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Staying ahead on downside risk 145

In addition, several dynamic EVaR models have been developed in the recent
econometric literature and will be briefly reviewed in the next section. My contri-
bution is to suggest a simple asset allocation procedure that can be used to build
the optimal portfolio by minimizing risk as measured by the predicted EVaR.
6.2 Measuring downside risk: VaR and EVaR
6.2.1 Definition and properties
EVaR is introduced in Kuan, Yeh, and Hsu (2009) . The concept of ω -expectile,
for 0 Ͻ ω Ͻ 1, can be found in Newey and Powell (1987) . They defined µ ( ω ),
for any random variable Y with finite mean and cumulative distribution func-
tion F ( y ), as the solution of the equation:

µ ω
ω
ω
µ ω
µ ω
( ) ( ) ( ( )) ( )
( )
ϭ ϩ
Ϫ
Ϫ
Ϫ E Y y dF y
2 1
1



(6.1)
The ω -EVaR of Kuan et al. (2009) is just Ϫ µ ( ω ). Expression (6.1) can be
rearranged to give:

ω µ ω ω µ ω
µ ω
µ ω
( ( )) ( ) ( ) ( ( ) ) ( )
( )
( )
y dF y y dF y Ϫ ϭ Ϫ Ϫ
Ϫ


∫ ∫
1

The differences that appear in the integrals are nonnegative. When ω ϭ 0.5,
the solution is simply µ ( ω ) ϭ E ( Y ), while as ω varies between zero and 0.5,
the expectile function µ ( ω ) describes the lower tail of the distribution of Y .
Intuitively, the quantities ω and 1 Ϫ ω can be seen as asymmetric weights that
multiply the integrals of the deviations from µ ( ω ). If ω Ͻ 0.5, then the weight
on the outcomes y that lie below µ ( ω ) (i.e., the weight on the integral on the
right hand side) dominates.
It can be shown that a solution exists and it is unique. Furthermore, the
expectiles of a linear transformation of Y , Y * ϭ aY ϩ b can be easily found
since µ *( ω ) ϭ a µ ( ω ) ϩ b for any real numbers a and b .
Suppose that we have obtained a sample of n observations Y
i
. The sample
equivalent of the population expectile can be found by solving:

min
µ
ω
ρ µ ( ) Y
i
i
n
Ϫ
ϭ1


(6.2)
where

ρ ω
ω
( ) | ( )| x I x x ϭ Ϫ < 0
2

Optimizing Optimization 146
In other words, we minimize the weighted squared deviations from the obser-
vations. Weights are asymmetric: if ω Ͻ 0.5 then negative residuals receive a
larger weight than positive residuals. When ω ϭ 0.5, the problem boils down to
minimizing the sum of squared errors, yielding the sample mean as the solution.
It is easy to show that VaR can be characterized as the value that minimizes
asymmetric absolute deviations instead of square deviations. The function
ρ
ω
( x ) is replaced by ρ
α
( x ) ϭ | α Ϫ I ( x Ͻ 0)| | x |, 0 Ͻ α Ͻ 1. As a consequence,
the difference between VaR and EVaR can be stated in terms of the shape of
the objective function in the optimization problem (6.2).
A fundamental property of expectiles, which follows from the first-order
conditions of the minimization problem, is that the weighted sum of residuals
is equal to zero:

| ( )|( ) ω µ µ Ϫ Ϫ Ϫ ϭ
ϭ
I Y Y
i i
i
n
1
0


EVaR has several advantages. First, when expectiles exist, they characterize the
shape of the distribution just like quantiles. In fact, each ω -expectile corresponds
to an α -quantile, although the relation between ω and α varies from distribu-
tion to distribution, as can be seen from Table 6.1 . For example, a 5% EVaR
when returns are normally distributed corresponds to a 12.6% VaR. However,
for heavy tailed distributions like a t (5), the 5% EVaR corresponds to a 10%
VaR. If α is seen as an indication of how conservative the risk measure is, then it
can be seen that EVaR is more conservative when extreme losses are more likely.
A second advantage of EVaR is that it is a coherent measure of risk.
3
It also
admits an interpretation in terms of utility maximization. Manganelli (2007)
shows that an expectile can be seen as the expected utility of an agent having
asymmetric preferences on below target and above target returns. His argu-
ment is presented in more detail in the section on asset allocation. The resulting
portfolio allocations are not dominated in the second-order stochastic domi-
nance sense. In other words, a portfolio is second-order stochastic dominance
efficient if and only if it is optimal for some investor who is nonsatiable (i.e.,
the higher the profit, the better) and risk averse. It is interesting to note that
the mean – variance optimal portfolios do not satisfy this property: There may

