IIMB Management Review (2023) 35, 240–257

available at www.sciencedirect.com

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Dynamic market risk and portfolio choice:

Evidence from Indian stock market
Subham Agarwal, Sourish Chakravarti, Owendrilla Ghosh,
Gagari Chakrabarti*

Department of Economics, Presidency University, India

Received 22 October 2021; revised form 9 March 2022; accepted 9 August 2023; Available online 15 August 2023

KEYWORDS Abstract Undiversifiable market risk is a crucial factor that a risk-averse investor must consider
Market risk; while making any investment decision. We focus on dynamic market risk using time-varying beta
Time-varying beta; for 10 different sectoral indices from the Indian stock market, analyse its movement over volatil-
Volatility; ity regimes, and explore its relationship with market stress. The sectors that are most resilient
Regime switching towards market risk are chosen to construct the best portfolio for a risk-averse investor. Our find-
model; ings suggest that mere consideration of market risk and not taking its variability into account
Market stress; may leave a large chunk of risk unattended for a risk-averse investor.
Portfolio construction © 2023 Published by Elsevier Ltd on behalf of Indian Institute of Management Bangalore. This is
an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/
by-nc-nd/4.0/)

Introduction A major concern of the risk-averse investor is that market

According to the standard theory of portfolio selection, an
investor faces two types of risk, namely, the systematic or
market risk and the unsystematic or unique risk, each with
its own implications. Systematic risk is the risk or uncer-
tainty associated with the price volatility of any asset that
arises due to unanticipated fluctuations in the factors that
affect the entire financial market. Systematic risk is in sharp
contrast to unsystematic, or unique risk, which is unique to
the company or the specific industry itself. The main differ-
ence between these two is that unique risk reduces with
diversification. The essence of diversification is to invest in
assets across different industries with different economic
characteristics, as they would have lower covariance than
assets belonging to a particular industry (Markowitz, 1952).
*Corresponding author.
E-mail address: gagari.econ@presiuniv.ac.in (G. Chakrabarti).
risks that result from business cycles and several other micro
and macroeconomic factors do not subside with diversifica-
tion and remain even in efficient portfolios. Thus, under-
standing and minimising market risk is crucial in the
construction of a low-risk portfolio that will be resilient to
market shocks over time.
Capital asset pricing model (CAPM) (Sharpe, 1964) relates
the expected returns of an asset with the systematic risk,
measured by beta. Fama and French (1992) found a ‘flat’
relation between average return and beta as evidence
against CAPM. CAPM, built on the premise that investors live
for one period, has further flaws in assuming asset betas to
be time-invariant. It thus ignores the time-varying nature of
the relative risk of a firm’s cash flow. Fabozzi and Francis
(1978) found beta to move randomly over time. Thus, the
use of OLS produces biased estimates of beta, and the pres-
ence of heteroscedasticity reduces efficiency in estimation.
Fabozzi and Francis (1978) and Bollerslev, Engle and

