Open Access article published in "Financial Innovation"

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We are pleased to announce that the paper by Nando Ehler, Escobar-Anel, M., Stentoft, L., Zagst, R., titled "Behavioral Portfolio Decisions in a GARCH World," has been published in "Financial Innovation".

Abstract: This paper pioneers behavioral portfolio decisions based on prospect theory in a stochastic volatility setting, as exemplified by the use of an affine GARCH model. We derive a closed-form expression for the allocation to the risky asset based on a delta replication of the optimal terminal wealth under a given risk-neutral measure. Our proposed methodology can be viewed as an adaptation of the Martingale method, combining (1) a static maximization for a given pricing kernel to derive the optimal terminal wealth and (2) delta hedging to create a replicating portfolio. Our results demonstrate the significant impact of stochastic volatility on behavioral portfolio allocations and their performance across a variety of parameterizations for investors’ risk aversion and risk-seeking preferences, reference level, and investment horizon. Moreover, we find that neglecting stochastic volatility in the decision-making process can lead to significant losses in expected utility. In particular, the certainty equivalence derived from a GARCH model could be 20% higher than that resulting from assuming constant volatility for standard market conditions and investors.

Link to the article: Behavioral Portfolio Decisions in a GARCH World