionally, we impose the constraints
Pn (B) Pn (P )
i=1 βi (t) = 1 and i=1 βi (t) = 1. From these models, the excess return is obtained
as
n
X (P ) (B)
α(t) = (βi (t) − βi (t))ri (t).
i=1
The mechanics of active portfolio management are easily seen from this equation. For the
case ri (t) ≥ 0, the exposure of the manager should at least be as big as the portfolio
(P ) (B)
exposure, i.e., βi (t) ≥ βi (t). Accordingly for the case ri (t) ≤ 0, we would like to have
(P ) (B)
βi (t) ≤ βi (t). These trivial equations show that, from a mathematical point of view,
security selection and market timing are the same because in both cases, the portfolio
(P )
manager controls βi (t) by the mechanics described above. This can be either achieved
by a discretionary or are systematic approach. However, the crucial point for successful
security selection and market timing remains the correct prediction of ri (t).
Note that the correct prediction of security returns is not the only source of alpha.
We have argued that the significance of the outperformance of an investment strategy
is reflected by the information ratio. By now, we have shown that the information ratio
can be increased by better predictions of security prices. Obviously, the information ratio
may also be increased by a smaller variance of the residual returns, given that the mean
of the residual returns remains the same. Loosely speaking, one way to make money is
by not losing it. For an illustrative example of the value of superior risk management,
see Lo (2001). Again, the stylized facts of asset returns support this claim. For instance,
asset returns are not serially correlated, however, squared asset returns are. Therefore,
predicting risk is easier than predicting returns.
Treynor and Black (1973) is the first systematic active portfolio management approach,
coupling the identification of alpha and risk management. These ideas have been refined
in Black and Litterman (1991, 1992) by introducing uncertainty about the model param-
eters. A more recent publication on this topic is Grinold and Kahn (1999). The academic
literature usually does not distinguish between active portfolio management and optimal
portfolio construction. As for hedge funds, there is neither a generally accepted terminol-
ogy nor a unified framework to compare different strategies. We do not attempt to fill
these gaps since this is virtually impossible. However, what all active portfolio strategies
have in common is that the outperformance has to be gained through altering investment
positions. This is illustrated next in a case study.
6.1 Sector Rotation Example
In this case study, we are considering the S&P 500 index with its ten subindices, also called
sectors indices. All data used in the sequel of this chapter is obtained from the Datastream
database of Thomson Financial. In our case, the data ranges from 1995 to 2005 on a weekly
basis. The ten sectors are consumer discretionary, consumer staples, energy, financials,
health care, industrials, information technology, materials, telecommunication services,
and utilities. The weight of a sector in the index is determined by the corresponding
market capitalization. The investor’s goal is to outperform the S&P 500 index by over- and
under-weighting the individual sectors. Two implementation possibilities are presented: a
multi-period and a single-period environment. The actual implementation of the strategy
with historical data is done with the single-period strategy.
Asset Return Prediction
In order to improve the performance of the strategy, an adaptive factor model is used to
predict returns on a short term basis. A fairly large set of factors is chosen. In general, a
large set of factor gives good in-sample predictions. However, the resulting out-of-sample
prediction is usually poor. This problem is also called over-fitting. Therefore, the number
of factors is reduced to avoid this problem. The returns are modeled as a linear function of
the factor values. In order to find the corresponding beta values of the individual factors,
an ordinary least squares procedure is used, see Hamilton (1994) for details. To avoid the
mentioned over-fitting problem, the following methodology is used:
6.1 Sector Rotation Example 119
1. Start with the full model Mm , i.e., chose all m factors

2. Exclude the factor from the current model which increases the sum
of squared residuals the least.
3. Repeat step 2 until only one factor remains. This results in a sequence
of m models M1 ⊆ M2 ⊆ · · · ⊆ Mm .
4. Chose the model in the sequence M1 ⊆ M2 ⊆ · · · ⊆ Mm which
has the smallest information criterion, in this case we chose Akaike
(1974).
The chosen factors to start with consist of world equity indices returns, commodities
returns, bond indices returns, real estate indices returns, volatility indices, interest rates,
dividend yields, price-earnings ratios, and foreign exchange rates. Table D.1 (page 151)
shows a detailed list of all the factors used for the return prediction. The momentum is
calculated on all equity indices. Therefore, an exponentially weighted moving average has
to be calculated using a smoothing factor of 0.96. The reader is referred to Alexander
(2001) for details on calculating exponentially weighted moving averages.
A Multi-Period Asset Return Model
The volatilities of the ten sector indices are modeled as GARCH processes. A fairly simple
model for the dependence is used, in this case, the constant conditional correlation (CCC)
model is chosen. The technical details are found in Appendix B. Of course, a dynamic
conditional correlations (DCC) model could have been chosen as well. By using a CCC
model, however, we can make use of the convolution property of the NIG distribution,
as found in Appendix A.2.3. Therefore, we use dynamical variances with NIG distributed
innovations.
For the asset allocation strategy, a model predictive approach is chosen. At time t, the
covariance matrix of the ten sectors is estimated by the CCC-GARCH model. This gives
the straightforward prediction of the covariance matrix for t + 1. For the predictions of
the covariance matrices for t ≥ t + 4, the unconditional covariance matrix is used. As
mentioned, the returns are assumed to have a normal inverse Gaussian distribution. The
model is summarized in Figure 6.1. Note that the parameter ψ in the NIG distribution is
standardized to one and therefore dropped.
Predictions: Predictions: Predictions:
Adaptive factor model Unconditional mean Unconditional mean
CCC-GARCH model Unconditional Variance Unconditional Variance
r(t) ∼ NIGn (χ1 , µ1 , Σ, γ) r(t + 1) ∼ NIGn (χ2 , µ2 , Σ, γ) r(t + 4) ∼ NIGn (χ3 , µ3 , Σ, γ)

-
t t+1 t+4 T
Fig. 6.1. An MPC approach for the sector rotation problem.
The components of the vector π(t) denote corresponding sector weights in the index.
The control vector u(t) denotes the fraction of the investor’s wealth, invested in the
corresponding assets. This results in the following portfolio return distribution at time T
³ ´
R(T ) ∼ NIGn χ4 , uTt µ1 + uTt+1 µ2 + uTt+4 µ3 , uTt Σut , uTt γ ,
√ √ √
χ4 = ( χ 1 + χ 2 + χ 3 ) 2 .
We have made the assumptions uTt Σut ≈ uTt+1 Σut+1 ≈ uTt+4 Σut+4 and uTt γ ≈ uTt+1 γ ≈
uTt+4 γ. In this setup, transaction costs may trivially be integrated. The inclusion of risk
constraints at t + 1, t + 4, and T may also be included. However, the topic of multi-period
risk management has not been addressed yet. From the results in Chapter 2, we know
that coherent single-period risk measures are not necessarily coherent in a multi-period
setting. A possible multi-period solution is the measuring of risk by penalty functions.
The reader is referred to Dondi (2005) for a detailed case study. However, we prefer to
work with a monetary risk measure. Therefore, we consider a single-period version of the
investment strategy.
A Single-Period Asset Return Model
As in the multi-period case, the volatilities of the ten sector indices are modeled as
GARCH processes. However, a more sophisticated model for the correlation is used, i.e.,
the dynamic conditional correlation (DCC) model is used. The technical details are found
in Appendix B. By using a DCC model, we can make use of the dynamic dependence
structure of the multivariate asset returns. The NIG distribution is used to model the
multivariate asset returns.
The DCC-GARCH parameters are estimated by a quasi maximum-likelihood approach,
the reader is referred to McNeil et al. (2005) for details. Because the NIG distribution is a
normal mean variance mixture distribution, the portfolio distribution is easily calculated;
6.1 Sector Rotation Example 121
see Appendix A for the technical details. As risk measure, the conditional value at risk
(CVaR) is used. The asset allocation strategy consists of a mean-CVaR optimization. Let
Zt ∈ R10 be a random vector whose components are NIG distributed with zero mean
and unit variance. The sector returns are denoted by the random vector Rt ∈ R10 whose
covariance matrix is denoted by Σt . The return predictions µ̂t are obtained as described
above. The unconditional mean of the past returns is denoted by µ. In terms of risk
management, only the mean of the past returns is used in order not to avoid biases.
Mathematically, the problem at time t is formulated as follows:
maxn uTt µ̂t − γCVaR(uTt Rt )

