Islamic portfolio optimization under systemic risk: Vine Copula‐CoVaR based model

Abstract

AbstractWe propose a new methodology based on CoVaR to optimize Islamic portfolio. First, we generate the return distribution using the ARMA‐FIAPARCH and ARMA‐FIGARCH model. Then, we transform the standardized residuals onto copula scale using the empirical cumulative distribution function. Thereafter, using the best vine‐copula fits, we computed downside and upside risk. We obtained CoVaR of the market (sectors), conditional on the VaR for sectors (market) returns. We find the optimized portfolio wt through mean‐CoVaR optimization. The empirical results of Islamic industry show that the optimal allocation is influenced by the existence of systemic risk. Thus, when comparing the mean‐CoVaR model with the mean–Variance model we find that mean‐CoVaR more performant in optimization. The minimum risk portfolio allocation is influenced by the existence of systemic risk, the interdependence structure between sectors and the optimization model. Our findings offer a better understanding of the allocation during the crisis period which is very valuable for the international investors, multinational corporations and portfolio managers.