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Journal of Financial Econometrics 2005 3(1):107-125; doi:10.1093/jjfinec/nbi004
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Journal of Financial Econometrics, Vol. 3, No. 1, © Oxford University Press 2005; all rights reserved.

Portfolio Diversification Effects of Downside Risk

Namwon Hyung
     University of Seoul and Tinbergen Institute

Casper G. de Vries
     Erasmus University Rotterdam

Address correspondence to Casper G. de Vries, Department of Accounting and Finance, H14-25, Erasmus University Rotterdam, P.O. Box 1738, 3000 DR, Rotterdam, The Netherlands, or e-mail: cdevries{at}few.eur.nl.

Risk managers use portfolios to diversify away the unpriced risk of individual securities. In this article we compare the benefits of portfolio diversification for downside risk in case returns are normally distributed with the case of fat-tailed distributed returns. The downside risk of a security is decomposed into a part which is attributable to the market risk, an idiosyncratic part, and a second independent factor. We show that the fat-tailed-based downside risk, measured as value-at-risk (VaR), should decline more rapidly than the normal-based VaR. This result is confirmed empirically.

KEYWORDS: diversification, portfolio decomposition, value-at-risk

Received March 1, 2004; revised October 8, 2004; accepted October 19, 2004


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