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Journal of Financial Econometrics Vol. 2, No. 3, pp. 370-389
Journal of Financial Econometrics, Vol. 2, No. 3, © Oxford University Press 2004; all rights reserved.

Asset Allocation by Variance Sensitivity Analysis

Simone Manganelli
     European Central Bank

Address correspondence to Simone Manganelli, DG-Research, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany, or e-mail: simone.manganelli{at}ecb.int.

This article provides a solution to the curse of dimensionality associated to multivariate generalized autoregressive conditionally heteroskedastic (GARCH) estimation. We work with univariate portfolio GARCH models and show how the multivariate dimension of the portfolio allocation problem may be recovered from the univariate approach. The main tool we use is "variance sensitivity analysis," the change in the portfolio variance induced by an infinitesimal change in the portfolio allocation. We suggest a computationally feasible method to find minimum variance portfolios and estimate full variance-covariance matrices. An application to real data portfolios implements our methodology and compares its performance against that of selected popular alternatives.

KEYWORDS: dynamic correlations, multivariate GARCH, risk management

Received December 18, 2002; revised March 9, 2004; accepted March 31, 2004


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