ut ∈R
s.t.
1/2
Rt = µ + ε t , ε t = Σ t Zt ,
2
σt,k = ak0 + ak1 ε2t−1,k + bk1 σt−1,k
2
, k = 1, . . . , 10 .
∆t = diag(σt,1 , . . . , σt,10 ) ∈ R10×10
Σt = ∆t R(Qt )∆t ,
³ ´
Qt = 1 − a1 − b1 Qc + a1 ∆−1 −1 T
t−1 εt−1 [∆t−1 εt−1 ] + b1 Qt−1 .
³ ´
uTt Rt ∼ NIG χ, ψ, uTt µ, uTt Σt ut , uTt γ
The operator R is given in the appendix, see Definition B.1 (page 142). In Figure 6.2,
the out-of-sample performance of the active portfolio versus the benchmark is shown for
γ = 1. The data ranges from 1995 to 2005, the implementation of the investment strategy
starts in 1999 in order to have sufficient data for the parameter estimation. The model
selection is repeated every 50 weeks, i.e., the factor list is updated every 50 weeks. The
active portfolio obviously outperforms the benchmark considerably. Recall that the vector
π(t) denotes the corresponding sector weights in the benchmark. The control vector u(t)
denotes the fraction of the investor’s wealth, invested in the different sectors. We impose
the lower constraint for u(t) as − 21 π(t) and the upper constraint as 32 π(t). The resulting
strategy has an alpha of 4.8% p.a. and a tracking error of 5.0% p.a. This results in an
information ratio of 0.96, which is reasonably good. The benchmark has a disappointing
performance in the considered time period, the return is -0.2% p.a. and the volatility is
17%. The return of the active portfolio is 4.7% p.a. with a standard deviation of 18%.
We do not observe an outperformance if the return prediction is omitted, i.e., the risk
management on its own does not generate outperformance in this setup. However, if only
Benchmark
1.3 Active Portfolio
1.2
1.1
Value
0.9
0.8
PSfrag replacements
0.7
Dec99 Apr01 Sep02 Jan04 May05

Time
Fig. 6.2. Performance of the sector rotation asset allocation strategy.
the return predictions are used for the asset allocation, the information ratio is decreased
by 20%. This case study gives evidence that active portfolio management may produce
added value if implemented correctly. Similar case studies are found in Herzog, Dondi and
Geering (2004) and Herzog, Geering and Schumann (2004).
6.2 Portfolio Management with Lévy Processes
Stochastic processes in continuous time, driven by Brownian motion, have been exten-
sively discussed in Chapter 5. Most of the disadvantages which are present in this type of
model may be overcome by replacing the Brownian motion with a more general process.
A Lévy process is a continuous-time stochastic process with independent and station-
ary increments, and is continuous in probability. Lévy processes belong to the class of
semimartingales. The reader is referred to Protter (1990) for details on semimartingales.
Brownian motion itself is a Lévy process and is the only one whose sample paths are not
only continuous in probability but also with probability one. Lévy processes can take the
stylized facts of asset returns much better into account than Brownian motion. The reader
is referred is referred to Schoutens (2003) for details on Lévy processes in finance. For
more technical details on Lévy processes and semimartingales see Protter (1990), Sato
(1999), and Applebaum (2004). We will use the following conventions, ∆X(t) denotes the
6.2 Portfolio Management with Lévy Processes 123
the jump of the process X(t) at time t,
X(t−) = lim X(s), ∆X(t) = X(t) − X(t−).

s↑t
In order to define a stochastic process with independent and stationary increments, the
distribution of the increments has to be infinitely divisible. We briefly discuss infinitely
divisible distributions because of their importance in the realm of Lévy processes. We call
the logarithm of the characteristic function of a distribution its characteristic exponent.
The characteristic exponent of an infinitely divisible distribution may be decomposed
by the Lévy-Khinchine representation, see Protter (1990) for details. Because of this
property, every Lévy process L may be decomposed by the Lévy-Itô decomposition, i.e.,
every Lévy process L is fully characterized by the Lévy triplet (γ, σσ T , ν). We use the
abbreviation Σ = σσ T . The third component ν is called the Lévy measure and describes
the expected number of jumps and their sizes. The Poisson random measure N (t, A)
denotes the number of jumps of L of size ∆L(t) ∈ A which occur before or at time t.
e (dt, dz) = N (dt, dz)−ν(dz)dt is called the compensated Poisson random measure.
Here, N
Then we may write L(t) with the Lévy-Itô decomposition as
Z tZ Z tZ
L(t) = γt + σW (t) + zN e (dt, dz) + zN (dt, dz)
0 |z|<R 0 |z|≥R
Z tZ X
= γt + σW (t) + zN (dt, dz) = γt + σW (t) + ∆L(s),
0 R 0<s≤t
where W (t) is a standard n-dimensional Wiener process, R > 0 an arbitrary constant,

