Omega portfolio models with floating return threshold

Abstract

The Omega ratio is a risk-performance measure that specifies the upside profit and the downside loss by giving a return threshold (τ). Since there is no clear specification for the return threshold, this study advances the Omega models by incorporating various settings of the return threshold that reflect market dynamics: (1) the yields of Treasury securities, and (2) the negative CVaR value (or the gain) generated from equity markets. To ensure the practicality, our models consider the transaction costs and short selling. The empirical results that apply the two asset classes to rebalance portfolios over 17 and 20 years suggest that using the floating τ values, particularly the Treasury rates, realize higher out-of-the-sample performance and less downside loss. Our proposed approach is practical as the benchmark rates in fixed-income markets can be easily observed. The major findings hold for both non-robust and robust portfolio models. The tests of various preferences between seeking profit and controlling loss (δ) confirm robustness of the major conclusion.