SDIstanbul.pptVIP

The presentation is based on 3 papers: Kuosmanen, T. (2001): ”Stochastic Dominance Efficient Diversification ”, Helsinki School of Economics Working Paper W-232? Heikkinen, V.-P., and T. Kuosmanen (2003): ”Stochastic Dominance Portfolio Analysis of Forestry Assets”, chapter 12 in Wesseler et al. (Eds.): Risk and Uncertainty in Environmental and Resource Economics, Edward Elgar. Kuosmanen (2003): ”DEA and Stochhastic Dominance Portfolio Analysis: Do Environmentally Responsible Mutual Funds Diversify Efficiently?, paper presented at the 8EWEPA, Oviedo, Spain, 24-26 Sept. 2003. Stochastic Dominance as a Criterion of Risk Stochastic Dominance as a Criterion of Risk Definition of SD Risky portfolios j and k, return distributions Gj and Gk. Portfolio j dominates portfolio k by FSD (SSD, TSD) if and only if FSD: SSD: TSD: with strict inequality for some z. Economic interpretation of SD Consider the Expected Utility Theory of von Neumann Morgenstern. If portfolio j dominates portfolio k by FSD (SSD, TSD), then portfolio j is preferred to portfolio k by all investors who are FSD: non-satiated (u’(x)?0). SSD: non-satiated and risk averse (u’(x)?0, u’’(x)?0). TSD: non-satiated and risk averse with decreasing absolute risk aversion (u’(x)?0, u’’(x)?0, u’’’(x)?0). Setting N assets T different states of nature (time periods) R(j,t) = rate of return of asset j in state t ?j = portfolio weight of asset j Rate of return of portfolio in state t is Portfolio can be characterized equivalently in terms of the return vector R in the state space (primal) or the portfolio weights ? (dual). Stochastic Dominance (SD) Approach Return is an i.i.d. random variable drawn from an unknown distribution. Returns in different states are a sample drawn from that distribution. State independence: investor indifferent between return profiles (x,y) and (y,x). Empirical distribution function gives a nonparametric minimum variance unbiased estimator of the underlyi