As opposed to a firm’s individual risk of failure, which can be contained without harming the entire financial system, systemic risk is the risk of collapse of the entire financial system or market. Since the 2007–2009 financial crisis numerous attempts have been made to identify and measure the systemic risk of financial institutions. In this respect, the following question arises: how can a given systemic risk measure be used to construct portfolios that perform relatively well when systemic risk materializes? In this paper, we develop a framework for the optimal portfolio choice based on an exogenous systemic risk measure.
In his pioneering work on portfolio choice, Markowitz developed a theory of portfolio selection based on the “risk-return” characteristics of stocks in the portfolio. Markowitz’s investor was assumed to be minimizing the variance (risk) of a portfolio’s returns subject to meeting a given level of expected returns. In other words, Markowitz answered the question:
WHAT PORTFOLIO OF STOCKS WILL DELIVER A SPECIFIED EXPECTED RETURN AND AT THE SAME TIME HAVE THE LOWEST VARIANCE OF FUTURE RETURNS?
In this current research, we focus on adverse return scenarios and attempt to answer the question:
WHAT PORTFOLIO OF STOCKS WILL DELIVER THE HIGHEST EXPECTED RETURNS IN THE CASE OF A FINANCIAL CRISIS?