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Incorporating different sources of information for Bayesian optimal portfolio selection
Stockholm University, Faculty of Science, Department of Mathematics.
2025 (English)In: Journal of business & economic statistics, ISSN 0735-0015, E-ISSN 1537-2707, Vol. 43, no 2, p. 365-377Article in journal (Other academic) Published
Abstract [en]

This paper introduces Bayesian inference procedures for tangency portfolios, with a primary focus on deriving a new conjugate prior for portfolioweights. This approach not only enables direct inference about the weightsbut also seamlessly integrates additional information into the prior specification. Specifically, it automatically incorporates high-frequency returns and amarket condition metric (MCM), exemplified by the CBOE Volatility Index(VIX) and Economic Policy Uncertainty Index (EPU), significantly enhancing the decision-making process for optimal portfolio construction. While theJeffreys prior is also acknowledged, emphasis is placed on the advantages andpractical applications of the conjugate prior. An extensive empirical studyreveals that our method, leveraging this conjugate prior, consistently outperforms existing trading strategies in the majority of examined cases.

Place, publisher, year, edition, pages
2025. Vol. 43, no 2, p. 365-377
Keywords [en]
Conjugate prior, EPU, high-frequency data, Jeffreys prior, value-weighted portfolio, VIX
National Category
Probability Theory and Statistics
Identifiers
URN: urn:nbn:se:su:diva-231304DOI: 10.1080/07350015.2024.2379361ISI: 001315996200001Scopus ID: 2-s2.0-105001071241OAI: oai:DiVA.org:su-231304DiVA, id: diva2:1872775
Available from: 2024-06-18 Created: 2024-06-18 Last updated: 2025-05-16Bibliographically approved
In thesis
1. Discrete-time portfolio theory
Open this publication in new window or tab >>Discrete-time portfolio theory
2024 (English)Doctoral thesis, comprehensive summary (Other academic)
Abstract [en]

This thesis contributes to the field of statistical and mathematical finance by introducing novel Bayesian and game-theoretic methods in discrete-time portfolio theory. These methodologies enhance the precision and adaptability of investment strategies and risk management, particularly in complex market environments. The work is structured around five papers.

Paper I introduces a Bayesian framework for optimizing portfolio allocation, utilizing value at risk (VaR) and conditional value at risk (CVaR) as risk measures. This approach leverages the posterior predictive distribution to derive portfolio weights directly from observed data, contrasting with traditional methods that rely on estimates of unobserved variables. The benefit of the Bayesian method is demonstrated through simulations and empirical comparisons, particularly in predicting out-of-sample VaR.

Paper II presents a dynamic Bayesian approach to incorporate volatility clustering into VaR and CVaR estimation, utilizing hyperparameters based on different rolling windows to adapt quickly to changing market conditions. This method shows distinct advantages over existing models by adjusting the certainty and expected values of prior distributions in response to volatility changes, offering improved risk estimates during market turbulence.

Paper III develops a Bayesian inference procedure for tangency portfolios by establishing a new conjugate prior directly for the optimal portfolio weights, integrating high-frequency returns and a market condition metric, such as the CBOE Volatility Index (VIX) or Economic Policy Uncertainty Index (EPU). This approach enables direct inference on portfolio weights, and backtesting suggests potential advantages over traditional strategies in real-world scenarios.

Paper IV addresses the construction of tangency portfolios under short-selling constraints, using the same reparameterized asset return model within a Bayesian context as in Paper III. An innovative prior enforces positive weight constraints. The effectiveness of this method is empirically validated with selected stocks, highlighting its potential to enhance risk-adjusted returns.

Paper V innovates within a game-theoretic framework by introducing a recursive scheme for asset allocation using a mean-semivariance reward functional to better reflect investors' aversion to downside risk. This approach resolves the time-inconsistency problem in multi-period investments through an extended Bellman equation, effectively reaching a Nash equilibrium as demonstrated by an extensive numerical study.

Collectively, these studies provide a cohesive advancement in statistical and mathematical finance, demonstrating the effectiveness of Bayesian methods and game-theoretic approaches in improving the theoretical and practical aspects of portfolio optimization and risk management.

Place, publisher, year, edition, pages
Stockholm: Department of Mathematics, Stockholm University, 2024. p. 49
Keywords
Bayesian statistics, Optimal portfolio, Risk estimation, Volatility clustering, Time inconsistency
National Category
Probability Theory and Statistics
Research subject
Mathematical Statistics
Identifiers
urn:nbn:se:su:diva-231305 (URN)978-91-8014-845-0 (ISBN)978-91-8014-846-7 (ISBN)
Public defence
2024-09-06, lärosal 15, hus 2, Albano, Albanovägen 18, Stockholm, 13:00 (English)
Opponent
Supervisors
Available from: 2024-08-14 Created: 2024-06-18 Last updated: 2024-07-02Bibliographically approved

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Niklasson, Vilhelm

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