and

Ne (dt, dz), if |z| < R
N (dt, dz) =
 N (dt, dz), if |z| ≥ R.
The reader is referred to Oksendal and Sulem (2004) and Cont and Tankov (2004) for the
technical details. This means that Lévy processes may be decomposed into a deterministic
part, a Brownian motion part, and a discontinuous or jump part.
Besides optimal portfolio construction, Lévy processes are also well suited for asset
pricing, e.g., the pricing of contingent claims is. However, if asset prices are modeled as
Lévy processes, the market model is incomplete, in general. This means there is no unique
martingale measure, i.e., there exist an infinite number of equivalent martingale measures.
The publications on derivative pricing with Lévy processes are numerous, e.g., see Madan
and Milne (1991), Madan, Carr and Chang (1998), Prause (1999), Schoutens (2003), and
Carr and Wu (2004). However, we do not consider derivative pricing with Lévy processes
in this context.
Since we are more interested in optimal portfolio construction, the literature on this
topic is briefly reviewed. Kallsen (2000) considers the multi-dimensional problem of maxi-
mizing the expected logarithmic utility from consumption or terminal wealth in a general
semimartingale market model. The solution is given explicitly in terms of the semimartin-
gale characteristics of the securities price process. Benth, Karlsen and Reikvam (2001b)
consider a similar problem. However, the problem is solved in one dimension by a viscos-
ity solution approach. The NIG Lévy process is applied in Benth, Karlsen and Reikvam
(2001a), where the solution is given in one dimension. A multi-dimensional solution is
found in Emmer and Klüppelberg (2004) with a Capital-at-Risk constraint. Optimal port-
folio construction with the variance gamma (VG) Lévy process is considered in Cvitanić,
Polimenisz and Zapatero (2005) and Madan and Yen (2005).
The Generalized Hyperbolic Lévy Process and its Limiting Cases
We can define a corresponding Lévy process for every infinitely divisible distribution. In
Chapter 3, we have found that the generalized hyperbolic (GH) distribution is well suited
for describing returns of various assets. We may define a Lévy process whose increments
have a GH distribution because Barndorff-Nielsen and Halgreen (1977) proved that the
GH distribution is infinitely divisible. The GH distribution contains a huge variety of
important distributions in finance as limiting cases. Among these are the hyperbolic,
normal inverse Gaussian (NIG), a version of the skewed t, variance gamma, t, and the
normal distribution. All these limiting cases are derived in Eberlein and von Hammerstein
(2004) for the univariate case.
In order to work with the GH Lévy process, we need to know its Lévy triplet. The
notation for the GH distribution of Appendix A.2.3 is used. The corresponding Lévy
triplet is (γ, 0, νGH (dx)), i.e., there is no Brownian motion part and therefore, the GH
Lévy process is a pure jump process. Note that if the Lévy measure is of the form ν(dx) =
ν̃(x)dx, we call ν̃(x) the Lévy density. The n-dimensional Lévy measure of the GH Lévy
process is
2ex
T Σ −1 γ n n ¡ √ ¢
νGH (dx) = p n max(0, λ)α 2 K n2 α xT Σ −1 x
(2π)n det(Σ)(xT Σ −1 x) 4
Z ∞ 2 ¡p ¢
n
(α + 2y) 4 K n2 (α2 + 2y)(xT Σ −1 x) o
+ ¡ 2
√ 2
√ ¢ dy) dx,
0 π 2 y J|λ| ( 2χy) + Y|λ| ( 2χy
p
where α = ψ + γ T Σ −1 γ, Jλ and Yλ are Bessel functions, see Appendix A.2.4 for details.
The proof for this result is found in Masuda (2004). Accordingly, the n-dimensional Lévy
measure of the NIG distribution is
√
2 χ ex Σ γ ³ ψ + γ T Σ −1 γ ´ n+1
T −1
4 ¡p ¢
νN IG (dx) = p T −1
K n+1 xT Σ −1 x(ψ + γ T Σ −1 γ) dx,
(2π)n+1 det(Σ) x Σ x 2
see Masuda (2004) for the proof. Note that Masuda uses the notation of Blaesild and
Jensen (1981). The parameters λ and µ are in both cases the same, the correspondences
of the others are
√ p p
δ= χ, α= ψ + γ T Σ −1 γ, Λ = Σ, β = Σ −1 γ, γ= ψ.
The derivation of the Lévy densities is based on the fact that the GH Lévy process can be
introduced via Brownian subordination. The main idea of constructing a Lévy process by
a Brownian subordination is to replace calendar time of a Brownian motion with a random
time, given by a stochastic process which is called subordinator. For the construction of
the GH Lévy process, the generalized inverse Gaussian (GIG) Lévy process is used a
subordinator. The proof of this statement is found in Eberlein (2001). Correspondingly,
the limiting cases of the GIG distribution may also be used as subordinators. Note that
a subordinator is nondecreasing and always of finite variation. The Lévy measure of the
n-dimensional VG distribution is
T −1
2ex Σ γ ³ γ T Σ −1 γ + 2 ´ n4 ³r ¡ 2¢´
ν T Σ −1 x γ T Σ −1 γ +
νV G (dx) = p K n x dx,
ν (2π)n det(Σ) xT Σ −1 x 2
ν
see Appendix C.3 for the proof. By setting γ = θ and Σ = σ 2 , we arrive at the same
Lévy density as in Madan et al. (1998, Equation (14)) for the univariate case. The Lévy
measures of the NIG and the VG Lévy process are much more convenient to work with
than the Lévy measure of the GH Lévy process. Therefore, they are more often found in
financial applications than GH Lévy processes.
Portfolio Dynamics and Optimal Control Problem Formulation
We are considering a market which contains n investment opportunities. The price process
of the i-th investment opportunity is described as
Pi (t) = Pi (0)eLi (t) ,
Pi (0) > 0,
where Li (t) is a Lévy process. The returns of the single assets Li are assembled in the
n-dimensional vector Lévy process L = (L1 , . . . , Ln )T ∈ Rn . In addition, there exists a
risk-free investment opportunity B(t) with instantaneous rate of return r(t) ∈ R:
dB(t) = B(t)r(t)dt ,
B(0) > 0 .
Recall that in the Black-Scholes framework, L(t) is a Wiener process. The stochastic
processes considered in this context are defined on a fixed, filtered probability space
(Ω, F, {Ft }t≥0 , P) with Ft satisfying the usual conditions.
In order to account for the stylized facts of asset returns, let L(t) be an n-dimensional
Lévy process with characteristic triplet (γ, σσ T , ν), γ ∈ Rn , σ ∈ Rn×n , and ν(dx) ∈ R.
The Lévy measure describes the expected number of jumps of a certain height in a time
interval of length 1. A Lévy process is of infinite activity if almost all paths of a Lévy
process have an infinite number of jumps on every compact interval. The return vector
L(t) may have finite, e.g., the Poisson process, or infinite activity, e.g., the generalized
hyperbolic Lévy process. If the process is of infinite activity, we may omit the diffusion
component. For finite activity jump processes we must not omit the diffusion because this
would lead to absence of local activity which is not a reasonable assumption. On the topic
of disentanglement of the diffusion and the jump part in a stochastic process, the reader
is referred to Ait-Sahalia (2004).
We assume that the investor’s portfolio is self-financing and there are no exogenous in-
or outflows of money (e.g., consumption). We denote by the vector h(t) ∈ Rn the amount
of each corresponding asset held by the investor at time t. The dynamics of the investors
wealth V are self-financing if the following relation holds
dV (t) = hT (t)dP.
The reader is referred to Cont and Tankov (2004) for the proof. Note that h(t) is a simple
predictable process, see Protter (1990) for details, and therefore the equality h(t−) = h(t)
holds. Denote by u(t) the fraction of wealth invested in the corresponding asset. Using
Itô’s lemma we get the following dynamics for the price processes,
n1 o
dP (t) = diag(P (t−)) diag(Σ)dt + dL + e∆L − 1 − ∆L ,
2 Z
n£ 1 ¤
= diag(P (t−)) γ + diag(Σ) + {ez − 1n − z}ν(dz) dt
2 |z|<1
Z o
z
+ σdW (t) + {e − 1n }N (dt, dz)
Rn
where diag(P (t−)) denotes the diagonal matrix of the vector P (t−), diag(Σ) denotes
the vector of the diagonal elements of the matrix Σ, ez = (ez1 , . . . , ezn )T ∈ Rn , and
1n = (1, . . . , 1)T ∈ Rn . The same result is also derived in Kallsen (2000). The self-financing
dynamics of the investors wealth V may be expressed as
n
dV (t) dB(t) X dPi (t)
= u0 (t−) + ui (t−) ,
V (t−) B(t) i=1
Pi (t−)
asset and u0 (t) accordingly in the riskless asset at time t. Because the portfolio is self-
P
financing, we have the constraint ni=0 ui (t) = 1. We may then rewrite the wealth dy-
namics as
dV (t) © T 1 ª
= u [ diag(Σ) − 1n r] + r dt + uT (t−)(dL + e∆L − 1n − ∆L)
V (t−) 2
n¡ Z
T 1 T z
¢o
= u [γ + diag(Σ) − 1n r] + r + u {e − 1n − z}ν(dz) dt
2 |z|<1
| {z }
b(u)
Z
+ uT σdW (t) + uT {ez − 1n }N (dt, dz) (6.1)
Rn
V (0) > 0.
The second equality is obtained by using the Lévy-Itô decomposition. In order for the
wealth to remain positive for all t, we impose the constraint uT 1n ≤ 1 for u ≥ 0, i.e.,
u ∈ U = {u ∈ Rn |uT 1n ≤ 1, u ≥ 0}. Having derived the wealth dynamics of the considered
investor, we can finally state the optimization problem. We consider the case in which the
investor’s utility function of the constant relative risk aversion (CRRA) type. In order to
solve this problem with Bellman’s optimality principle, we introduce the value or cost-to-
go function as
h1 i
δ
J(t, V ) = max1 E V (T ) ,
u(·)∈Ln δ
where δ denotes the coefficient of risk aversion. The Hamilton-Jacobi-Belman equation

for this problem is
h 1
Jt (t, V ) + max JV (t, V )b(u)V + JV V (t, V )uT ΣuV 2
Z u∈U 2
i
T z T z
+ J(t, V + V u {e − 1n }) − J(V, t) − JV (t, V )V u {e − 1n }ν(dz) = 0
Rn
with b(u) as in (6.1) and with the terminal condition J(T, V (T )) = 1δ V (T )δ . Plugging the
separation ansatz J(t, V ) = h(t)V (t)δ into the HJB equation results in
h 1
δ δ
ḣ(t)V (t) + h(t)V (t) max γb(u)δ + δ(δ − 1)uT Σu
Z u∈U 2
i
+ (1 + uT {ez − 1n })δ − 1 − δuT {ez − 1n }ν(dz) = 0.
Rn
In order to compute the optimal asset allocation strategy, the constrained optimization
problem above needs to be solved numerically. This completes the derivation of the optimal
asset allocation strategy for Lévy driven asset prices. The optimal control vector u is fully
determined by the Lévy triplet of the risky investment opportunities.
7
Conclusions and Outlook
If we knew what it was we were doing, it

would not be called research, would it?
Albert Einstein
The aim of this thesis is to shorten the gap between the development of sophisticated
financial models and their application in practice. In order to achieve this goal, methods
and models from financial engineering are used. However, these are conceptually the
same as those found in feedback control theory. Therefore, the ideas of feedback control
are applied to financial problems. The main difference between the control of technical
systems and the control of financial systems is that financial systems are heavily dominated
by randomness. This rules out the use of deterministic models since these cannot take
the main properties of asset returns into account. By modeling asset prices as dynamic
stochastic models, optimal asset allocation strategies can be derived through dynamic
stochastic optimization.
In Chapter 2, the different components of asset allocation are presented. The consid-
ered financial assets are briefly described, while the asset allocation process as such is
described in greater detail. Risk measurement and management skills are key factors for
successful active portfolio management. Therefore, the topic of static and dynamic risk
measures is discussed. Chapter 3 reviews the current state of asset price modeling and
dynamic optimization techniques in finance. Different models are tested for their suit-
ability to describe univariate and multivariate asset returns. The generalized hyperbolic
distribution and its limiting cases offer a very rich modeling family for describing asset
returns. These types of distributions fit real-world financial data considerably better than
the predominantly encountered normal distribution. The dependence properties of var-
ious financial assets are analyzed as well. It is found that the simultaneous occurrence
130 7 Conclusions and Outlook
of extreme losses cannot be explained by correlation alone. This type of phenomenon is

