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Constructing Bayesian tangency portfolios under short-selling restrictions

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  • Bodnar, Olha
  • Bodnar, Taras
  • Niklasson, Vilhelm

Abstract

We address the challenge of constructing tangency portfolios in the context of short-selling restrictions. Utilizing Bayesian techniques, we reparameterize the asset return model, enabling direct determination of priors for the tangency portfolio weights. This facilitates the integration of non-negative weight constraints into an investor’s prior beliefs, resulting in a posterior distribution focused exclusively on non-negative values. Portfolio weight estimators are subsequently derived via the Markov Chain Monte Carlo (MCMC) methodology. Our novel Bayesian approach is empirically illustrated using the most significant stocks in the S&P 500 index. The method showcases promising results in terms of risk-adjusted returns and interpretability.

Suggested Citation

  • Bodnar, Olha & Bodnar, Taras & Niklasson, Vilhelm, 2024. "Constructing Bayesian tangency portfolios under short-selling restrictions," Finance Research Letters, Elsevier, vol. 62(PA).
    • Handle: RePEc:eee:finlet:v:62:y:2024:i:pa:s1544612324000953
    DOI: 10.1016/j.frl.2024.105065
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