3
It can be shown that EVaR satisfies all the properties required by the definition of Artzner et al.
(1999) , including monotonicity and subadditivity.
Table 6.1 α corresponding to ω when ω -EVaR and α -VaR are equal
ω Normal t (30) t (5) t (3)
1% 4.3% 4.0% 3.0% 2.4%
5% 12.6% 12.3% 10.0% 8.5%
10% 19.5% 19.0% 16.6% 14.5%
Staying ahead on downside risk 147
exist portfolios that would be chosen by all nonsatiable risk averse agents over
the mean – variance solution.
6.2.2 Modeling EVaR dynamically
Another notable advantage of expectiles is their mathematical tractability,
as argued in Newey and Powell (1987) . Dynamic expectile models have been
derived in Taylor (2008) , Kuan et al. (2009), and De Rossi and Harvey (2009) .
An early example appeared in Granger and Sin (2000) . Computationally, simple
univariate models compare favorably to GARCH or dynamic quantile models.
The analysis presented in this chapter is based on the dynamic model of De
Rossi and Harvey (2009) . Intuitively, their estimator produces a curve rather
than a single value µ , so that it can adapt to changes in the distribution over
time. The two parameters needed for the estimation are ω and q .
The former can be interpreted as a prudentiality level: the lower ω , the more
risk aversion. Figure 6.1 shows a typical expectile plot for alternative values of ω .
By decreasing ω , one focuses on values that are further out in the lower tail,
i.e., more severe losses.
By increasing q , we can make the model more flexible in adapting to the
observed data. The case q ϭ 0 corresponds to the constant expectile (estimated
by the sample expectile). As Figure 6.2 shows, larger values of q produce esti-
mated curves that follow more and more closely the observations.
0.04
0.02
0.00
R
e
t
u
r
n
–0.02
–0.04
1996 1998 2000 2002 2004 2006 2008
Figure 6.1 Time-varying expectiles. The solid black lines represent estimated dynamic
expectiles for ω ϭ 0.05, 0.25, 0.5 (mean), 0.75, and 0.95.
Optimizing Optimization 148
De Rossi and Harvey (2009) assume that a time series y
t
, a risk tolerance
parameter 0 Ͻ ω Ͻ 1, and a signal to noise ratio q are given. They then decom-
pose each observation into its unobservable ω -expectile, µ
t
( ω ), and an error
term ␧ having ω -expectile equal to zero:

y
t t t
t t t
ϭ ϩ
ϭ ϩ
Ϫ
µ ω ε ω
µ ω µ ω η ω
( ) ( )
( ) ( ) ( )
1

The ω -expectile, µ
t
( ω ), is assumed to change over time following a (slowly
evolving) random walk that is driven by a normally distributed error term η
t

having zero mean.
4
In the special case, ω µ ϭ 0 5 5 . , (0. )
t
is just the time-varying
mean and therefore y
t
is a random walk plus noise. The signal µ
t
( . ) 0 5 can be
estimated via the Kalman filter and smoother (KFS).

4
The dynamics could be specified alternatively as following an autoregressive process or an inte-
grated random walk.
2
1
0
–1
2
1
0
–1
2
1
0
–1
2
1
0
–1
5 10 15 20
R
e
t
u
r
n
,

p
c
t
q = 0.1
5 10 15 20
R
e
t
u
r
n
,

p
c
t
q = 1
5 10 15 20
R
e
t
u
r
n
,

p
c
t
q = 10
5 10 15 20
R
e
t
u
r
n
,

p
c
t
q = 1000
Figure 6.2 Time-varying expectiles for alternative values of q. The data is a simulated
time series. The dotted line represents the sample 5% expectile, which corresponds to
the case q ϭ 0.
Staying ahead on downside risk 149
Equivalently , the problem can be cast in a nonparametric framework. The
goal is to find the optimal curve f ( t ), plotted in Figure 6.1 , that fits the obser-
vations. It is worth stressing that f ( t ) is a continuous function, so here the argu-
ment t , with a slight abuse of notation, is allowed to be a positive real number
such that 0 Ͻ t Ͻ T . The solution minimizes:

[ ( )] ( ( )) f t dt q y f s
s
s
T
T

2
1
0
ϩ Ϫ
ϭ
ρ
ω ∑


(6.3)
with respect to the whole function f , within the class of functions having square
integrable first derivative. At any point t ϭ 1,..., T , we then set µ
t
( ω ) ϭ f ( t ).
The first term in Equation (6.3) is a roughness penalty . Loosely speaking,
the more the curve f ( t ) wiggles, the higher the penalty. The second term is the
objective function for the expectile, which as noted above gives asymmetric
weights on positive and negative errors.
The constant q represents the relative importance of the expectile criterion.
As q grows large, the objective function tends to become influenced less and
less by the squared first derivative. In the limit, only the errors y
t
Ϫ µ
t
( ω ) mat-
ter and the solution becomes µ
t
( ω ) ϭ y
t
, i.e., the estimated expectile coincides
with the corresponding observation. As q tends to zero, instead, the integral of
the squared derivative is minimized by a straight line. As a result, the solution
in the limit is to set all expectiles equal to the historical expectile. The role of q
is illustrated in Figure 6.2 .
It can be shown that the optimal curve is a piecewise linear spline.
Computationally, finding the optimal spline boils down to solving a nonlinear
system in µ , the vector of T expectiles. After some tedious algebra, the first-
order conditions to minimize Equation (6.3) turn out to be:

[ ( )] ( ) Ω µ µ µ ϩ ϭ D y D y y , ,

where D(y, µ ) is diagonal with element ( t , t ) given by

| ( )| ω µ Ϫ Ϫ I y
t t
< 0

and

Ω ϭ
Ϫ
Ϫ Ϫ
Ϫ Ϫ
Ϫ
Ϫ
Ϫ
q
1
1 1 0 0 0
1 2 1 0 0
0 1 2 1 0
0 2 1
0 1 1

































Optimizing Optimization 150
Both Ω and D are T ϫ T matrices. Starting with an initial guess, µ
(1)
, the
optimal µ is found by iterating the equation:

µ Ω µ µ
( ) ( ) ( )
[ ( )] ( )
i i i ϩ Ϫ
ϭ ϩ
1 1
D y D y y , ,

until convergence. I define
ˆ
D y ( )
the matrix D upon convergence of µ
(

i

)
to ˆ µ .
The repeated inversion of the T ϫ T matrix in the formula can be efficiently
carried out by using the KFS.
5
To this end, it is convenient to set up an auxil-
iary linear state space form at each iteration:

y u
v
t t t
t t t
ϭ ϩ
ϭ ϩ
Ϫ
δ
δ δ
1

(6.4)
where

Var u I y
t t t
i
( ) /| ( )|
( )
ϭ Ϫ Ϫ 1 0 ω µ <

and

Var v q
t
( ) ϭ

The unobservable state δ
t
replaces µ
t
. The model in Equation (6.4) is just a
convenient device that can be used to carry out the computation efficiently. It
can be shown that the linear KFS applied to Equation (6.4) yields the optimal
µ characterized above.
The parameter q can be estimated from the data by cross-validation. The
method is very intuitive: It consists of dropping one observation at a time from
the sample and thus re-estimating the time-varying expectile with a missing
observation T times. The T residuals are then used to compute the objective
function:

CV q y
t t
t
t
T
ω ω
ρ µ ( ) ( )
( )
ϭ Ϫ
Ϫ
ϭ

1


where µ
t
t ( ) Ϫ
is the estimated value at time t when y
t
is dropped. CV
ω
( q )
depends on q through the estimator
µ
t
t ( ) Ϫ
. De Rossi and Harvey (2006) devise a
computationally efficient method to minimize CV
ω
( q ) with respect to q .
6.3 The asset allocation problem
This section illustrates a method for finding, given a set of basic assets, the
portfolio with the lowest estimated risk — where risk is measured as EVaR. It is

5
The connection between spline smoothing and signal extraction in linear Gaussian systems has
been thoroughly investigated in the statistical literature. An early example is Wahba (1978) .