Volume 11, Number 1, First Quarter 2013
Most portfolio risk analysis implicitly assumes that risks are stable, despite copious evidence of instability. This article presents an alternative, VarGamma, that provides neat formulas for certainty equivalents (risk-adjusted returns) even with stochastic volatility and volatility-dependent drift. VarGamma measures are far more flexible and robust than standard mean-variance formulations or quantiles (VaR), with minimal extra complexity. Parameters can be readily inferred from either historical data or options prices. Compared to Sharpe ratio maximization, VarGamma encourages more diversification and caps exposure to highly volatile volatility. Compared to standard VaR, VarGamma discourages herding, pro-cyclical lending behavior, and wasteful regulatory arbitrage.