Optimize your Investment Portfolio in Bearish Markets

Abstract

Since the 2008-2009 global financial crisis, VaR (Value-at-Risk) techniques have become critical tools for monitoring and predicting the market risk and liquidity of financial assets. These financial risk modeling techniques, which have been recognized by the Bank for International Settlements (BIS) or the Basel Committee on capital adequacy and bank regulations, measure and prevent any potential losses that arise, not only from securities’ price changes and the interdependence between the different types of assets (stocks, currencies, interest rates or commodities), but also from their negative tail co-movements in bearish market conditions. In the event of a financial crisis or market downturn, adequate liquidity risk modeling is advisable. In fact, the main advantage of VaR models is their focus on downside risk (i.e., the impact of the results of negative tails) and their direct interpretation in monetary terms. Nevertheless, particularly in times of financial turbulence, traditional VaR models do not properly consider nonlinear dependence between portfolio assets and become inefficient in illiquid market scenarios. Despite the advances in measurement models, obtaining precise market liquidity risk estimations and applying them to optimize portfolios continues to be a challenge for financial institutions.