One idea of portfolio risk control for absolute return strategy risk adjustments by signals from correlation behavior

Abstract

Absolute return strategy provided from fund of funds (FOFs) investment schemes is the focus in Japanese Financial Community. FOFs investment mainly consists of hedge fund investment and it has two major characteristics which are low correlation against benchmark index and little impact from various external changes in the environment given maximizing return. According to the historical track record of survival hedge funds in this business world, they maintain a stable high return and low risk. However, one must keep in mind that low risk would not be equal to risk free. The failure of Long-term capital management (LTCM) that took place in the summer of 1998 was a symbolized phenomenon. The summer of 1998 exhibited a certain limitation of traditional value at risk (VaR) and some possibility that traditional VaR could be ineffectual to the nonlinear type of fluctuation in the market. In this paper, I try to bring self-organized criticality (SOC) into portfolio risk control. SOC would be well known as a model of decay in the natural world. I analyzed nonlinear type of fluctuation in the market as SOC and applied SOC to capture complicated market movement using threshold point of SOC and risk adjustments by scenario correlation as implicit signals. Threshold becomes the control parameter of risk exposure to set downside floor and forecast extreme nonlinear type of fluctuation under a certain probability. Simulation results would show synergy effect of portfolio risk control between SOC and absolute return strategy.