called tail dependence and empirical evidence is given that investors should be aware of
concurrent extreme losses.
In Chapter 4, the topic of hedge funds is discussed. Since hedge fund managers actively
manage their portfolios, the hedge fund industry is an inspiring area for active portfolio
management strategies. A wide range of different styles categorize the strategies of hedge
fund managers. However, the performance measurement considering the whole hedge fund
industry is difficult because of the lack of transparency. This also complicates the modeling
of hedge funds because their the real sources of returns are hard to discover. The statistical
properties of hedge funds are analyzed in detail. As for traditional assets, the generalized
hyperbolic distribution and its limiting cases are flexible enough to accurately take the
possible skewness and fat-tailedness of hedge funds returns into account. However, returns
of some styles show volatility clustering and serial correlation, which are both awkward
properties of hedge fund returns. A possible explanation for serial correlation are the
presence of illiquid assets in the hedge fund manager’s portfolio. Finally, the peculiarities
of hedge fund investing and risk management for hedge funds are discussed.
Having extensively discussed the modeling properties of financial assets in the first
part, the second part is devoted to the conception and implementation of asset alloca-
tion strategies. Chapter 5 considers the well-studied continuous-time models driven by
Brownian motion. A closed-form solution is derived for an investor with constant relative
risk aversion and three risk-bearing investment opportunities. One of the investment op-
portunities is an alternative investment. The optimal fraction of wealth invested in the
alternative investment is analyzed in detail. In the second part of Chapter 5, the optimal
asset allocation strategy is derived for the case in which not all factors influencing the
return of the risky assets are exactly known to the investor. We call this type of problem
optimal asset allocation under partial information. This problem is solved by using the
methods of Kalman filtering to shown that the partial information problem can be trans-
formed to a full information problem whose solution is known. The results are applied in
a balanced fund case study including alternative investments.
Chapter 6 is devoted to active portfolio management, for which a formal definition
is given. Active portfolio management, per definition, needs an associated benchmark,
otherwise risk and performance measurement are ambiguous. The returns of an active
7 Conclusions and Outlook 131
portfolio management strategy are driven by the investment universe and the investment
strategy. An active portfolio management case study concerning the sector rotation prob-
lem is conducted. An adaptive factor model is used for the prediction of the returns and a
dynamic volatility model with normal inverse Gaussian distributed innovations is used to
perform the risk management. The results of an out-of-sample case study are promising,
yielding an alpha of 5% and an information ratio of 0.96. The remaining part of the chap-
ter discusses the use of Lévy processes for active portfolio management. The necessary
Lévy densities are given for describing the corresponding multivariate Lévy processes.
Outlook
Since so many research areas such as economics and mathematics intersect in financial
engineering, the room for improvement is vast. However, the statistical testing of asset
price models as well as the implementation of optimal asset allocation strategies is time
consuming. Concerning the statistical properties of asset returns, it would be interesting
to compare the α-stable models against the hyperbolic models analyzed in this work. On
the subject of copulas, only two members of the class of elliptical copulas are analyzed in
this work. However, there is a huge variety of different copulas which may be better suited
for describing the dependence of multivariate asset returns. For instance, the copula of
the generalized hyperbolic distribution should offer better results than the t copula. Since
the introduction of Lévy processes in finance, dynamic asset models in continuous-time
have become much more promising for further research. Since the use of Lévy processes
for solving optimal asset allocation problems is still a rather young research area, many
questions remain unanswered. This is also the case for dynamic risk measures.
Dynamic stochastic optimization in continuous-time is a well-known procedure. How-
ever, the numerical computation of constrained problems is still limited to small problems.
Nevertheless, viscosity solutions offer a powerful tool for solving nonlinear partial differ-
ential equations. Their use for optimal portfolio construction would have exceeded the
scope of this work. For the unconstrained case, either Bellman’s optimality principle or
Pontryagin’s maximum principle can be used to find optimal solutions. The solution of
the partial information problem in a general Lévy framework, however, is not straightfor-
ward and has not been found yet. The use of copulas in connection with optimal portfolio
construction is particularly well suited in a stochastic programming framework. Clearly,
132 7 Conclusions and Outlook
there are still a lot of interesting problems to be solved in financial engineering, and in
optimal portfolio construction in particular.
A
Probability and Statistics
A.1 Moments of Random Variables
We consider an n-dimensional random vector X. The first central moment is the mean
vector, denoted by µ = E[X]. The second central moment is the covariance matrix, defined
as cov(X) = E[(X − µ)(X − µ)T ]. We consider the skewness and kurtosis instead of the
third and fourth central moments. The univariate skewness γ1 and the kurtosis γ2 are
defined as
E[(Xi − µ)3 ]
γ1 (Xi ) = 3 ,
(var(Xi )) 2
E[(Xi − µ)4 ]
γ2 (Xi ) = ,
var(Xi )
respectively. In the literature the term excess kurtosis is often found instead of kurtosis.
The excess kurtosis is defined as γ2 (Xi )−3. The excess kurtosis to the normal distribution
is zero. There also are measures of multivariate skewness and kurtosis, e.g., see Mardia
(1970).
A.2 Probability Distributions
A.2.1 Normal Mean-Variance Mixture Distributions
Let U be a random variable on [0, ∞), Σ ∈ Rn×n a covariance matrix, and µ, γ ∈ Rn two
arbitrary vectors. The random variable
X| U = u ∼ N (µ + uγ, uΣ)
134 A Probability and Statistics
is said to have a normal mean-variance mixture distribution. This distribution is elliptical

for γ = 0 and is called normal variance mixture in this case. The characteristic function
of random variable X which has normal mean-variance mixture distribution is
TX T
³1 ´
φX (y) = E[eiy ] = eiy µ Ĥ y T Σy − iy T γ ,
2
where Ĥ is the Laplace-Stieltjes transform of the distribution of the mixing variable. See
Bingham and Kiesel (2002) for the proof.
An important property of normal mean-variance mixture distributions is that they are
closed under linear operations, i.e., let X as introduced above, and Y = AX + b with
A ∈ Rk×n and b ∈ Rk . The characteristic function of Y becomes
T (AX+b) T T T
φY (y) = E[eiy ] = eiy b E[ei(y A)X ] = eiy b φX (AT y)
T
³1 ´
= eiy (Aµ+b) Ĥ y T AΣAT y − iy T Aγ .
2
Therefore, we have for the random vector Y
Y | W = w ∼ N (Aµ + b + wAγ, wAΣAT )
The mean and the variance of X are calculated as
• E[X] = µ + E[W ]γ,

• cov[X] = E[W ]Σ + var[W ]γγ T .
The reader is referred to McNeil et al. (2005) for more details.
A.2.2 Univariate Probability Distributions
Generalized Inverse Gaussian (GIG) Distribution
A random variable X ∈ R has a generalized inverse Gaussian distribution, i.e., X ∼

GIG(λ, χ, ψ), if its density is
p
( ψ/χ)λ λ−1 − 1 (χx−1 +ψx)
f (x) = √ x e 2 , x > 0,
2Kλ ( χψ)
with χ ∈ R, ψ ∈ R, and λ ∈ R. Kλ denotes the modified Bessel function of the third
kind with index λ, see Appendix A.2.4 for details. The parameters satisfy χ > 0, ψ ≥ 0 if
λ < 0; χ > 0, ψ > 0 if λ = 0; and χ ≥ 0, ψ > 0 if λ > 0. The GIG density contains the
gamma and inverse gamma densities as limiting cases. The non-central moments of the
GIG density are:
A.2 Probability Distributions 135
³ χ ´ α2 K (√χψ)
λ+α
E[X α ] = √ , α ∈ R.
ψ Kλ ( χψ)
The Laplace transform Ĥ of the X ∼ GIG(λ, χ, ψ) distribution is given by
³ ψ ´ λ2 K (pχ(ψ + 2s))
λ
Ĥ(s) = √ , s > 0.
ψ + 2s Kλ ( χψ)
For more details on the GIG distribution and its properties see Jorgensen (1982).
q √
• E[X] = µ + ψχ KKλ+1 ( χψ)
√
λ ( χψ)
γ
√ √ 2
√
χ Kλ+2 ( χψ) Kλ ( √χψ)−Kλ+1 ( χψ)
• var[X] = ψ Kλ2 ( χψ)
Inverse Gaussian (IG) Distribution
The best-known limiting distribution of the GIG distribution is the inverse Gaussian
distribution X ∼ IG(χ, ψ) = GIG(− 21 , χ, ψ), the density of which is
√ √
χ 3 1 −1
f (x) = √ e χψ x− 2 e− 2 (χx +ψx) , x > 0.
2π
The Laplace transform of the inverse Gaussian distribution is
√ √
χψ− χ(ψ+2s)
Ĥ(s) = e , s > 0.
These equations are easily derived from the properties of the modified Bessel function of
the third kind, see Appendix A.2.4.
q
• E[X] = ψχ
q
• var[X] = ψ1 ψχ
Gamma (Γ ) Distribution
Another important limiting case of the GIG distribution is, for λ > 0 and χ = 0, the
gamma distribution X ∼ Γ (λ, ψ/2) = GIG(λ, 0, ψ). Its density is
(ψ/2)λ λ−1 − 1 ψx
f (x) = x e 2 , x > 0.
Γ (λ)
The Laplace transform of the gamma distribution is
³ ψ ´λ
Ĥ(s) = , s > 0.
ψ + 2s
• E[X] = 2 ψλ
• var[X] = 4 ψλ2
Inverse Gamma (IΓ ) Distribution
For λ < 0 and ψ = 0, we get another limiting case of the GIG distribution. This case is
called the inverse gamma distribution X ∼ IΓ (λ, χ/2) = GIG(λ, χ, 0). Its density is
(χ/2)−λ λ−1 − 1 χx−1

f (x) = x e 2 , x > 0.
Γ (−λ)
The Laplace transform of the inverse gamma distribution is

