Evaluation of Optimum and Coherent Economic-Capital Portfolios Under Complex Market Prospects

Evaluation of Optimum and Coherent Economic-Capital Portfolios Under Complex Market Prospects

Mazin A. M. Al Janabi (EGADE Business School, Tecnologico de Monterrey, Mexico)
Copyright: © 2020 |Pages: 17
DOI: 10.4018/978-1-7998-0106-1.ch011

Abstract

This chapter examines the performance of liquidity-adjusted risk modeling in obtaining optimum and coherent economic-capital structures, subject to meaningful operational and financial constraints as specified by the portfolio manager. Specifically, the chapter proposes a robust approach to optimum economic-capital allocation in a liquidity-adjusted value at risk (L-VaR) framework. This chapter expands previous approaches by explicitly modeling the liquidation of trading portfolios, over the holding period, with the aid of an appropriate scaling of the multiple-assets' L-VaR matrix along with GARCH-M technique to forecast conditional volatility and expected return. Moreover, in this chapter, the authors develop a dynamic nonlinear portfolio selection model and an optimization algorithm, which allocates both economic-capital and trading assets by minimizing L-VaR objective function. The empirical results strongly confirm the importance of enforcing financially and operationally meaningful nonlinear and dynamic constraints, when they are available, on the L-VaR optimization procedure.
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Literature Review And Objectives Of Present Research Study

Based on studies to date, there is little agreement as to the best method for developing VaR risk measures. However, literature related to VaR is continually growing as researchers attempt to reconcile several pending issues. The prior literature on VaR and portfolio risk management has been focused on two distinct lines of research. The first category focuses mainly on the use of different VaR models for market and credit risk management and for selecting optimum portfolios within VaR framework, whereas the second category emphasizes the development of asset liquidity risk as an integral part of market risk and, therefore, leads to several approaches for the estimation of L-VaR. Below we discuss some of the relevant literature classified according to the above two categories.

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