https://doi.org/10.1016/j.iimb.2023.08.001
0970-3896 © 2023 Published by Elsevier Ltd on behalf of Indian Institute of Management Bangalore. This is an open access article under the CC
BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/)
Dynamic market risk and portfolio choice: Evidence from Indian stock market
Wooldridge (1988) came up with tests of CAPM that sug-
gested time-varying systematic risk. Conditional CAPM was
used by Jagannathan and Wang (1996) to overcome the
insufficiencies of static CAPM. In this approach, although
betas and expected returns were allowed to vary over busi-
ness cycles, the CAPM held for every period and explained
the cross-section of stock returns.
While making betas time-varying is crucial, some related
yet critical issues remain unattended. Time-varying market
risks bear significant implications for portfolio constructions,
but allowing betas merely to be time-varying is not sufficient
to capture the entire systematic risk posed to an investor.
Market risks may themselves be extremely volatile, passing
through different volatility regimes. This will escalate the
risk of investment further, particularly in the presence of
persistence. Moreover, such risks may vary across different
phases of market movements, with risks intensifying during
market stress. The issues seem particularly critical for
emerging markets that are more susceptible to market
stress.
The Indian stock market has witnessed significant growth
in the last 40 years. While a number of studies employed
time-varying beta (TVB) in different markets, there is a
dearth of studies in the Indian context, particularly at the
sectoral level. Investors usually prefer to invest in sectoral
funds, as these possess a high risk-to-return ratio, could
beat the market, and enable investors to profit from trends.
Moreover, investing in sectoral funds rather than in individ-
ual stocks offers better opportunities for diversification.
However, while constructing portfolios with sectoral funds,
one should proceed with caution. The sectoral funds are usu-
ally volatile, inconsistent, and susceptible to concentration
risks. Therefore, a deep understanding of the intricacies of
sectoral risks is crucial. We intervene here and reconnoitre
the role of time-varying market risks in the construction of
resilient, well-diversified sectoral portfolios for risk-averse
investors in the Indian stock market. Specifically, we explore
the dynamics of market risks at the sectoral level and iden-
tify sectors that are resilient enough to qualify as potential
members of a low-risk portfolio. The variability in dynamic
market risks in the wake of major crises such as the financial
meltdown of 2007–2008 and the recent pandemic has also
been incorporated to get better insight into prudent invest-
ment decision. Specifically, we attempt to answer the fol-
lowing set of questions:
Q1: How does the dynamic market risk of the sectoral
indices (given by TVB) behave over time?
Q2: Do such risks pass through different volatility
regimes? Specifically, are the risks persistent, reducing
opportunities for hedging?
Q3: Do such dynamic market risks escalate as the domes-
tic market plunges into stress?
Q4: Given such dynamic nature of market risks, can we
find out a resilient portfolio for a risk-averse investor?
We proceed further as follows: the second section
reviews the relevant literature, the third section describes
the data and presents the methodology, the fourth section
presents the results with analysis and the last section con-
cludes.
241
Literature review
The traditional CAPM (Lintner, 1965; Sharpe, 1964) was
developed around the portfolio choices of rational investors
(Markowitz, 1952). Initially, the model was highly applauded
due to its empirical success (Black, Fraser & Power, 1992)
and was extensively used in assessing the desirability of dif-
ferent financial assets and the consequent investors’ choice.
Such exuberance, however, faded gradually as studies
pointed towards the inadequacies of time-invariant CAPM
beta (Fama & MacBeth, 1973; Jensen, Black, & Scholes,
1972). Backed by empirical support in the global financial
markets, the stability of beta was questioned (Bos & New-
bold, 1984; Brooks & Faff, 1997; Fabozzi & Francis, 1978;
Wells, 1994). Similar results were obtained for financial mar-
kets in Korea (Bos & Fetherston, 1992), Finland (Bos, Fether-
ston, Martikainen & Perttunen, 1995), Hong Kong (Cheng,
1997), Malaysia (Kok, 1992; Brooks, Faff & Ariff, 1997), and
Sweden (Wells, 1994). Apprehension escalated that the tra-
ditional CAPM would fail to capture persistent asset pricing
anomalies such as the ‘size effect’, ‘book-to-market effect’,
and the ‘momentum effect’ (Fama & French, 1992, 1993,
1996).
Consequently, recommendations followed in the litera-
ture to make the CAPM beta time-varying for effective
redressal of such issues. Fabozzi and Francis (1978) and Bol-
lerslev et al. (1988) recommended the modification of tradi-
tional CAPM and proposed tests of the modified model.
Studies found the conditional beta models to have consis-
tently outperformed the traditional constant beta model
(Jagannathan & Wang, 1996; Lettau & Ludvigson, 2001).
Such models can estimate undiversifiable market risks with
considerable accuracy (Huang & Hueng, 2008) and can
account for omitted variables (Gonza
lez-Rivera, 1996).
Fama and French (1992) emphasised that a model with TVB
can explain the market risks more efficiently as the variabil-
ity of asset returns can be made to incorporate some funda-
mental variables such as size and book-to-market ratio. A
TVB is able to capture excess volatility, value and momen-
tum premium (Ball & Kothari, 1989), and even the effects of
financial market crises (Choudhry, Lu, & Peng, 2010). The
much worried-about size, industry, and value anomalies in
the stock markets are resolved once the beta varies over
time (Campbell & Vuolteenaho, 2004; Fama & French, 1996;
Ferson & Harvey, 1999). Long movements in asset risks
(Adrian & Franzoni, 2009) and variations at the portfolio
level (Ferson & Harvey, 1991) are better explained with
TVBs.
Dynamic or TVBs are widely used in modelling market
risks. Studies have considered different approaches for com-
puting TVBs. Brooks, Faff and McKenzie (1998) considered
the three available techniques, namely, the multivariate
generalised ARCH approach, the TVB market model
approach, and the Kalman filter technique. Using industry
portfolio returns in the Australian market over the period
1974
1996, they favoured the use of the Kalman filter
approach. Bollerslev (1990) favoured using suitable multi-
variate GARCH models. This approach has been extensively
followed in literature. Studies by Braun, Nelson and Sunier
(1995), Giannopoulos (1995), McClain, Humphreys and
Boscan (1996), Gonzalez-Rivera (1996), and Brooks, Faff,
242
McKenzie and Ho (2000) are noteworthy in the list. Recently,
Bauwens, Laurent and Rombouts (2006) concluded that Mul-
tivariate GARCH models, particularly, the diagonal VECH and
BEKK are more parsimonious and capture the dynamics of
variances and covariances better than others. Schwert and
Seguin (1990), Koutmos, Lee and Theodossiou (1994), and
Episcopos (1996) employed the market model to estimate
TVB. The Kalman filter method has been used by Black et al.
(1992), Wells (1994) and Nieto, Orbe and Zarraga (2014).
Faff, Hillier and Hillier (2000), however, have shown that
the M-GARCH model of Bollerslev (1990), the security return
heteroscedasticity model of Schwert and Seguin (1990), and
the Kalman Filter method are equally efficient in providing
consistent estimates of beta.
Li (2003) modelled the market risk of the New Zealand
industry portfolios using a multivariate GARCH model. Huang
and Hueng (2008) examined the systematic risk-return rela-
tionship in the US up market and down market using the TVB
model. Jawadi, Louhichi, Cheffou and Bameur (2019) used a
three-regime threshold GARCH model to estimate TVB.
Chakrabarti and Sen (2021) have used the multivariate
GARCH model to relate the dynamic market risk of green
stocks in the global market to their stresses. Analyses of
industry-level portfolio behaviour using TVB are also avail-
able in the literature. Koutmos (2012) found industry betas
to respond positively to escalated market risk and reported
the presence of volatility persistence in various industries.
Moonis and Shah (2003) used TVB to account for index vola-
tility that varies over time claiming that traditional OLS
beta calculations overstate the potential advantages from
diversification as they underestimate the level of systematic
risk embodied in a stock. Choudhry (2005) studied the
impact of the September 11 attacks on TVBs and found that
changes in market volatility bear a significant impact on the
TVB as opposed to the company’s volatility and in the period
that ensued, some firm’s betas rose thereby implying addi-
tional risk to the companies. Petkova and Zhang (2005) esti-
mated beta first by regressing the excess returns of value
and growth portfolios on that of the market using rolling
window regression and second, by employing a conditional
model that makes beta of a security a function of dividend
yield, the default spread, the term spread, and the short-
term treasury bill rate.
Literature also offers cases where TVBs are found to be
regime-switching. Hamilton (1989) introduced Markov-
switching model of business cycle for serially autocorrelated
data. Kim and Nelson (1999) applied the Markov-switching
model to the post-war US data and reported a narrowing gap
between the boom and recession growth rates. Subse-
quently, several studies have used Markov-switching regres-
sion models. Abdymomunov and Morley (2011) found betas
to vary significantly across high and low volatility regimes
for the high B/M (value portfolios) as well as for the low B/M
(growth) portfolios and especially momentum portfolio
betas that vary appreciably across the two volatility regimes
for both winner and loser portfolios. Prukampai (2015)
explored the dynamics of eight industrial betas in the Thai-
land Stock Exchange using the regime-switching approach.
They found betas to vary over time and regime shifts in
them to be tied to economic policies during the research
period. Galagedera and Shami (2004) used the model to esti-
mate dynamic betas and compared the results with the
S. Agarwal et al.
constant beta estimates and concluded that the constant
betas, although significant, cannot capture conditional risk-
return relationship that varies over up-market and down-
market days. A few studies have related dynamic betas to
market stresses also. The coefficients of market stress
(CMAX) method of Patel and Sarkar (1998) is widely used to
measure stress in the stock market (Illing & Liu, 2006; Huo-
tari, 2015). Chakrabarti and Das (2021) found the Indian sec-
toral betas to increase under domestic market stress as
opposed to the US market betas that could largely avoid
such stresses. In certain cases, the US market betas even fall
in stressed markets. Few other studies have employed TVB
to model market risk in the Indian stock market. Gupta and
Mallick (1996) found year-to-year variation in beta among
stocks on the Bombay Stock Exchange (BSE) and further
found that this variation could not be explained by any
accounting information. Chawla (2001) found evidence
against the stationarity of beta for a considerable percent-
age of stocks in Indian stock markets using regression with
slope dummy variables. Moonis and Shah (2003) tested for
constancy of beta in the Indian stock market and found beta
to be time-varying in 52% of cases. Singh (2008) found con-
siderable variation in the value of beta, and its stationarity
and stability, depending on the method used for its computa-
tion. Thomas and George (2010) examined the stationarity
of beta in the Indian stock market for the period January
1996 to December 2009. Das (2015) estimated industry beta
in the Indian stock market with three alternative models
and compare the accuracy of forecasting error to find the
most suitable model for TVB estimation. Majdoub, Bouhouch
and Salim (2017) explored the effects of the global financial
crisis of 2008 on the TVB of 20 firms from China and India.
They found that the Indian stock markets do not exhibit the
same dynamic correlation relationship as Chinese stock mar-
kets in local and world betas. Dash and Sundarka (2019)
tested for TVB for information technology (IT) sector stocks
in the Indian stock markets. For a sample of nine IT sector
stocks listed on the BSE, India, they found betas to be sta-
tionary over time. Shetty and Dsouza (2018) studied the sta-
bility of beta for several different sectors of the Indian
economy and found evidence supporting beta stationarity.
As is evident from the review of relevant literature, mak-
ing market risks vary over time is crucial. However, such
dynamic market risks have hardly been incorporated into
portfolio construction. The issues of volatile TVBs, particu-
larly during periods of market stresses and their relevance
for investment decisions of risk-averse investors have hardly
been focussed on in the existing literature. This leads to the
underestimation of investment risk. This highlights the con-
tribution of the present study. While the exploration fills the
lacuna in the existing literature, the results will bear signifi-
cance for investment decisions of risk-averse investors.
Database and methodology
Database
Data has been collected from the official website of BSE for
the period of January 2, 2006 to April 15, 2021. We selected
10 sectors, namely automobile, banking, IT, public sector
undertakings, healthcare, fast-moving consumer goods,
Dynamic market risk and portfolio choice: Evidence from Indian stock market
realty, oil and gas, power, and telecommunication. BSE
introduced market capitalisation-weighted indices for these
sectors in 1999. We take the S&P BSE SENSEX, the bench-
mark index of the 30 most highly valued stocks, as the mar-
ket index. The period of study includes two major crises,
namely, the financial crisis of 2007
2008 and the current
COVID-19 pandemic.
The choice of these 10 sectors is guided by several consid-
erations. First, daily data is available for these sectors over
the chosen period of study. Second, these indexes represent
the major sectors in the Indian stock market. The bundle is a
fair combination of new economy (i.e., knowledge based) sec-
tors and traditional old economy sectors. We have incorpo-
rated the knowledge-based and research-orientated IT and
healthcare sectors that are usually constituted of growth
stocks. We could not incorporate infrastructural index due to
the non-availability of data. The telecommunication sector
has gained significance in the Indian stock market, particularly
after the IT revolution. A growing telecommunication sector is
now treated as part of infrastructural development. The bank-
ing index is a set of 30 efficient and financially sound Indian
banks. Value investors are usually tilted towards the bank
stocks, which are the most susceptible to emotional short-
term forces given the leverage and nature of the business.
Traditional automobile stocks are usually cyclical stocks that
are affected by the cycles of the economy. Economic slow-
down affects the sector and policies and phenomena like fuel
price hikes, emission norms, liquidity constraints, and import
duties on commercial and sports utility vehicles hit their sales.
An economic recovery, however, spurts the valuation of such
stocks. Realty sector index usually attracts investors, particu-
larly busy professionals, to enjoy the benefits of owning prop-
erty without the hassles of being a landlord. The initial
investment is much lower. PSU stocks, with their strong funda-
mentals, are usually lower valued than their private counter-
parts, and they offer high dividend yields. These
considerations attract value investors to the PSU index. His-
torically, the BSE PSU Index has traded at a 50% discount to
the Sensex. The valuation gap has widened in the past couple
of years to 65%. The oil and gas index and power index are
constituted of traditional, old-economy stocks. These sectors
usually attract the energy investors. Oil and gas stocks can
produce significant capital gains from share price appreciation
and attractive dividend income during periods of high oil and
gas prices. Historically, these stocks have offered better divi-
dends than others during the boom. The timing to market,
thus, is important. Investment in the oil and gas stocks must
be made as the economy transits from a recession to an
expansion. Investors, however, need to be cautious as these
cyclical stocks are vulnerable to the global economy shocks.
The power stocks in emerging countries, including India, are
always in focus. The growing urban population and its quest
for affordable, clean, and reliable power provide a huge scope
for continued growth in power demand. In India, the fast-
moving consumer goods sector, the fourth-largest growing
industry, is another area that the investors can bank on. Grow-
ing awareness for branded products, increased spending
power, ease of access, and modified lifestyles have been the
major growth drivers for this sector. These are steady stocks
offering steady, or even rising, returns. Moreover, given their
nature, they have flourished during the pandemic, and the
revenge spending that usually spurts after any crisis is
243
expected to create additional demand for these items. Thus,
the study has selected 10 sectors that seem to be relevant to
investors’ choices. We have not considered the thematic
indexes like the BSE GREENEX, BSE CARBONEX, BSE ESG or
BSE SHARIAH indexes. The prices of thematic indexes are
often influenced by irrational exuberance or pessimism. More-
over, these indexes will have members common to the chosen
sectoral indexes.
Daily return for each index has been calculated as Rt = ln
(Pt/Pt-1), where Pt is the closing value of the index at time ‘t’.
Methodology
Construction of TVB
Constant beta CAPM
Constant Beta CAPM (Sharpe, 1964) is described as:


