Risk management and portfolio selection using \alpha-stable regime switching models

Abstract

This article tries to enhance the current Gaussian distribution paradigm for modeling asset returns by emphasizing two points. It proposes a model which captures fat tails and skewness, and takes into account distinct market regimes. Therefore, an alpha-stable regime-switching model is proposed. The implications of this model on asset management are shown. The alpha-stable regime-switching model is employed for applications in risk management and portfolio selection. An empirical study shows that the model is better suited than Gaussian and Gaussian regime-switching models to measure risk accurately. A portfolio optimization case study for a traditional stocks and bonds investor is pursued. In this study, the model leads to less risky and more diversified portfolios. In particular, the model avoids huge losses in times of crisis and thus leads to a better (adjusted) Sharpe ratio and Omega.