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Portfolio diversification under local and moderate deviations from power laws

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  • Ibragimov, Rustam
  • Walden, Johan

Abstract

This paper analyzes portfolio diversification for nonlinear transformations of heavy-tailed risks. It is shown that diversification of a portfolio of convex functions of heavy-tailed risks increases the portfolio's riskiness if expectations of these risks are infinite. In contrast, for concave functions of heavy-tailed risks with finite expectations, the stylized fact that diversification is preferable continues to hold. The framework of transformations of heavy-tailed risks includes many models with Pareto-type distributions that exhibit local or moderate deviations from power tails in the form of additional slowly varying or exponential factors. The class of distributions under study is therefore extended beyond the stable class.

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  • Ibragimov, Rustam & Walden, Johan, 2008. "Portfolio diversification under local and moderate deviations from power laws," Insurance: Mathematics and Economics, Elsevier, vol. 42(2), pages 594-599, April.
    • Handle: RePEc:eee:insuma:v:42:y:2008:i:2:p:594-599
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    Cited by:

    1. Rustam Ibragimov & Johan Walden, 2011. "Value at risk and efficiency under dependence and heavy-tailedness: models with common shocks," Annals of Finance, Springer, vol. 7(3), pages 285-318, August.
    2. Chen Zou, 2009. "Dependence structure of risk factors and diversification effects," DNB Working Papers 219, Netherlands Central Bank, Research Department.
    3. Valérie Chavez-Demoulin & Paul Embrechts & Marius Hofert, 2016. "An Extreme Value Approach for Modeling Operational Risk Losses Depending on Covariates," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 83(3), pages 735-776, September.
    4. Tong, Bin & Wu, Chongfeng & Xu, Weidong, 2012. "Risk concentration of aggregated dependent risks: The second-order properties," Insurance: Mathematics and Economics, Elsevier, vol. 50(1), pages 139-149.
    5. Embrechts, Paul & Puccetti, Giovanni, 2010. "Bounds for the sum of dependent risks having overlapping marginals," Journal of Multivariate Analysis, Elsevier, vol. 101(1), pages 177-190, January.
    6. Moore, Kyle & Sun, Pengfei & de Vries, Casper G. & Zhou, Chen, 2013. "The cross-section of tail risks in stock returns," MPRA Paper 45592, University Library of Munich, Germany.
    7. Moore, Kyle & Sun, Pengei & de Vries, Casper G. & Zhou, Chen, 2013. "The drivers of downside equity tail risk," MPRA Paper 45591, University Library of Munich, Germany.
    8. Zhou, Chen, 2010. "Dependence structure of risk factors and diversification effects," Insurance: Mathematics and Economics, Elsevier, vol. 46(3), pages 531-540, June.
    9. Ibragimov, Rustam & Prokhorov, Artem, 2016. "Heavy tails and copulas: Limits of diversification revisited," Economics Letters, Elsevier, vol. 149(C), pages 102-107.
    10. Kyle Moore & Pengfei Sun & Casper de Vries & Chen Zhou, 2013. "Shape Homogeneity and Scale Heterogeneity of Downside Tail Risk," Working Papers 13-13, Chapman University, Economic Science Institute.
    11. Michael Grabchak, 2014. "Does value-at-risk encourage diversification when losses follow tempered stable or more general Lévy processes?," Annals of Finance, Springer, vol. 10(4), pages 553-568, November.
    12. Ibragimov, Rustam, 2014. "On the robustness of location estimators in models of firm growth under heavy-tailedness," Journal of Econometrics, Elsevier, vol. 181(1), pages 25-33.

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