Ri
Rf ¼ bi Rm
Rf ð1Þ
Ri and Rm are the returns of the ith asset and the market
respectively, Rf is the risk-free return. The static beta bi is
defined as:
covarianceð Ri ; Rm Þ
bi ¼
varianceð Rm Þ
Following Bollerslev et al. (1988), TVB is computed using
a suitably lagged diagonal VECH model.
TVB - multivariate Garch (diagonal VECH) model
In multivariate GARCH models, the series co-move over time
which makes it reasonable to assume the presence of time-
varying co-volatility. In these models, the contemporaneous
shocks to different series are correlated. The time-varying
covariances computed from such models help us in con-
structing TVB for the sectoral indices.
We use a suitably lagged diagonal VECH model with two-
variable specification for our calculations. With N = 2, a
VECH (1,1) can be written as:
h11t ¼ c10 þ a11 21t
1 þ b11 h11t
1 ð2Þ
h12t ¼ c20 þ a22 1t
1 2t
1 þ b22 h12t
1 ð3Þ
h22t ¼ c30 þ a33 22t
1 þ b33 h22t
1 ð4Þ
where Eqs. (2) and (4) are conditional variance equations
and Eq. (3) is the conditional covariance equation. We pair
each sector with the market and obtain conditional varian-
ces and covariances. The TVB for the ith sectoral index is
calculated as:
conditional covarianceðRi ; Rm Þ
TVBi ¼ ð5Þ
conditional varianceðRm Þ
Movement in TVB over time
A frequency band-pass filter (Christiano & Fitzgerald, 2003)
is used to isolate cycles and remove short-term fluctuations
in TVB series so that their movements over time may be bet-
ter analysed. Empirical survivor graphs (ESGs) are then used
to check the probability of a sector being aggressive or
defensive over time.
244
Frequency band pass filter. These linear filters employ a two-
sided weighted moving average and isolate the cyclical com-
ponent of a time series by specifying a range for its duration.
The upper and lower bounds of the range are selected to
extract the cycle. We have used a general, time-varying,
full sample asymmetric filter that allows the weights on lead
and lag to differ. The weights are time-varying and depend
on the observations.
Empirical survivor graph
The ESG of a series returns an estimate of the probability of
observing a value at least as large as some specified value.
ESG helps us estimate the most probable value of any series.
This study employs ESG to check the probabilities of having
betas greater than one or the probabilities of a sector being
aggressive or defensive.
Regime switching TVB - estimation of Markov switching
regression model
To explore the possible regime-switching behaviour of TVBs,
we employ a suitable Markov switching regression model.
Switching regression models are linear models with discrete
changes in regimes. In the Markov switching model, the sam-
ple separation into regimes is unobservable.
We consider a random variable yt to follow a process that
depends on the value of an unobserved discrete state vari-
able st. Assuming there are M regimes, we are in regime m in
period t when st = m, for m = 1. . .M. For each regime m, con-
ditional mean of yt assumes a linear specification:
mt ðmÞ ¼ x 0 t bm þ z0 t r ð6Þ
bm, the coefficients for xt vary over regime, while the r
coefficients associated with zt are regime-invariant. Regres-
sion errors are assumed to be normally distributed, which
may be regime-varying as well. Moreover, the Markov
switching model returns transitional probabilities. The first-
order Markov assumption requires that the probability of
being in a regime depends on the previous state, so that
Pðst ¼jjst
1 ¼iÞ ¼ pij
Transitional probabilities may be either time-varying or
constant and reveal the possible persistence in any series.
Such probabilities are useful because, in the presence of sig-
nificant persistence in asset returns, hedging is not profit-
able, making the construction of dynamic portfolios useless.
We use the TVB of each sector as a dependent variable
and its lags as independent variables. The intercept term,
the coefficients, and the error terms are allowed to be
regime-dependent. The appropriate model is chosen on the
basis of the minimum AIC criterion.
While TVBs may themselves be extremely volatile, exoge-
nous factors such as market stress and crises might escalate
such volatility. Our next step is thus to relate TVBs to market
stress.
TVB and market stress
The mere presence of volatility in any series is not an indica-
tion of stress in it. It is only when the returns fall below a
certain threshold, can we conclude of existing stress in the
S. Agarwal et al.
system. We compute a market stress index following the
CMAX method of Patel and Sarkar (1998).
Construction of market stress index (CMAX method)
The CMAX method relates the return of the market on any
particular day to its maximum return over, usually, the past
365 days. Hence, CMAX is defined as:
Retrurn of the day
CMAX ¼ ð7Þ
Maximum return of the past 365 days
Any decrease in CMAX implies a lower return in terms of
historical return on a particular day and, hence, the pres-
ence of stress in the market. The choice of window is criti-
cal. Usually, a period of 365 days is used to incorporate the
annual policy changes in an economy. We have calculated a
CMAX series for the SENSEX to identify periods of market
stress.
Relating TVB to market stress - estimation of Garch model
We use a suitable GARCH model for ith sector with the fol-
lowing mean equation:
X
n X
n
TVBt;i ¼ Ci þ aj :TVBt
j;i þ bj :CMAXt
j;i ð8Þ
j¼1 j¼0
The variance equation includes a constant, an ARCH
term, a GARCH term, and, if required, a term for incorporat-
ing asymmetry and leverage. TVB in each sector is taken to
depend on its own past values and on the current and past
values of market stress. Models are selected on the basis of
the minimum AIC criterion. A positive coefficient of CMAX
will imply a fall in TVB in response to a fall in CMAX or a rise
in market stress.
Using the results of the Markov switching regression and
the relationship between TVB and market stress, the sec-
toral indices will be ranked in terms of their risk resilience.
Finally, minimum variance portfolios will be constructed by
taking the high- and low-resilient sectors separately.
Construction of minimum variance portfolio
Markowitz (1952) suggested the construction of efficient and
diversified portfolios using the E-V rule, where portfolio risk,
given by the variance of portfolio return, is minimised for a
given expected return or more. We have followed Markowitz
(1952) to construct a minimum-variance portfolio suitable
for any risk-averse investor.
In case of n-assets, with wi as the weight of asset ‘i’, the
portfolio returns and risk are defined as follows:
X
n
Returnp ¼ wi  Returni ð9Þ
i
X
n n X
X n
Risk ¼ s 2p ¼ wi2 s 2i þ wi wj s ij ð10Þ
i i j
s 2i is the variance of return of asset ‘i’ and s ij is the
covariance between returns of assets ‘i’ and ‘j’. The risk-
averse investor chooses weights (that sum up to one) to min-
imise portfolio risk. We allow short selling so that some
weights may be negative. Performances of such portfolios
are evaluated using the method of value-at-risk (VaR).
Dynamic market risk and portfolio choice: Evidence from Indian stock market 245

