Coherent Distortion Risk Measures in Portfolio Selection
Feng, Ming Bin
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The theme of this thesis relates to solving the optimal portfolio selection problems using linear programming. There are two key contributions in this thesis. The first contribution is to generalize the well-known linear optimization framework of Conditional Value-at-Risk (CVaR)-based portfolio selection problems (see Rockafellar and Uryasev (2000, 2002)) to more general risk measure portfolio selection problems. In particular, the class of risk measure under consideration is called the Coherent Distortion Risk Measure (CDRM) and is the intersection of two well-known classes of risk measures in the literature: the Coherent Risk Measure (CRM) and the Distortion Risk Measure (DRM). In addition to CVaR, other risk measures which belong to CDRM include the Wang Transform (WT) measure, Proportional Hazard (PH) transform measure, and lookback (LB) distortion measure. Our generalization implies that the portfolio selection problems can be solved very efficiently using the linear programming approach and over a much wider class of risk measures. The second contribution of the thesis is to establish the equivalences among four formulations of CDRM optimization problems: the return maximization subject to CDRM constraint, the CDRM minimization subject to return constraint, the return-CDRM utility maximization, the CDRM-based Sharpe Ratio maximization. Equivalences among these four formulations are established in a sense that they produce the same efficient frontier when varying the parameters in their corresponding problems. We point out that the first three formulations have already been investigated in Krokhmal et al. (2002) with milder assumptions on risk measures (convex functional of portfolio weights). Here we apply their results to CDRM and establish the fourth equivalence. For every one of these formulations, the relationship between its given parameter and the implied parameters for the other three formulations is explored. Such equivalences and relationships can help verifying consistencies (or inconsistencies) for risk management with different objectives and constraints. They are also helpful for uncovering the implied information of a decision making process or of a given investment market. We conclude the thesis by conducting two case studies to illustrate the methodologies and implementations of our linear optimization approach, to verify the equivalences among four different problem formulations, and to investigate the properties of different members of CDRM. In addition, the efficiency (or inefficiency) of the so-called 1/n portfolio strategy in terms of the trade off between portfolio return and portfolio CDRM. The properties of optimal portfolios and their returns with respect to different CDRM minimization problems are compared through their numerical results.