Evaluation of Optimum and Coherent Economic-Capital Portfolios Under Complex Market Prospects

Abstract

This chapter examines the performance of liquidity-adjusted risk modeling in obtaining optimum and coherent economic-capital structures, subject to meaningful operational and financial constraints as specified by the portfolio manager. Specifically, the chapter proposes a robust approach to optimum economic-capital allocation in a liquidity-adjusted value at risk (L-VaR) framework. This chapter expands previous approaches by explicitly modeling the liquidation of trading portfolios, over the holding period, with the aid of an appropriate scaling of the multiple-assets' L-VaR matrix along with GARCH-M technique to forecast conditional volatility and expected return. Moreover, in this chapter, the authors develop a dynamic nonlinear portfolio selection model and an optimization algorithm, which allocates both economic-capital and trading assets by minimizing L-VaR objective function. The empirical results strongly confirm the importance of enforcing financially and operationally meaningful nonlinear and dynamic constraints, when they are available, on the L-VaR optimization procedure.