Evaluation of portfolios - VaR
VaR is used to evaluate portfolio performances (Angelidis &
Degiannakis, 2009) by calculating the maximum amount of
loss to be incurred with a certain probability, say, 99% or
95%. The calculation of VaR requires knowledge about the
functional form of the portfolio return series. If the returns
demonstrate stylised facts like fat tails, skewness, non-nor-
mality, and volatility clustering, assuming a normal distribu-
tion will be inappropriate. Alternatively, a t-distribution
with heavier tails may be used, and means and standard
deviations may be replaced by conditional mean and condi-
tional standard deviations estimated from a suitable GARCH
model. Thus,
VaRðassetÞ ¼ conditional mean
þ conditional variance  F
1 ðaÞ ð11Þ
where F
1 ðaÞ is the inverse probability distribution function
of t-distribution.
Results and analysis
Descriptive statistics and testing for the presence of
unit roots
Table 1 reports the descriptive statistics for the sectoral and
market return. All the series are stationary, non-normal,
negatively-skew with fat tails. They thus demonstrate styl-
ised facts of financial time series and suitable GARCH family
models may be employed to model them.
Sectoral TVBs and their movements over time
Table 2 reports the descriptive statistics and the augmented
Dicky-Fuller test statistic for the sectoral TVBs.
Fig. 1(a)-(j) shows the cycles of sectoral TVBs over time.
Plotting cycles rather than the original series smoothens
undue disturbances and helps us understand the behaviour
of a series better. Movements of sectoral TVBs are in the
Appendix (Fig. A1-A10).
The sectoral TVBs show two distinct humps: one during
the financial meltdown of 2007
2008 and the other during
the recent pandemic. Betas increased significantly during
the crisis in all sectors. Hence, in all the sectors, market
risks increased during crises. The extent of the increase,
however, differs.
During the financial meltdown of 2007
2008, the auto-
mobile, PSU, realty, banking, and oil and gas sectors faced
huge escalations in market risks. Such escalation for the IT,
FMCG, power and healthcare sectors was moderate, while
the telecom sector was least affected. The situation, how-
ever, has changed during the recent pandemic. The banking
sector has experienced the largest increase in market risks.
Market risks in sectors such as realty, PSU, automobiles, and
oil and gas increased moderately. The market risks of the
telecom, IT, FMCG, power, and healthcare sectors are least
affected by the pandemic. The crisis thus has significant
impacts on the market risks of different sectoral indices, but
the extent of the risk differs. A look at Fig. 2 will make the
proposition clear.
While taking positions in a particular asset, investors
often enquire whether the asset is aggressive or defensive in
nature. An aggressive asset adds to portfolio risks as its
returns are oversensitive to changes in market movements.
This is particularly risky during crises in the market. The
defensive assets, on the other hand, are less risky as their
returns fall less than proportionately in a sliding market.
The constant beta CAPM identifies assets with beta h1 as
defensive and assets with beta i 1 as aggressive. In the
framework of TVB, we cannot identify whether betas are
greater or less than one. But we can explore the probability
of a sector to be aggressive or defensive, using empirical sur-
vivor graphs of sectoral TVBs (Fig. 3(a)-(j)). Specifically, we
consider the probability of getting a value of TVB at least as
great as one.
From Table 3, we observe that healthcare and FMCG are
mostly defensive sectors. The probability of having beta  1
is only 0.01 for them. Similarly, telecom, IT, power, PSU,