¡√ ¢ λ
2Kλ 2χx (χx/2)− 2
Ĥ(x) = , x > 0.
Γ (−λ)
χ
• E[X] = − 12 λ+1
1 χ2
• var[X] = 4 (λ+1)2 (−λ−2)
, λ < −2.
Univariate Skewed t
There are several methods for constructing a skewed t distribution. One is found in Fernan-
dez and Steel (1998). It is a method for extending a unimodal and symmetric distribution
to a skewed version. Let t(ν, µ, σ 2 ) denote the univariate t density. The following density
is a skewed version of the univariate t density,
2 ³ 2 2
´
f (x) = t(ν, (x − µ)/γ, σ )I [µ,∞) (x) + t(ν, (x − µ)γ, σ )I (−∞,µ) (x) . (A.1)
γ + γ1
The skewness is measured by the parameter γ ∈ (0, ∞). We have no skewness for γ = 1.
A.2.3 Multivariate Probability Distributions
Multivariate Normal
A random variable X ∈ Rn has a normal distribution, i.e., X ∼ Nn (µ, Σ), if its density is
1 1 T Σ −1 (x−µ)
f (x) = p e− 2 (x−µ) ,
(2π)n det(Σ)
with µ ∈ Rn , and Σ ∈ Rn×n . The mean and covariance are E[x] = µ and cov[X] = Σ,
respectively.
Multivariate t
A random variable X ∈ Rn has a t distribution, i.e., X ∼ tn (ν, µ, Σ), if its density is
Γ ( ν+n ) ³ 1 ´− 12 (ν+n)
2 T −1
f (x) = p 1 + (x − µ) Σ (x − µ) , (A.2)
Γ ( ν2 ) (πν)n det(Σ) ν
with ν ∈ R, µ ∈ Rn , and Σ ∈ Rn×n , Γ denotes the gamma function. The mean and the
ν
covariance are E[X] = µ and cov[X] = ν−2
Σ, respectively. The univariate skewness and
6 3(ν−2)
kurtosis are γ1 (X) = 0 and γ2 (X) = ν−4
+3 = ν−4
, respectively. The k-th moment is
not defined for k > ν. For ν → ∞, the t-distribution converges to the normal distribution.
Multivariate Generalized Hyperbolic (GH)
A generalized hyperbolic random variable has a normal mean-variance mixture distri-

bution, the mixing variable has a GIG distribution. The random variable X ∈ R n has
a multivariate generalized hyperbolic distribution, i.e., X ∼ GHn (λ, χ, ψ, µ, Σ, γ), if its
density is
³q¡ ¢¡ ¢´ T −1
Kλ− n2 χ + (x − µ)T Σ −1 (x − µ) ψ + γ T Σ −1 γ e(x−µ) Σ γ
f (x) = c ³ ´ n4 − λ2 , (A.3)
χ + (x − µ)T Σ −1 (x − µ)
where λ ∈ R, χ ∈ R, ψ ∈ R, µ ∈ Rn , Σ ∈ Rn×n , and γ ∈ Rn . The normalizing constant c

is given as
p ¡ ¢n−λ
( ψ/χ)λ ψ + γ T Σ −1 γ 4 2
c= p √ ,
(2π)n det(Σ) Kλ ( χψ)
Kλ denotes the modified Bessel function of the third kind with index λ. The domain of vari-
ation of the parameters is as for the GIG distribution. Many different kind of parametriza-
tions of the generalized hyperbolic distribution are found in the literature. The advantage
of the present parametrization is that the GIG parameters are scale and location invariant.
Note that we cannot distinguish between the parameterizations GHn (λ, χ/c, cψ, µ, cΣ, cγ)
and GHn (λ, χ, ψ, µ, Σ, γ) for an arbitrary c > 0. We therefore introduce the constraint
ψ = 1 when fitting the GH distribution.
q √
• E[X] = µ + ψχ KKλ+1 ( χψ)
√
λ ( χψ)
γ
q √ √ √ 2
√
χ Kλ+1√
( χψ) χ Kλ+2 ( χψ) Kλ ( χψ)−Kλ+1 ( χψ)
• cov[X] = ψ Kλ ( χψ) Σ + ψ √
Kλ2 ( χψ)
γγ T
Multivariate Normal Inverse Gaussian (NIG)
A random variable X ∈ Rn has a multivariate normal inverse gaussian distribution, i.e.,

X ∼ NIGn (χ, ψ, µ, Σ, γ), if its density is a GHn (λ = − 12 , χ, ψ, µ, Σ, γ). The characteristic
function of the NIG distribution is, by using the properties the normal mean-variance
mixture distributions,
TX T µ+
√ √
χ(ψ+tT Σt−2itT γ)
φX (t) = E[eit ] = eit χψ−
From this, we immediately see that the class of NIG distributions is closed under convo-
lutions, i.e.,
NIGn (χ1 , ψ, µ1 , Σ, γ) ∗ NIGn (χ2 , ψ, µ2 , Σ, γ) = NIGn (χ3 , ψ, µ3 , Σ, γ),

√ √
where µ3 = µ1 + µ2 and χ3 = ( χ1 + χ2 )2 .
q
• E[X] = µ + ψχ γ
q ³ ´
χ 1 T
• cov[X] = ψ Σ + ψ γγ
The NIG distribution is a normal mean-variance mixture distribution with the IG distri-
bution as mixing variable.
Multivariate Skewed t (s-t)
A random variable X ∈ Rn has a multivariate skewed t distribution, i.e., X ∼ stn (ν, µ, Σ, γ),
if its density is a GHn (λ = − ν2 , χ = ν, ψ → 0, µ, Σ, γ), ν > 0. If the limit ψ → 0 is evalu-
ated in (A.3), we arrive at
³q¡ ¢ ´
T −1
K ν+n ν + (x − µ)T Σ −1 (x − µ) γ T Σ −1 γ e(x−µ) Σ γ
2
f (x) = c ³¡ , (A.4)
¢´ ν+n
4
T −1
ν + (x − µ) Σ (x − µ)
where ν ∈ R, µ ∈ Rn , Σ ∈ Rn×n , and γ ∈ Rn . The normalizing constant c is given as

ν+n ν ν+n ν+n
2(γ T Σ −1 γ) 4 ( ν2 ) 2 2(γ T Σ −1 γ) 4 ( ν2 ) 2
c = ¡ ν ¢p = ¡ ν ¢p .
Γ 2 (2π)n det(Σ) Γ 2 (πν)n det(Σ)
The limiting case γ → 0 results in the multivariate t distribution as described in (A.2).
The skewed t distribution is a normal mean-variance mixture distribution with the inverse
gamma distribution as mixing variable.
ν
• E[X] = µ + ν−2
γ
ν 2ν 2
• var[X] = ν−2
Σ + (ν−2)2 (ν−4)
γγ T , ν > 4, for γ 6= 0, ν > 2, for γ ≡ 0.
Multivariate Variance Gamma (VG)
A random variable X ∈ Rn has a multivariate variance gamma distribution, i.e., X ∼

VG(ν, µ, Σ, γ), if its density is a GHn (λ = ν1 , χ → 0, ψ = ν2 , µ, Σ, γ), ν > 0. If the limit
χ → 0 is evaluated in (A.3), we arrive at
³q¡ ¢¡ ¢´ T −1
K1−n (x − µ)T Σ −1 (x − µ) ν2 + γ T Σ −1 γ e(x−µ) Σ γ
ν 2
f (x) = c ³ ´ n4 − 2ν1 ,
(x − µ)T Σ −1 (x − µ)
where ν ∈ R, µ ∈ Rn , Σ ∈ Rn×n , and γ ∈ Rn . The normalizing constant c is given as

