Second Order Risk

Details Second Order Risk Second Order Risk

2009-08-17

arxiv.org/abs/0908.2455v1

Economy

Quantitative Finance

Portfolio Management

23 pages, 5 figures

Scientific paper

Managing a portfolio to a risk model can tilt the portfolio toward weaknesses of the model. As a result, the optimized portfolio acquires downside exposure to uncertainty in the model itself, what we call "second order risk." We propose a risk measure that accounts for this bias. Studies of real portfolios, in asset-by-asset and factor model contexts, demonstrate that second order risk contributes significantly to realized volatility, and that the proposed measure accurately forecasts the out-of-sample behavior of optimized portfolios.

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