Table 1 Descriptive statistics and unit-root testing for sectoral and market return.

Sector Listing name Mean SD Skewness Kurtosis Jarque–Bera Augmented

Statistic Dicky–Fuller
test statistic
Automobile S&P BSE AUTO 0.0004 0.02
0.41 9.51 6790.77*
56.08*
Banking S&P BSE BANKEX 0.0005 0.02
0.17 10.68 9329.93*
55.57*
FMCG S&P BSE FMCG 0.0005 0.01
0.27 8.66 5097.48*
60.67*
Healthcare S&P BSE Healthcare 0.0005 0.01
0.58 8.95 5793.25*
57.12*
IT S&P BSE Information Technology 0.0005 0.02
0.19 8.56 4904.33*
45.63*
Power S&P BSE POWER 0.0001 0.02
0.18 11.09 10,352.58*
56.26*
PSU S&P BSE PSU 0.0001 0.02
0.30 10.56 9068.02*
56.01*
Realty S&P BSE Realty 0.0002 0.03
0.50 10.48 8989.33*
54.09*
Telecom S&P BSE Telecom 0.0001 0.02 0.00 7.45 3119.68*
60.88*
Oil and gas S&P BSE Oil and gas 0.0003 0.02
0.50 13.55 17,737.70*
59.22*
SENSEX S&P BSE SENSEX 0.0004 0.01
0.23 14.44 20,672.86*
58.93*
Source: authors.
Observations: 3787 in each case.
*
Implies significance at 5%.
246 S. Agarwal et al.

Table 2 Descriptive statistics and unit-root testing for sectoral time-varying beta.

Sector Mean SD Skewness Kurtosis Jarque–Bera Augmented

statistic Dicky-Fuller
test statistic
Automobile 0.95 0.19
0.05 3.55 50.32*
7.15*
Banking 1.21 0.16 0.31 3.49 97.25*
8.15*
FMCG 0.64 0.18 0.62 6.86 2597.14*
8.40*
Healthcare 0.58 0.18 0.64 4.38 564.08*
8.28*
IT 0.70 0.18 0.65 6.48 2180.48*
10.61*
Power 0.93 0.18 0.90 6.23 2153.03*
8.39*
PSU 0.95 0.18 0.72 3.89 451.85*
8.16*
Realty 1.34 0.28
0.06 3.74 87.21*
8.99*
Telecom 0.47 0.34 0.18 2.35 86.26*
6.97*
Oil and gas 0.97 0.17 0.93 6.82 2850.66*
11.75*
Source: authors.
Observations: 3787 in each case.
*
Implies significance at 5%. The observations are summarised in Table 3.

automobile, and oil and gas are mostly defensive, while
banking and realty sectors are mostly aggressive sectors.
Risk-averse investors usually refrain from including aggres-
sive assets in their portfolios. Therefore, it seems that the
banking and the realty sectors may not be the optimal
choices for risk-averse investors. However, in a framework
of dynamic market risks, such considerations alone may not
be sufficient to determine investors’ choices. Once we make
the risks time-varying, the issues of shock transmission from
external as well as endogenous sources gain significance.
The following sections would help us understand the true
nature of market risks in different sectors and their desir-
ability to be included in a risk-averse investor’s portfolio.
Do market risks vary over regimes? Results of
Markov switching regression
For each sector, a three-regime Markov switching model
seems appropriate. The TVBs pass through three regimes,
namely, the low-volatility, medium-volatility, and high-vola-
tility regimes. Most of the intercept terms and coefficients
of lagged values of TVB are significant in the estimation. The
detailed results are in the Appendix (Table A1).
Risk-averse investors consider the strong persistence of
TVB in high-volatility regimes to be perilous as it magnifies
market risk. They prefer transitions, particularly if, starting
from an initial high-volatility regime, market risks enter a
low-volatility regime with a higher probability and/or
remain in the high-volatility regime with a lower probability.
Thus, the transitional probabilities for the high-volatility
regimes are important for our analysis (Table 4). The
expected duration of staying in the three regimes is also
reported. The remaining transitional probabilities are in the
Appendix (Table A2).
Starting from an initial regime of high volatility, High to
High (H