¡2 ¢ n4 − 2ν1
2 ν
+ γ T Σ −1 γ
c= 1 p ,
νν (2π)n det(Σ)Γ ( ν1 )
2
Note that we have chosen ψ = ν
to be most conform with the notation in Madan et al.
(1998). To arrive at the same distribution as in Madan et al. (1998) for the univariate
case, set γ = θ and Σ = σ 2 . The VG distribution is a normal mean-variance mixture
distribution with the gamma distribution as mixing variable. The characteristic function
of the VG distribution is, by using the properties the normal mean-variance mixture
distributions,
TX Tµ
³ ¡1 T ¢´− ν1
φX (t) = E[eit ] = eit 1+ν t Σt − itT γ
2
From this, we immediately see that the class of VG distributions is closed under convolu-
tions, i.e.,
ν
VG(ν, µ1 , Σ, γ) ∗ VG(ν, µ2 , Σ, γ) = VG( , µ1 + µ2 , 2Σ, 2γ).
2
• E[X] = µ + γ
• cov[X] = Σ + νγγ T
A.2.4 Bessel Functions and Modified Bessel Functions
Bessel functions are solutions of the following differential equation,
d2 f df
x2 2
+ x + (x2 − λ2 )f = 0.
dx dx
Jλ is called Bessel function of the first kind and has the following series representation
∞
X (−x/2)2k
Jλ (x) = (x/2)λ , | arg(x)| < π.
k=0
k!Γ (λ + k + 1)
The Bessel function of the second kind, Nλ (x), is defined as

Jλ (x) cos(λπ) − J−λ (x)

Nλ (x) = , | arg(x)| < π.
sin(λπ)
Modified Bessel functions are solutions of the following differential equation,
d2 f df
x2 2
+ x − (x2 + λ2 )f = 0.
dx dx
Iλ is called modified Bessel function of the first kind and has the following series repre-
sentation
∞
X
λ (x/2)2k
Iλ (x) = (x/2) .
k=0
k!Γ (λ + k + 1)
Kλ denotes the modified Bessel function of the third kind with index λ. The modified
Bessel function of the third kind is also called MacDonald function. Kλ may be expressed
as function of Iλ , i.e.,
Z
π Iλ (x) − I−λ (x) 1 ³ x ´λ ∞
x2
Kλ (x) = = t−λ−1 e−t− 4t dt. (A.5)
2 sin(λπ) 2 2 0
A special case is λ = − 21 , the modified Bessel function of the third kind becomes
r
π − 1 −x
K− 1 (x) = x 2e .
2 2
Useful properties of the modified Bessel function of the third kind are
K−λ (x) = Kλ (x),

2λ
Kλ+1 (x) = Kλ (x) + Kλ−1 (x).
x
From this, we immediately get K 3 (x) = K 1 (x)(1 + x1 ). For the asymptotic expansions for
2 2
x → 0 we get
Kλ (x) ∼ 2λ−1 Γ (λ)x−λ , λ > 0, Kλ (x) ∼ 2−λ−1 Γ (−λ)xλ , λ < 0.
More details are found in Abramowitz and Stegun (1972) and Gradshteyn and Ryzhik
(1994).
B
GARCH Models for Dynamic Volatility
We follow the notation of Zivot and Wang (2002), see McNeil et al. (2005) for the technical
details. The estimations are all done by a maximum likelihood approach.
B.1 Univariate GARCH Processes
Univariate GARCH(p,q) Process
Let zt be independent, identically distributed (i.i.d.) random variables with zero mean and
unit variance. The process yt is a GARCH(p,q) process if it has the following dynamics
yt = µ + ε t , ε t = z t σt ,
p q
X X
2 2 2
σt = a 0 + ai εt−i + bj σt−j ,
i=1 j=1
where a0 > 0, ai ≥ 0, i = 1, . . . , p, and bj ≥ 0, i = 1, . . . , q.
Univariate TARCH(p,o,q) Process
Let zt be i.i.d. random variables with zero mean and unit variance. The process yt is a
TARCH(p,o,q) process if it has the following dynamics
yt = µ + ε t , ε t = z t σt ,
p o q
X X X
2 2 2 2
σt = a 0 + ai εt−i + 1{εt−k <0} γk εt−k + bj σt−j ,
i=1 k=1 j=1
where 1 denotes the identicator function, a0 > 0, ai ≥ 0, i = 1, . . . , p, and bj ≥ 0,

i = 1, . . . , q.
142 B GARCH Models for Dynamic Volatility
B.2 Multivariate GARCH Processes
The operator R is defined as follows:
Definition B.1 (Operator R).

1/2
Let Σ be a positive-definite covariance matrix. By Σd we define the diagonal matrix
whose elements are the square roots of the diagonal elements of Σ. The operator R is
defined as
1/2 1/2
R(Σ) = (Σd )−1 Σ(Σd )−1 ,
where R(Σ) is the correlation matrix of Σ.
Constant Conditional Correlation (CCC) GARCH Process
Let Zt ∈ Rn be a random vector whose components are i.i.d. random variables with zero
mean and unit variance. The process Yt is a multivariate CCC-GARCH process if it has
the following dynamics
1/2
Yt = µ + ε t , ε t = Σ t Zt ,
1/2
where Σt ∈ Rn×n is the Cholesky factor of a positive-definite matrix Σt which is mea-
surable with respect to the filtration Ft−1 . Let ∆t ∈ Rn×n be a diagonal matrix whose
elements are the square roots of the univariate GARCH(pk ,qk ) processes is of the form
pk qk
X X
2
σt,k = ak0 + aki ε2t−i,k + bkj σt−j,k
2
, k = 1, . . . , n .
i=1 j=1
where, for all k, ak0 > 0, aki ≥ 0, i = 1, . . . , pk , and bkj ≥ 0, i = 1, . . . , qk . The conditional
covariance matrix Σt is defined as
Σ t = ∆ t Rc ∆ t ,
where Rc is a positive-definite correlation matrix.
Dynamic Conditional Correlation (DCC) GARCH Process
Let Zt ∈ Rn be a random vector whose components are i.i.d. random variables with zero
mean and unit variance. The process Yt is a multivariate DCC-GARCH process if it has
the following dynamics
B.2 Multivariate GARCH Processes 143
1/2
Yt = µ + ε t , ε t = Σ t Zt ,
1/2
where Σt ∈ Rn×n is the Cholesky factor of a positive-definite matrix Σt which is mea-
surable with respect to the filtration Ft−1 . Let ∆t ∈ Rn×n be a diagonal matrix whose
elements are the square roots of the univariate GARCH(pk ,qk ) processes is of the form
pk qk
X X
2
σt,k = ak0 + aki ε2t−i,k + bkj σt−j,k
2
, k = 1, . . . , n .
i=1 j=1
where, for all k, ak0 > 0, aki ≥ 0, i = 1, . . . , pk , and bkj ≥ 0, i = 1, . . . , qk . The conditional
covariance matrix Σt is defined as
Σt = ∆t R(Qt )∆t ,
where R(Qt ) is the conditional correlation matrix and Qt has the dynamics
³ p
X q
X ´ p
X q
X
−1 −1 T
Qt = 1 − ai − bi Q c + ai ∆t−i εt−i [∆t−i εt−i ] + bj Qt−j .
i=1 j=1 i=1 j=1
Qc is a positive-definite covariance matrix. As noted in McNeil et al. (2005), Q c should be

estimated in one step by maximum likelihood. However, we use the unconditional covari-
ance of the standardized residuals resulting from the first stage estimation for convenience.
C
Proofs
C.1 Tail Dependence within a t Copula

