The importance of dynamic risk constraints for limited liability operators
File(s)
Published version
Author(s)
Armstrong, John
Brigo, Damiano
Tse, Alex
Type
Journal Article
Abstract
Previous literature shows that prevalent risk measures such as value at risk or expected shortfall are ineffective to curb excessive risk-taking by a tail-risk-seeking trader with S-shaped utility function in the context of portfolio optimisation. However, these conclusions hold only when the constraints are static in the sense that the risk measure is just applied to the terminal portfolio value. In this paper, we consider a portfolio optimisation problem featuring S-shaped utility and a dynamic risk constraint which is imposed throughout the entire trading horizon. Provided that the risk control policy is sufficiently strict relative to the Sharpe ratio of the asset, the trader’s portfolio strategies and the resulting maximal expected utility can be effectively constrained by a dynamic risk measure. Finally, we argue that dynamic risk constraints might still be ineffective if the trader has access to a derivatives market.
Date Issued
2024-05
Date Acceptance
2023-03-13
Citation
Annals of Operations Research, 2024, 336 (3), pp.861-898
ISSN
0254-5330
Publisher
Springer
Start Page
861
End Page
898
Journal / Book Title
Annals of Operations Research
Volume
336
Issue
3
Copyright Statement
Open Access This article is licensed under a Creative Commons Attribution 4.0 International License, which permits use, sharing, adaptation, distribution and reproduction in any medium or format, as long as you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons licence, and indicate if changes were made. The images or other third party material in this article are included in the article's Creative Commons licence, unless indicated otherwise in a credit line to the material. If material is not included in the article's Creative Commons licence and your intended use is not permitted by statutory regulation or exceeds the permitted use, you will need to obtain permission directly from the copyright holder. To view a copy of this licence, visit http://creativecommons.org/licenses/by/4.0/.
License URL
Identifier
https://link.springer.com/article/10.1007/s10479-023-05295-5
Publication Status
Published
Date Publish Online
2023-04-04