H), High to Medium (H-M) and High to Low (H-L) in
Table 4 indicate the respective probabilities of moving into a
high-volatility, medium-volatility or low-volatility regime in
the next period.
Starting from an initial high-volatility regime, the beta of
the aggressive banking sector has only an 18% chance of stay-
ing in the high-volatility regime, but a 26% chance to enter
the low-volatility regime in the next period. It moves to the
medium-volatility regime with 56% chance. The beta of the
other aggressive sector, namely the realty sector, demon-
strates a similar trend. It has a high chance to enter a
medium-volatility regime from a high-volatility one.
The market risks of defensive sectors like oil and gas,
PSU, FMCG, healthcare and automobiles, however, demon-
strate a different trend. Starting from a high-volatility
regime, they have very little or almost no chance to switch
from high-volatility regimes to low-volatility regimes. This is
likely to affect their desirability to the risk-averse investors.
Their market risks, however, have a greater tendency to slip
into a medium-volatility regime from a high-volatility one.
This perhaps can provide some cushion to the investors in
the sense that such market risks at least do not persist in
high-volatility regimes. But the risk remains, as their betas
hardly enter low-volatility regimes. The market risks of the
two other defensive sectors, namely, IT and the power sec-
tor, have quite high chances of switching from high-volatility
to low-volatility regimes. In contrast to the previous group
of defensive sectors, the market risks of these two sectors
switch from high-volatility to medium-volatility regimes
with lesser chances. This increases their desirability to the
risk-averse investors. Thus, choosing the defensive sectors
and discarding the aggressive ones may not always be opti-
mal for the risk-averse investors, particularly in a more real-
istic situation of dynamic market risks. The proposition
would be clear if we consider the defensive telecom sector.
Starting from a high-volatility regime, its beta shows the
highest probability among all the sectors to remain there
with no chances to enter a low-volatility one.
The expected duration denotes the number of days in a
particular volatility regime. Banking, automobiles, IT,
healthcare, power, and oil and gas stay in low-volatility
regimes for the maximum number of days, whereas PSU,
realty, FMCG, and telecom stay in medium-volatility regimes
for the highest number of days.
Dynamic market risk and portfolio choice: Evidence from Indian stock market 247

Fig. 1 Cyclical movement of sectoral time-varying betas. (a) realty sector; (b) FMCG sector; (c) automobile sector; (d) banking sec-
tor; (e) PSU sector; (f) IT sector; (g) telecom sector; (h) healthcare sector; (i) power sector; and (j) oil and gas sector. Source:
Authors.
248
Fig. 2 Cyclical movement in sectoral time-varying beta (combined). Source: Authors.
In order to rank the sectors for a risk-averse investor, we
now proceed to check the impact of market stress on sec-
toral TVBs.
Impact of market stress on sectoral TVB: CMAX
method
Table 5 reports the coefficients of market stress (CMAX)
along with the coefficients of appropriate lagged values of
CMAX and of TVB for all the sectors. The dependent variable
is sectoral TVB, as in Eq. (8).
The IT and FMCG sectors may be considered ‘safe’ as their
market risks remain unaffected by increased market stress.
This is evident by the insignificant coefficients of CMAX and
all its lags. The realty sector may also be treated as ‘safe’ as
a consistent positive relationship exists between its TVB and
CMAX for certain lags. An escalated market stress leads to a
fall in market stress on the very next day and subsequently
on the fifth day after increased market stress. For all other
lags, increased market stress has no impact on market risks
in the realty sector.
For the power and banking sectors, the significantly
positive coefficient of CMAX(
1) suggests a fall in market
risks following an escalation in market stress on the previ-
ous day. As is evident from the coefficient values, the
impact is stronger in the banking sector. No further lagged
impact of increased market stress on dynamic market risks
is discernible. Hence, these two sectors, although, not as
safe as the previous set, may also be preferred by a risk-
averse investor.
For the automobile and PSU sectors, current stress has no
impact on market risks. Some lagged impact, however, exists
as the coefficient of CMAX(
1) is significantly positive and
that of CMAX(
2) is negative. With additional market stress
on a particular day, the market risks fall on the very next
day but increase subsequently on the second day after
S. Agarwal et al.
stress. As is evident from the values of the coefficients, the
decrease in risk is more and the increase in risk is less in the
automobile sector. No further lagged impact, however, is
discernible. This inconsistent behaviour of market risks in
the face of increased market stress may make a risk-averse
investor sceptical about these two sectors. Given similar
inconsistencies in its behaviour of market risks in face of
escalated market stress, scepticism may predominate for
the healthcare sector also. Following an increase in market
stress, market risks in the healthcare sector escalated on
the very next day. Such effects, however, subside and dis-
solve subsequently.
The behaviour of the market risks in the telecom and oil
and gas sectors is quite different. With increased market
stress, market risks in the telecom sector fall over the next
2 days and increase thereafter. While risk-averse investors
may be sceptical about the riskiness of the telecom sector,
the scepticism will be more intense for the oil and gas sec-
tor. An escalated market stress leads to increased market
risks in the oil and gas sector significantly on most subse-
quent days.
Using these results and the transitional probabilities
obtained from the Markov switching regression, we now rank
the sectors according to their resilience to risk. As men-
tioned earlier, the criteria will be twofold: each sector’s per-
sistence in terms of its own volatility and how it reacts to
market stress. Low persistence and a favourable relation
with market stress are preferred.
While ranking the sectors according to their volatility
persistence, we emphasise the high-volatility regime. A risk-
averse investor detests high volatility and would always pre-
fer to exit such regimes to enter a low-volatility, or at least,
a medium-volatility, regime. Hence, we rank the sectors
according to the transitional probabilities in the following
sequence: H

H (lower the better), H-L (higher the better)
and H-M (higher the better). The ranking is presented in
Table 6.
Dynamic market risk and portfolio choice: Evidence from Indian stock market 249

From the point of view of a risk-averse investor, the
oil and gas sector ranks first. Starting from a high-volatil-
ity regime, the beta of the sector has the lowest proba-
bility of staying there. Moreover, it has a moderate
chance of moving to a low-volatility regime. The power
sector follows, as its market risks have low persistence in
the high-volatility regime but a strong tendency to move
to the low-volatility regime. The FMCG sector follows,
but its market risks bear no chances of moving into a
low-volatility regime. The market risks of the banking
and IT sectors show greater persistence in the high-vola-
tility regime, but they have greater chances of moving
into the low-volatility regime. The healthcare, PSU, and
telecom sectors are ranked low. Their risks show greater
persistence in a high-volatility regime and no tendency
to switch to a low-volatility one.
To arrive at the final ranking, we consider the relationship
between the sectoral TVB and market stress once again
Table 7.
As mentioned earlier, a risk-averse investor prefers a sec-
tor if the coefficients of CMAX and/or its lagged values are
either insignificant or positive.
For the telecom sector, we cannot identify any consistent
relationship between market risk and market stress. More-
over, its market risks show strong persistence in the high-vol-
atility regime with no tendency to move into a low-volatility
one. The oil and gas sector, although desirable in terms of
persistence, loses merit when we consider the effect of mar-
ket stress on its risk. On most occasions, escalated market
stress increases market risks. This behavioural pattern would
restrain risk-averse investors to include these two sectors in
their portfolios.

