Publication: Testing downside risk efficiency under market distress
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2008-09
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Abstract
In moments of distress downside risk measures like Lower Partial Moments (LPM) are more
appropriate than the standard variance to characterize risk. The goal of this paper is to study
how to compare portfolios in these situations. In order to do that we show the close connection
between mean-risk efficiency sets and stochastic dominance under distress episodes of the
market, and use the latter property to propose a hypothesis test to discriminate between
portfolios across risk aversion levels. Our novel family of test statistics for testing stochastic
dominance under distress makes allowance for testing orders of dominance higher than zero,
for general forms of dependence between portfolios and can be extended to residuals of
regression models. These results are illustrated in the empirical application for data from US
stocks. We show that mean-variance strategies are stochastically dominated by mean-risk
efficient sets in episodes of financial distress.
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Comovements, Downside risk, Lower partial moments, Market Distress, Mean-risk models, Mean-variance models, Stochastic dominance