t
Suppose we have an n dimensional random vector with t copula CR,ν . At first we are
interested in the distribution of the first n − 1 components, therefore we integrate over
the whole range of xn in (3.2) for the t copula (3.3). By R̂ we denote the correlation matrix
which equals R but has the n-th row and column removed. We make use of the integration
Rb R g(b) −1
rule a f (g(x))g 0 (x)dx = g(a) f (u)du, note that ui = Fi (xi ) and d(tνdu(u
n
n )) 1
= f (t−1 (u ))
,
1,ν ν n
Z ∞ n
Y
t
f (x1 , . . . , xn−1 ) = cR,ν (F1 (x1 ), . . . , Fn (xn )) fi (xi )dxn
−∞ i=1
n−1
Y Z 1
t
= fi (xi ) cR,ν (u1 , . . . , un )dun
i=1 0
n−1
Y Z 1
1 fR,ν (t−1 −1
ν (u1 ), . . . , tν (un ))
= fi (xi ) Qn−1 dun
i=1
−1
i=1 f1,ν (tν (ui )) 0
f1,ν (t−1
ν (un ))
n−1
Y Z ∞
fR,ν (t−1 −1
ν (u1 ), . . . , tν (un−1 )), xn )
= fi (xi ) Qn−1 dxn (C.1)
−1
i=1 −∞ i=1 f1,ν (tν (ui ))
n−1
Y fR̂,ν (t−1 −1
ν (u1 ), . . . , tν (un−1 )))
= fi (xi ) Qn−1 −1
i=1 i=1 f1,ν (tν (ui ))
n−1
Y
t
= fi (xi )cR̂,ν (F1 (x1 ), . . . , Fn−1 (xn−1 )).
i=1
In order to solve the integral of C.1, we make use of the properties of the multivariate t
density, see Kotz and Nadarajah (2004). From this result we can apply the formula for
the tail dependence (3.5) for every pair in an n-dimensional t copula. Every pair in a n-
dimensional t copula has a bivariate t copula with the corresponding correlation coefficient
and the same degree of freedom parameter as the n-dimensional copula.
146 C Proofs
C.2 Transformation from Partial to Full Information
Let the price dynamics evolve as introduced (5.28), the factors as in (5.26) and (5.27).
The function µ(x, y) is defined in (5.30). Summarized,
dP = diag(P ) {µ(x, y) dt + σp dWp },
dx = [Ax x + Ay y + a]dt + σx dWx ,
dy = [Cx x + Cy y + c]dt + σy dWy .
We calculate the dynamics of the logarithmic prices p = ln(P ) ∈ Rn with Itô’s lemma,
where diag{Σ} denotes the vector of the diagonal elements of the matrix Σ. Note that
the time arguments are omitted from now on wherever possible.
1
dp = [µ(x, y, t) − diag{Σ}] dt + σp dWp ,
2
p(0) = ln(P (0)).
For notational convenience, we introduce the new vector ξ = [pT , xT ]T ∈ Rn+m , containing
all the observable processes. We define the Brownian motion Wξ = [WpT , WxT ]T ∈ Rn+m ,
where Wp is introduced in Equation (5.28) and Wx in Equation (5.26). The filtering
problem then consists of
dy = [Cξ ξ + Cy y + c] dt + σy dWy ,
dξ = [Dξ ξ + Dy y + d] dt + σξ dWξ ,
where the deterministic matrix functions Cξ ∈ Rk×n+m and Dξ ∈ Rn+m×n+m are defined
as
 
h i 0 G
Cξ = 0 Cx , Dξ =  ,
0 Ax
The deterministic matrix function Dy ∈ Rn+m×k and the deterministic vector function
d ∈ Rn+m are
   
1
H f− 2
diag{Σ}
Dy =  , d=  .
Ay a
The matrix and vector functions Cy , c, and σy are defined in (5.27). The diffusion term
of ξ, denoted by σξ ∈ Rn+m×n+m , is easily seen to be
C.2 Transformation from Partial to Full Information 147
 
σp 0
σξ =  . (C.2)
0 σx
The Brownian motions Wp , Wx , and Wy need not be independent. The correlation matrix
of the n + m + k dimensional Brownian motion W = [WyT , WpT , WxT ]T ∈ Rn+m+k is defined
as
 
I1 ρyp (t) ρyx (t) 
  I1 ρyξ (t)
 
ρ(t) =  ρTyp (t) I2 ρpx (t)  =  , (C.3)
  ρTyξ (t) ρξ (t)
ρTyx (t) ρTpx (t) I3
where I denotes the identity matrix and ρyp ∈ Rk×n , ρyx ∈ Rk×m , ρpx ∈ Rn×m , I1 ∈ Rk×k ,
I2 ∈ Rn×n , and I3 ∈ Rm×m . In order to be regular, the correlation matrix ρ needs to be
symmetric and positive-definite for all t. Therefore, the matrix square root of ρ, denoted
1 1 1 1
by ρ 2 , exists. Since ρ 2 is the matrix square root of ρ, we have the relationship ρ = ρ 2 (ρ 2 )T .
Rt 1
We may construct the new Brownian motions W (t) by W (t) = 0 ρ 2 (s)dW (s). Thus,
1
we have for the increments dW = ρ 2 dW . The n + m + k Brownian motions W are
uncorrelated. The filtering problem with uncorrelated Brownian motions then is
dy = [Cξ ξ + Cy y + c]dt + σ y dW y + σ yξ dW ξ , (C.4)
dξ = [Dξ ξ + Dy y + d]dt + σ ξ dW ξ , (C.5)
where the volatility matrices σ y ∈ Rk×k , σ yξ ∈ Rk×n+m , σ ξ ∈ Rn+m×n+m are obtained by

the identity of the following block matrices
   
σ σ σ 0
 y yξ  =  y  ρ 12 . (C.6)
0 σξ 0 σξ
1 1
The Cholesky factorization of ρ is a good choice for ρ 2 , i.e., ρ 2 is an upper triangular
matrix. The equality above still holds when the left and the right hand side are multiplied
by their transposed. This simple block matrix calculations gives
   
T T T T T
σ σ + σ yξ σ yξ σ yξ σ ξ σ σ σy ρyξ σξ
 y y = y y . (C.7)
T T T T T
σ ξ σ yξ σξ σξ σξ ρyξ σy σξ ρξ σξ
From Lipster and Shiryaev (2001a, Theorem 10.3) we get the instantaneous changes of
the estimation m, or the conditional mean, of the factors y with the Kalman filter as
dm = [Cξ ξ + Cy m + c]dt + [B1 + νDyT ]B2 [dξ − {Dξ ξ + Dy m + d}dt] , (C.8)
m(0) = E[y(0)|ξ(0)].
148 C Proofs
The definition of B1 is given in (C.10). The error of the estimation is denoted by ν. In

Lipster and Shiryaev (2001a, Theorem 10.3) it is proofed that the variance of m, denoted
by ν ∈ Rk×k , evolves according to the following dynamics
ν̇ = Cy ν + νCyT + B3 − [B1 + νDyT ]B2 [B1 + νDyT ]T , (C.9)
ν(0) = E[(y(0) − m(0))(y(0) − m(0))T ].
The matrices B1 ∈ Rk×n+m , B2 ∈ Rn+m×n+m , and B3 ∈ Rk×k are defined as
B1 = σ yξ σ Tξ = σy ρyξ σξT , (C.10)
B2 = [σ ξ σ Tξ ]−1 = [σξ ρξ σξT ]−1 , (C.11)
B3 = σ y σ Ty + σ yξ σ Tyξ = σy σyT , (C.12)
where the second equalities are obtained from (C.7). In the dynamics of m in (C.8), the
term dξ is involved. But dξ is a function of the unobservable factors y, therefore we cannot
derive the optimal asset allocation strategy in this setup. Like this, we would not get an
admissible investment process (see Bielecki and Pliska (1999) for details). To overcome
this problem, we introduce the innovation process Wξ0 (t) given by the following stochastic
differential equation
dWξ0 = σ −1
ξ [dξ − {Dξ ξ + Dy m + d}dt]
= σ −1
ξ Dy [y − m]dt + dW ξ . (C.13)
It is proved in Lipster and Shiryaev (2001b, Theorem 12.5) that Wξ0 is indeed a Wiener
process and that
ξ0 ,Wξ0
Ftξ = Ft . (C.14)
Or, informally speaking, the information generated by ξ is equivalent to the information

generated by (ξ0 , Wξ0 ). This new innovation process, as given in (C.13), is inserted into
(C.5) and (C.8). This results in
dm = [Cξ ξ + Cy m + c]dt + [B1 + νDyT ]B2 σ ξ dWξ0 , (C.15)
dξ = [Dξ ξ + Dy m + d]dt + σ ξ dWξ0 .
In order to derive the asset price dynamics under the new innovation process Wξ0 , we
decompose σ ξ into
C.3 Lévy Density of the Multivariate VG Lévy Process 149
 
σp
σξ =  , (C.16)
σx
where σ p ∈ Rn×n+m , and σ x ∈ Rm×n+m . With this decomposition we may also decompose
ξ in p and x. This yields the following new dynamics of p and x as
1
dp = [µ(x, m, t) − diag{Σ}]dt + σ p dWξ0 , (C.17)
2
dx = [Ax x + Ay m + a]dt + σ x dWξ0 . (C.18)
From (C.7) we can identify the relationship σ ξ σ Tξ = σξ ρξ σξT . By inserting (C.2) and (C.16)
in this relation we get
   