Fig. 3 Empirical survivor graph of sectoral time-varying beta. (a) realty sector; (b) FMCG sector; (c) automobile sector; (d) banking
sector; (e) PSU sector; (f) IT sector; (g) telecom sector; (h) healthcare sector; (i) power sector; and (j) oil and gas sector. Source:
Authors.
250
Fig. 3 Continued.
The sectors like IT, power, FMCG, banking, and realty are
highly desirable as the coefficients of CMAX and its lagged
values are either insignificant or positive. The market risks
of these sectors remain unchanged or dwindle in the face of
escalating market stress. Further, betas of these sectors
show significantly lower persistence in the high-volatility
regime.
The remaining three sectors rank moderately in terms of
volatility persistence of market risks. Moreover, increased
market stress increases the market risk of these sectors on
only one occasion. These sectors may not be as desired as
the previous group, but including them in the portfolio may
still be profitable. Thus, in terms of their resilience towards
risk, the sectors may be classified into two groups. The first
group consists of the most desirable sectors, namely, power,
FMCG, banking, IT, and realty. This group includes two
aggressive sectors, namely, banking and realty. The second
group includes the three less desirable sectors, namely,
automobile, healthcare and PSU, all of which are defensive.
S. Agarwal et al.
It now remains to be shown that choosing sectors with
such resilience will indeed help a risk-averse investor.
Towards the purpose, we construct minimum variance port-
folios for these two groups and compare their performances
in terms of market and unique risks.
Portfolio construction and performance evaluation
Table 8 shows the weights, returns, and unique risks of the
two portfolios.
In portfolio A, realty and banking sectors receive negative
weights, implying short-selling in these two aggressive sec-
tors. Investors usually do this in anticipation that the under-
lying asset will decline in value in the future. The three
other defensive sectors, namely, FMCG, IT and power,
receive positive weights. Portfolio B includes defensive sec-
tors, all of which receive positive weights. Portfolio A has a
slightly lower unique risk. However, a comparison of the
Dynamic market risk and portfolio choice: Evidence from Indian stock market 251

Fig. 3 Continued.
252 S. Agarwal et al.

Table 3 Probability of a sector for being defensive or aggressive.

Healthcare FMCG Telecom IT Power PSU Automobile Oil and gas Banking Realty
Prob(Beta  1) 0.01 0.01 0.05 0.06 0.30 0.35 0.40 0.40 0.90 0.90
Nature Defensive Aggressive
Source: authors.

Table 4 Transitional probabilities and expected duration of sectoral time-varying beta estimated from Markov switching regres-
sion model.

Transitional probabilities Expected duration (days)

H
H H
M H
L High-volatility Medium-volatility Low-volatility
Regime Regime Regime
Banking 0.18 0.56 0.26 1.22 1.56 1.76
PSU 0.29 0.71 0.00 1.40 2.25 2.08
Realty 0.24 0.51 0.25 1.31 1.78 1.66
Automobile 0.19 0.80 0.01 1.23 1.79 2.23
FMCG 0.17 0.83 0.00 1.20 2.57 2.54
IT 0.20 0.46 0.34 1.24 2.15 2.16
Telecom 0.37 0.63 0.00 1.59 3.12 2.63
Healthcare 0.28 0.72 0.00 1.38 2.69 3.23
Power 0.14 0.53 0.33 1.12 2.02 2.47
Oil and gas 0.11 0.72 0.17 1.16 1.52 2.05
Source: authors.
H: high; M: medium; and L: low.

market risk of portfolios is more relevant for a risk-averse
investor.
The portfolio returns are stationary and exhibit stylised facts
of a financial time series (Table 9). We now calculate TVB for the
two portfolios using the methodology described earlier. The
movements in portfolio betas are shown in the appendix (Figure
A11). We then identify the portfolio that is least affected by cri-
ses and offers lower losses, particularly during crises.
Fig. 4(a) and (b) shows the ESG of the portfolio TVBs. The
portfolios are mostly defensive, as the probability of getting

Table 5 Time-varying beta and coefficient of market stress - results from GARCH model estimation.

Variable Realty Power Banking IT FMCG Automobile Healthcare PSU Telecom Oil and
gas
C 0.077* 0.033 0.044* 0.036* 0.023* 0.012* 0.031* 0.031* 0.010* 0.041*
CMAX 0.051* 0.000 0.000 0.001 0.003 0.001 0.007 0.001 0.007*
0.059*
CMAX (
1) 0.049* 0.012* 0.016* 0.014
0.001 0.019*
0.096* 0.010* 0.027* 0.0583*
CMAX (
2)
0.005
0.004
0.001
0.002
0.004
0.004* 0.036*
0.010*
0.022*
0.0033
CMAX (
3)
0.002
0.008 0.002 0.003
0.007 0.001 0.010
0.003
0.010*
0.014*
CMAX (
4) 0.005
0.001 0.005
0.006
0.000 0.002 0.007 0.000
0.006
0.0158*
CMAX (
5) 0.007* 0.001 0.002
0.002 0.002 0.000 0.010 0.006 0.001
0.0133*
TVB (
1) 0.957* 0.967* 1.135* 1.120* 0.950* 1.059* 0.778* 0.948* 1.417* 0.938*
TVB (
2)
0.017
0.019
0.236*
0.2 0.018
0.096* 0.081*
0.009
0.645* 0.005
TVB (
3) 0.010 0.065 0.045
0.004 0.019
0.001 0.018 0.272* 0.0118
TVB (
4) 0.034 0.013
0.004 0.041
0.006
0.148* 0.0152*
TVB (
5)
0.071*
0.031 0.003
0.041 0.018 0.097*
TVB (
6) 0.084* 0.008 0.047
0.042
TVB (–7)
0.040
0.003 0.041 0.017
TVB (
8) 0.011
R-Square 0.91 0.93 0.94 0.92 0.93 0.95 0.86 0.93 0.97 0.86
Source: authors.
*
Implies significance at 5%.
Dynamic market risk and portfolio choice: Evidence from Indian stock market 253

Table 6 Sectors ranked according to transitional probabili- Table 8 Weights, return, and risk of portfolios A and B.
ties obtained from Markov switching regression.
Portfolio A Portfolio B
H
H H
M H
L Aggressive/
Sectors Weights Sectors Weights
defensive
Realty
0.11 Auto 0.16
Oil&Gas 0.11 0.72 0.17 Defensive
FMCG 0.63 Healthcare 0.75
Power 0.14 0.53 0.33 Defensive
Banking
0.02 PSU 0.09
FMCG 0.17 0.83 0.00 Defensive
IT 0.26
Banking 0.18 0.56 0.26 Aggressive
Power 0.24
Automobile 0.19 0.80 0.01 Defensive
Total 1 Total 1
IT 0.20 0.46 0.34 Defensive
Risk 0.000134 Risk 0.000138
Realty 0.24 0.51 0.25 Aggressive
Return 0.012 Return 0.017
Healthcare 0.28 0.72 0.00 Defensive
PSU 0.29 0.71 0.00 Defensive Source: authors.
Telecom 0.37 0.63 0.00 Defensive
H: high; M: medium; and L: low.
Table 9 Descriptive statistic and unit-root testing for port-
folio returns.

