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A generalized VECM/VAR-DCC/ADCC framework and its application in the Black-Litterman model: Illustrated with a China portfolio

Qi Deng (Accounting and Finance Group, International Business School Suzhou, Xi’an Jiaotong-Liverpool University, Suzhou, China)

China Finance Review International

ISSN: 2044-1398

Publication date: 19 November 2018

Abstract

Purpose

The existing literature on the Black-Litterman (BL) model does not offer adequate guidance on how to generate investors’ views in an objective manner. Therefore, the purpose of this paper is to establish a generalized multivariate Vector Error Correction Model (VECM)/Vector Auto-Regressive (VAR)-Dynamic Conditional Correlation (DCC)/Asymmetric DCC (ADCC) framework, and applies it to generate objective views to improve the practicality of the BL model.

Design/methodology/approach

This paper establishes a generalized VECM/VAR-DCC/ADCC framework that can be utilized to model multivariate financial time series in general, and produce objective views as inputs to the BL model in particular. To test the VECM/VAR-DCC/ADCC preconditioned BL model’s practical utility, it is applied to a six-asset China portfolio (including one risk-free asset).

Findings

With dynamically optimized view confidence parameters, the VECM/VAR-DCC/ADCC preconditioned BL model offers clear advantage over the standard mean-variance method, and provides an automated portfolio optimization alternative to the classic BL approach.

Originality/value

The VECM/VAR-DCC/ADCC framework and its application in the BL model proposed by this paper provide an alternative approach to the classic BL method. Since all the view parameters, including estimated mean return vectors, conditional covariance matrices and pick matrices, are generated in the VECM/VAR and DCC/ADCC preconditioning stage, the model improves the objectiveness of the inputs to the BL stage. In conclusion, the proposed model offers a practical choice for automated portfolio balancing and optimization in a China context.

Keywords

  • VAR
  • VECM
  • Portfolio optimization
  • DCC
  • ADCC
  • Black-Litterman (BL)
  • C32
  • C53
  • G11

Acknowledgements

The author would like to thank the anonymous reviewers for their detailed comments. The author would also like to thank the participants of the first China Derivatives Markets Conference (CDMC) held in May 2016 at Suzhou for their constructive and help inputs. All remaining errors are of the author.

Citation

Deng, Q. (2018), "A generalized VECM/VAR-DCC/ADCC framework and its application in the Black-Litterman model: Illustrated with a China portfolio", China Finance Review International, Vol. 8 No. 4, pp. 453-467. https://doi.org/10.1108/CFRI-07-2016-0095

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