Dynamic Asset Allocation Strategies Based on Volatility, Unexpected Volatility and Financial Turbulence

Abstract

This master thesis looks at unexpected volatility- and financial turbulence’s predictive ability, and exploit these measures of financial risk, together with volatility, to create three dynamic asset allocation strategies, and test if they can outperform a passive and naively diversified buy-and-hold strategy. The idea with the dynamic strategies is to increase the portfolio return by keeping the portfolio risk at a low and stable level over time. This is be done by changing the allocation between risky asset and risk-free asset, as the market environment changes. Three dynamic asset allocation strategies are implemented: a turbulence-responsive strategy, an unexpected volatility-responsive strategy, and a volatility-responsive strategy. The empirical results show that all three dynamic asset allocation strategies strongly outperform a passive equally-weighted benchmark in the out-of-sample period with respect to risk-adjusted return.