Beyond Conditional Second Moments: Does Nonparametric Density Modelling Matter to Portfolio Allocation?

Li, Chenxing and Maheu, John M (2023): Beyond Conditional Second Moments: Does Nonparametric Density Modelling Matter to Portfolio Allocation?

Abstract

This paper investigates the economic importance of nonparametrically/semiparametrically modelling the shape and the change in the unknown distribution of returns in portfolio allocation problems from a Bayesian perspective. Besides parametric multivariate GARCH (MGARCH) benchmark models for returns, we consider an MGARCH with innovations following a Dirichlet process mixture and an infinite hidden Markov model (IHMM). We introduce a new Bayesian semiparametric model that combines the MGARCH component with the IHMM for innovations. This new model nonparametrically approximates both the shape and evolution through time of the unknown distribution of returns beyond that captured by the MGARCH part. The results show that the Bayesian nonparametric/semiparametric models lead to improved statistical forecast accuracy and economic gains for a quadratic utility and CRRA utility investor. The new model makes the greatest gains. Portfolio choice is improved by modelling beyond the conditional second moments.

• Item Type: MPRA Paper
• Language: English
• Keywords: Multivariate GARCH; IHMM; Bayesian nonparametric; Portfolio allocation; Transaction costs
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C11 - Bayesian Analysis: General; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C14 - Semiparametric and Nonparametric Methods: General; C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C34 - Truncated and Censored Models ; Switching Regression Models; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics

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