Building and Evaluating Risk-Aware Investment Strategies

Author
Valentin Braun
Director-Industry Practice Lead

Investment managers who manage a portfolio of assets are often subject to restrictions. They must consider regulation, environmental and social guidelines, and the loss absorption capabilities of their sponsors. While many sponsors, for example pension funds or endowments, need to generate a certain level of income to meet their obligations, they also demand capital preservation. This dilemma is a major challenge for investment managers as the Capital Asset Pricing Model (CAPM) (Sharpe, 1964) states that higher expected return comes at the cost of more risk.

The investment industry offers various strategies to tackle this challenge, posing the question to investors; which strategy is best suited to meet their investment goals? Deriving the risk and return characteristics of the strategies solely from historically observable data, is error prone. Whereas advanced scenario simulation techniques cover historically observable and unprecedented market conditions; hence, offer a realistic view on the future risk and return characteristics. This helps investors pick the right strategy to achieve their overall objectives.

This paper considers a case study of using equity put-options to offer downside protection for the multi-asset portfolio. An advanced stochastic simulation model is utilized to evaluate the risk and return profile of the strategy.