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Risk Management with Benchmarking

Authors: Basak, Suleyman
Shapiro, Alex
Tepla, Lucie
Keywords: Benchmarking;Investments;Shortfall Risk;Tracking Errors;Value-at-Risk
Issue Date: Dec-2003
Series/Report no.: FIN-03-048
Abstract: Portfolio theory must address the fact that, in reality, portfolio managers are evaluated relative to a benchmark, and therefore adopt risk management practices to account for the benchmark performance. We capture this risk management consideration by allowing a pre-specified shortfall from a target benchmark-linked return, consistent with growing interest in such practice. In a dynamic setting, we demonstrate how a risk averse portfolio manager optimally under- or over-performs a target benchmark under different economic conditions, depending on his attitude towards risk and choice of the benchmark. The analysis therefore illustrates how investors can achieve their desired gain/loss characteristics for funds under management through an appropriate combined choice of the benchmark and money manager. We consider a variety of extensions, and also highlight the ability of our setting to shed some light on documented return patterns across segments of the money management industry.
Appears in Collections:Finance Working Papers

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