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Optimal asset allocation using a combination of implied and historical information

Optimal asset allocation using a combination of implied and historical information
Optimal asset allocation using a combination of implied and historical information
This paper investigates the contribution of option-implied information for strategic asset allocation for individuals with minimum-variance preferences and portfolios with a variety of assets. We propose a covariance matrix that exploits a mixture of historical and option-implied information. Implied variance measures are proposed for those assets for which option-implied information is available. Historical variance and correlation measures are applied to the remaining assets. The performance of this novel approach for constructing optimal investment portfolios is assessed out-of-sample using statistical and economic measures. An empirical application to a sophisticated portfolio comprised by a combination of equities, fixed income, alternative securities and cash deposits shows that implied variance measures with risk premium correction outperform variance measures constructed from historical data and implied variance without correction. This result is robust across investment portfolios, volatility and portfolio performance metrics, and rebalancing schemes.
asset allocation, implied volatility, historical volatility, realized variance, Sharpe ratio
1057-5219
1-14
Cheang, Chi Wan
f9aaaf3c-6edc-4cb1-a780-daabfd5822a0
Olmo, Jose
706f68c8-f991-4959-8245-6657a591056e
Ma, Tiejun
1f591849-f17c-4209-9f42-e6587b499bae
Sung, Ming-Chien
2114f823-bc7f-4306-a775-67aee413aa03
McGroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Cheang, Chi Wan
f9aaaf3c-6edc-4cb1-a780-daabfd5822a0
Olmo, Jose
706f68c8-f991-4959-8245-6657a591056e
Ma, Tiejun
1f591849-f17c-4209-9f42-e6587b499bae
Sung, Ming-Chien
2114f823-bc7f-4306-a775-67aee413aa03
McGroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072

Cheang, Chi Wan, Olmo, Jose, Ma, Tiejun, Sung, Ming-Chien and McGroarty, Frank (2020) Optimal asset allocation using a combination of implied and historical information. International Review of Financial Analysis, 67, 1-14, [101419]. (doi:10.1016/j.irfa.2019.101419).

Record type: Article

Abstract

This paper investigates the contribution of option-implied information for strategic asset allocation for individuals with minimum-variance preferences and portfolios with a variety of assets. We propose a covariance matrix that exploits a mixture of historical and option-implied information. Implied variance measures are proposed for those assets for which option-implied information is available. Historical variance and correlation measures are applied to the remaining assets. The performance of this novel approach for constructing optimal investment portfolios is assessed out-of-sample using statistical and economic measures. An empirical application to a sophisticated portfolio comprised by a combination of equities, fixed income, alternative securities and cash deposits shows that implied variance measures with risk premium correction outperform variance measures constructed from historical data and implied variance without correction. This result is robust across investment portfolios, volatility and portfolio performance metrics, and rebalancing schemes.

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IRFA_OptAA - Accepted Manuscript
Restricted to Repository staff only until 8 November 2021.
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Accepted/In Press date: 8 November 2019
e-pub ahead of print date: 20 November 2019
Published date: January 2020
Keywords: asset allocation, implied volatility, historical volatility, realized variance, Sharpe ratio

Identifiers

Local EPrints ID: 435804
URI: http://eprints.soton.ac.uk/id/eprint/435804
ISSN: 1057-5219
PURE UUID: 3d4703c9-c688-4df0-8dd3-c28a754af8e8
ORCID for Jose Olmo: ORCID iD orcid.org/0000-0002-0437-7812
ORCID for Ming-Chien Sung: ORCID iD orcid.org/0000-0002-2278-6185
ORCID for Frank McGroarty: ORCID iD orcid.org/0000-0003-2962-0927

Catalogue record

Date deposited: 21 Nov 2019 17:30
Last modified: 18 Feb 2020 01:34

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