σ p σ Tp σ p σ Tx σp σpT σp ρpx σxT
 = . (C.19)
σ x σ Tp σ x σ Tx σx ρTpx σpT σx σxT
We may now state the price dynamics with respect to the Wiener process Wξ0 .
Lemma C.1. Let the price dynamics evolve as in (5.28), where the factors evolve as in
(5.26) and (5.27). Then the dynamics of the prices
dP (t) = diag(P (t)) {µ(x(t), y(t), t) dt + σp (t)dWp (t)} ,
are the same as written in terms of Wξ0 , i.e.,
dP (t) = diag(P (t)){µ(x(t), m(t), t)dt + σ p (t)dWξ0 (t)}, (C.20)
where Wξ0 is defined as in (C.13) and the factors x and m are defined as in (C.18) and
(C.15), respectively.
Proof. The logarithmic prices are defined in (C.17). By using the equality σ p σ Tp = σp σpT =
Σ from (C.19) we get (C.20) by using Itô’s lemma.
The transformation of the price dynamics of the investment opportunities is necessary

to transform the partial-information problem into a full-information problem.
C.3 Lévy Density of the Multivariate VG Lévy Process
We proceed as in Masuda (2004). First, we make use of the subordination property of the
VG distribution and use Sato (1999, Theorem 30.1) or Cont and Tankov (2004, Theorem
4.2). Therefore,
150 C Proofs
Z Z ∞ T −1 n ¡ ¢
e x Σ γ s− 2 1 1 T −1
x Σ x+sγ T Σ −1 γ
νV G (B) = νΓ (s) p e− 2 s dsdx,
B 0 (2π)n det(Σ)
1 − ν1 s
where νΓ is the Lévy density of the gamma distribution, i.e., νΓ (s) = νs
e , where we
1 2
have set λ = ν
and ψ = ν
(see Schoutens (2003) for the definition of the Lévy density of
the gamma distribution). Evaluation the integral yields
Z T Σ −1 γ Z ∞ ¡ ¢
ex −n −1 −x
T Σ −1 x 1
−s γ T Σ −1 γ
+ ν1
νV G (B) = p s 2 e 2 s 2 dsdx.
B ν (2π)n det(Σ) 0
R a −b 1s −sc
R ³ 1 á+1 1
By using the equality s e ds = c
ta e−bc t −t dt we get
Z T Σ −1 γ Z ∞ ¡ ¢
ex ¡ γ T Σ −1 γ 1 ¢ n2 −n −1 − x
T Σ −1 x γ T Σ −1 γ
+ ν1 1
−t
νV G (B) = p + t 2 e 2 2 t dtdx.
B ν (2π)n det(Σ) 2 ν 0
Making use of the integral representation of the modified Bessel function of the third kind
as given in (A.5) yields
Z
2ex
T Σ −1 γ ³ γ T Σ −1 γ + 2 ´ n4 ³r ¡ 2¢´
ν T −1 T −1
νV G (B) = p K2
n x Σ x γ Σ γ+ dx.
B ν (2π)n det(Σ) xT Σ −1 x ν
D
Additional Data for the Sector Rotation Case Study
Table D.1. Factors for the sector rotation case study.
S&P 500 Composite Index FTSE US Real Estate Index

S&P Global 1200 Index Gold
Dow Jones World Ex US Index Crude Oil
S&P Europe 350 Index Platinum
Dow Jones World Emer. Markets Index GSCI Commodity Index
Dow Jones Wilshire Small Cap Index Lehman Corporate A+ Index
Dow Jones Wilshire Large Cap Index Lehman Corporate Enhanced BB Index
S&P 500 Barra Value Index Citigroup German 1-3Y Bond Index
S&P 500 Barra Growth Index Citigroup German 10+Y Bond Index
NASDAQ Composite Index Citigroup Japan 1-3Y Bond Index
FTSE 100 Index Citigroup Japan 10+Y Bond Index
France CAC 40 Index Citigroup US Big Corp. 1-3Y Bond Index
DAX 30 Performance Index Citigroup US Big Corp. 10+Y Bond Index
AEX Index Citigroup UK 1-3Y Bond Index
Swiss Market (SMI) Index Citigroup UK 10+Y Bond Index
TOPIX Index Citigroup UK All Mat. Bond Index
NIKKEI 225 Index VIX Volatility Index
ASX All Ordinaries Index VDAX Volatility Index
HANG SENG Index 3 months US Tr. Bills rate
S&P CNX 500 Index 1 month LIBOR rate
Korea SE Composite (KOSPI) Index US Treas. 10 yr Bond red. Yield
Brazil Bovespa Index US Corporate Bond Moody’s AAA rate
Mexico IPC (BOLSA) Index US Corporate Bond Moody’s BAA rate
UK £ to US $ Exchange Rate US Corporate Bond middle rate
Euro to US $ Exchange Rate Dividend yield on S&P 500
Swiss Franc to US $ Exchange Rate Price/Earnings ratio on S&P 500
US $ to Japanes YEN Exchange Rate Dividend yield on Dow Jones
Japanese Yen to Euro Exchange Rate Price/Earnings ratio on Dow Jones
Swiss Franc to US $ Exchange Rate Dividend yield on FTSE 100
FTSE W Japan Real Estate Index Price/Earnings ratio on FTSE 100
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Curriculum Vitae
Personal Data
Name: Simon Theodor Keel
Date of birth: January 26, 1976
Parents: Alex Keel and Margrith Keel-Tanner
Education
1983–1989 Primary school in St. Gallen, Switzerland
1989–1991 Secondary school in St. Gallen, Switzerland
1991–1996 Gymnasium in St. Gallen, Switzerland
1996 Matura certificate, type C
1996–2001 Studies in mechanical engineering, Swiss Federal Institute of

Technology (ETH) Zurich, Switzerland
2001 Diploma as Dipl. Masch.-Ing. ETH
2002-2006 Doctoral student and research assistant at the Measurement

and Control Laboratory, Swiss Federal Institute of Technology
(ETH) Zurich, Switzerland
Professional Experience
2001-2002 IT Consultant for NetArchitects SA (Altran Group), Zurich

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Diss. ETH No.

Optimal Portfolio Construction

and Active Portfolio Management

Including Alternative Investments

A dissertation submitted to the

SWISS FEDERAL INSTITUTE OF TECHNOLOGY ZURICH

for the degree of

Doctor of Technical Sciences

Simon Theodor Keel

Dipl. Masch.-Ing. ETH

born 26 January 1976

accepted on the recommendation of

Prof. Dr. H. P. Geering, examiner

Prof. Dr. A. J. McNeil, co-examiner

Prof. Dr. D. B. Madan, co-examiner

Zurich, May 2006

One aspect of financial engineering is the development of portfolio management strategies.

Diese Arbeit enthält eine ausführliche Untersuchung von alternativen Anlagen. Im

2 Financial Assets and Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3 Modeling of Financial Assets and Financial Optimization . . . . . . . . . . . . 21

4.1.3 Hedge Fund Styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

5 Optimal Portfolio Construction with Brownian Motions . . . . . . . . . . . . . 77

6 Active Portfolio Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

7 Conclusions and Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

A Probability and Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

A.2.2 Univariate Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

B GARCH Models for Dynamic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

D Additional Data for the Sector Rotation Case Study . . . . . . . . . . . . . . . . . 151

Curriculum Vitae . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

2.1 Asset allocation process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

3.1 Classes of distributions in finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

4.1 Assets under management by the hedge fund industry. . . . . . . . . . . . . . . . . . . 49

5.1 Asset allocation strategy under full information for γ = −10. . . . . . . . . . . . . 92

6.1 An MPC approach for the sector rotation problem. . . . . . . . . . . . . . . . . . . . . . 120

2.1 Financial assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3.1 Distributions for daily Dow Jones returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

4.1 Hedge fund styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

5.1 Typical values for the estimated parameters. . . . . . . . . . . . . . . . . . . . . . . . . . . 92

D.1 Factors for the sector rotation case study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

r Risk-free interest rate

1.1 Financial Engineering

1.2 Structure of the Thesis

Chapter 2: Financial Assets and Risk Management

Chapter 3: Modeling of Financial Assets and Financial Optimization

Chapter 4: Alternative Investments

the variance of a hedge fund portfolio is decreased by combining an increasing number

Chapter 5: Optimal Portfolio Construction with Brownian Motions

Chapter 6: Active Portfolio Management

Chapter 6 discusses the role of active portfolio management as well as implementation

Financial Assets and Risk Management

Being a language, mathematics may be used not only

2.1 Financial Assets

Table 2.1. Financial assets

2.2 The Asset Allocation Process

Fig. 2.1. Asset allocation process

companies, commodities, hedge fund managers, etc. If the investment opportunities do

2.3 Risk Management and Risk Measures

Definition 2.1 (Risk).

The mathematical tool to describe problems including uncertainty is probability theory.

2.3.1 The Concept of Utility

• A utility function must be an increasing continuous function: U 0 > 0.

1. the exponential function (a > 0): U (x) = −e−ax .

2.3.2 Financial Risk

Definition 2.2 (Risk measure).