Portfolio A Portfolio B
beta  1 is almost zero in both cases. Moreover, the proba- Mean 0.00048 0.00046
bilities of getting a higher value of beta are lower for portfo- SD 0.011 0.012
lio A. For example, the probability of beta  0.8 is 0.1 for Skewness
0.26
0.73
portfolio A but 0.2 for portfolio B. Similarly, the probability Kurtosis 10.30 10.64
of beta  0.9 for portfolio A is negligible but 0.1 for portfolio Jarque–Bera test statistic 8448.76* 9545.69*
B. Thus, portfolio B, although constituted of three defensive Observations 3787 3787
sectors, is more likely to exhibit higher market risk than Augmented Dicky–Fuller statistic
62.40*
56.99*
portfolio A.
Source: authors.
Fig. 5 shows the movement of the portfolio TVBs over *
Implies significance at 5%.
time. We notice two major peaks in market risk. The first
peak was reached just before the financial meltdown of
2007
2008, and the second one is around the recent pan-
demic period. We notice further that market risks fell drasti- Fig. 7 depicts the cycles of the portfolio TVBs during the
cally when the economy entered periods of crisis. This shows recent pandemic. Throughout the pandemic period, the TVB
the resilience of the portfolios, but a comparison of the two of portfolio B was higher than that of portfolio A.
around crisis periods will help us conclude about their rela- Thus, the more defensive portfolio A is less exposed to
tive merits. market risks than portfolio B as the market plunges into cri-
Fig. 6 shows the cycles in portfolio TVBs around the finan- sis.
cial meltdown of 2007
2008. From January 2008 to June Finally, we check the desirability of portfolios in terms of
2008, the recession was in full swing, and portfolio A exhib- loss by using VaR at 99% confidence interval. Since the port-
ited lower market risks than portfolio B. The same phenome- folio returns exhibit stylised facts of a financial time series,
non was observed in March 2009, when the Indian market we use the modified version of VaR. Figs. 8 and 9 show the
started recovering. percentage (maximum) loss from the two portfolios and the

Table 7 Relationship between sectoral time-varying beta and market stress.

TVB CMAX CMAX (
1) CMAX (
2) CMAX (
3) CMAX (
4) CMAX (
5)
Oil&Gas Negative Positive Insignificant Negative Negative Negative
Power Insignificant Positive Insignificant Insignificant Insignificant Insignificant
FMCG Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant
Banking Insignificant Positive Insignificant Insignificant Insignificant Insignificant
Automobile Insignificant Positive Negative Insignificant Insignificant Insignificant
IT Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant
Realty Positive Positive Insignificant Insignificant Insignificant Positive
Healthcare Insignificant Negative Positive Insignificant Insignificant Insignificant
PSU Insignificant Positive Negative Insignificant Insignificant Insignificant
Telecom Positive Positive Negative Negative Insignificant Insignificant
Source: Authors.
CMAX: coefficients of market stress.
254 S. Agarwal et al.

Fig. 4 Empirical survivor graph of portfolio TVBs. (a) Portfolio A and (b) Portfolio B. Source: Authors.

Fig. 5 Cyclical movement of portfolio TVB. Source: Authors.

market during the two crisis periods. During the financial
meltdown, the two portfolios offered lower losses than the
market. Although they offered roughly the same percentage
of maximum losses, losses for portfolio B have shown more
spikes and have been more volatile (Fig. 8).
During the recent pandemic, the losses from the market
and the two portfolios moved similarly until March 2020 and
showed a spike in April 2020 (Fig. 9). However, since May
2020, losses from the portfolio A have fallen significantly
and remained consistently lower than the losses imparted by

Fig. 6 Cyclical movement of portfolio time-varying beta during financial meltdown of 2008. Source: Authors.
Dynamic market risk and portfolio choice: Evidence from Indian stock market 255

Fig. 7 Cyclical movement of portfolio time-varying betas around COVID-19 pandemic. Source: Authors.

Fig. 8 Percentage of maximum loss during financial meltdown of 2008. Source: Authors.

Fig. 9 Percentage of maximum loss during COVID-19 pandemic. Source: Authors.

256
the market and the other portfolio. The losses for portfolio B
have been quite spikey and, at times, higher than those of
the market. This establishes the resilience of portfolio A and
its desirability to the risk-averse investors.
Conclusion
We attempted to construct a portfolio with the risk-resilient
sectors in the Indian stock market. Investing in sectoral
funds offers opportunities for diversification but involves
concentration risk. Risk-averse investors are mostly both-
ered by undiversifiable market risk, and as suggested by the
literature, these risks do vary over time rather than being
constant as is suggested by the traditional CAPM. Thus, we
have incorporated dynamic market risk in our analysis. How-
ever, once the market risks are time-varying, judging sectors
according to their nature (i.e., aggressive or defensive) does
not give us true insight about their market risks. Market risks
may be extremely volatile and may be affected by market
stress and can escalate the risk of investment. Considering
such risk of the risk is thus crucial. We have ranked the sec-
tors accordingly and have found that being aggressive does
not restrict a sector from becoming a member of the lower
market-risk portfolio. Moreover, investors can reduce risks
and profit further by short-selling such assets as the prices of
these assets drop. On the other hand, investing in an all-
defensive asset portfolio does not always help in risk reduc-
tion. Such modifications in the concepts and issues are cru-
cial to identify a portfolio that is resilient to market risks,
less susceptible to market crashes, and imparts lower losses
on the investors, particularly during crises. This is an addi-
tion to the existing literature. Moreover, the results of the
study have significant implications for investors. It empha-
sises that the mere consideration of market risk and dealing
with it in the traditional way is not sufficient. Market risks
are undiversifiable, but ignoring market risks makes such
risks unmanageable. Our paper is different from the earlier
studies in the Indian context. The studies available in the lit-
erature have primarily focused on the issues of stability of
beta and have attempted to offer the most appropriate
methodology for calculating TVB for Indian sectoral indexes.
The consideration of TVB in portfolio construction is rare.
Moreover, attempts to relate dynamic market risks to mar-
ket stresses have been limited. The regime-switching behav-
iour of sectoral betas has never been incorporated in
portfolio construction. The use of dynamic value-at-risk for
portfolio evaluation and relating it to crises is still limited.
In that way, our study fills some lacunae in existing literature
in the Indian context and supplements the literature in cer-
tain contexts.
Supplementary materials
Supplementary material associated with this article can be
found in the online version at doi:10.1016/j.iimb.2023.08.
001.
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