International Journal of Forecasting 34 (2018) 497–506

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International Journal of Forecasting

journal homepage: www.elsevier.com/locate/ijforecast

Portfolio optimization based on GARCH-EVT-Copula

forecasting models
Maziar Sahamkhadam a, *, Andreas Stephan a,b , Ralf Östermark c
a
Linnaeus University, Växjö, Sweden
b
Jönköping International Business School, Jönköping, Sweden
c
Åbo Akademi, Turku, Finland

article info a b s t r a c t
Keywords: This study uses GARCH-EVT-copula and ARMA-GARCH-EVT-copula models to perform
GARCH models out-of-sample forecasts and simulate one-day-ahead returns for ten stock indexes. We
Extreme value theory construct optimal portfolios based on the global minimum variance (GMV), minimum
Copula models
conditional value-at-risk (Min-CVaR) and certainty equivalence tangency (CET) criteria,
Conditional value-at-risk
and model the dependence structure between stock market returns by employing elliptical
Portfolio optimization
(Student-t and Gaussian) and Archimedean (Clayton, Frank and Gumbel) copulas. We
analyze the performances of 288 risk modeling portfolio strategies using out-of-sample
back-testing. Our main finding is that the CET portfolio, based on ARMA-GARCH-EVT-
copula forecasts, outperforms the benchmark portfolio based on historical returns. The
regression analyses show that GARCH-EVT forecasting models, which use Gaussian or
Student-t copulas, are best at reducing the portfolio risk.
© 2018 International Institute of Forecasters. Published by Elsevier B.V. All rights reserved.

1. Introduction improvement on the traditional GARCH volatility mod-

A range of different portfolio optimization methods,
generally consisting of two steps (Markowitz, 1952), have
been proposed over the last few decades. The first step
involves forecasting the future returns of the underlying
assets. One of the models that has been used for this step is
the generalized autoregressive conditional heteroscedas-
ticity (GARCH) extreme value theory (EVT) copula (Longin,
1996). The second step consists of optimal portfolio alloca-
tion, which is achieved by defining each asset’s weight in
the corresponding portfolio. There are three main methods
that are used for this step: Min-CVaR (minimizing the
conditional Value-at-Risk), GMV (minimizing the variance)
and CET (maximizing the Sharpe ratio).
GARCH-EVT-copula models are used mainly for min-
imizing the downside risk, and are considered to be an
* Corresponding author.
E-mail address: maziar.sahamkhadam@lnu.se (M. Sahamkhadam).
els. In general, the downside risk can be measured by
the Value-at-Risk (VaR) and Conditional Value-at-Risk
(CVaR) (Gençay & Selçuk, 2004). The latter measures the
expected loss at a specific confidence level. GARCH models
can be employed for forecasting asset returns (Crato &
Ruiz, 2012), though it is recommended that forecasters
take into account the fact that the financial assets (e.g. stock
prices, interest rates and exchange rates) possess the fea-
tures of fat-tailed distributions (Bondt & Thaler, 1985; Da-
corogna & Pictet, 1997; Harmantzis, Miao, & Chien, 2006).
EVT can be used to estimate the tail behavior of the re-
turns of these financial assets, and the volatility has been
shown to be an important factor in extreme value fore-
casting models (Gençay & Selçuk, 2006; Gençay, Selçuk,
& Ulugülyaci, 2003). A combination of GARCH and EVT
models has been proposed and used in several previous
studies (Bhattacharyya & Ritolia, 2008; Chan & Gray, 2006;
Deng, Ma, & Yang, 2011; McNeil & Frey, 2000). The basic
idea behind this combination is that EVT is suitable for the
independently and identically distributed series that can

https://doi.org/10.1016/j.ijforecast.2018.02.004
0169-2070/© 2018 International Institute of Forecasters. Published by Elsevier B.V. All rights reserved.
498 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506
be derived from the residuals obtained from GARCH mod-
els.
Furthermore, one of the characteristics of financial time
series is that movements in one series can affect those in
other series (Christoffersen, Errunza, Jacobs, & Jin, 2014).
This provides researchers with a vast array of choices when
modeling the dependency structures between different
types of financial assets, such as stock markets, exchange
rates, commodities and so forth. Of the various choices,
copula models have shown adequate practicality, perhaps
because of the technique employed in copula models. In
this technique, originally shown by Sklar (1959), the corre-
lations between assets are obtained from the joint distribu-
tion and then used in each separate marginal distribution.
The application of GARCH-EVT-copula models to risk
management has been the focus of several previous stud-
ies. For instance, a study performed by Wang, Chen, Jin, and
Zhou (2010) used three copula models to estimate the in-
vestment risk of foreign currencies. Of these copulas, both
the Clayton and Student-t copulas yield better estimates of
the correlation between exchange rates than the Gaussian
copula. Berger (2013) forecasts the portfolio risk (VaR) by
employing a time-varying dynamic conditional correlation
(DCC) copula in combination with EVT, which leads to a
better estimation of VaR than a static copula approach.
In addition, a semi-parametric GARCH-EVT-copula model
was proposed by Koliai (2016), who performed stress tests
on corresponding portfolios and found that different mod-
els affect stress scenarios in various different ways.
In another study, based on the DCCGARCH-copula (but
without EVT), two dynamic robust portfolio optimization
methods are considered and compared with non-robust
portfolios (Han, Li, & Xia, 2017). Several more complex cop-
ula models, including the regular vine (R-vine), canonical
vine (C-vine) and drawable vine (D-vine), are examined
by Zhang, Wei, Yu, Lai, and Peng (2014), who use these cop-
ulas to forecast both VaR and CVaR. The authors conclude
that D-vine is better than the other vine copulas in terms of
forecasting the CVaR. Bhatti and Nguyen (2012) suggest the
use of a conditional EVT and time-varying copula for mod-
eling the tail dependency between stock markets. Wang,
Jin, and Zhou (2010) use the GARCH-EVT-copula model to
evaluate the risk of foreign currencies. They concentrate
on Student-t, Gaussian and Clayton copulas, and, in cor-
respondence with Huang, Lee, Liang, and Lin (2009), who
implement GARCH-copula and GJRGARCH-copula models
for estimating the VaR of a portfolio of stock indexes, point
out that the Student-t provides better estimation of the
VaR when compared with other copula models.
Most studies of the GARCH-EVT-copula model have fo-
cused on its application to forecasting and the examination
of the resulting downside risk. However, some studies have
used these models not only for risk modeling, but also for
portfolio allocation and back-testing. For instance, Huang
and Hsu (2015) consider two GARCH-EVT-copula models
(based on Student-t and Gaussian copulas) for simulating
future returns of stock markets, and use a rolling window
to compute the optimal weights based on the Min-CVaR
allocation for the out-of-sample period. In addition, they
also conduct four re-balancing strategies (daily, weekly,
biweekly and monthly) and evaluate the performance of
each model during the financial crisis and post-crisis peri-
ods. Their results indicate that daily and weekly strategies
based on GARCH-EVT-copula models outperform others
with respect to both the annual average return and the
Sharpe ratio. Another study performed by Low, Alcock, Faff,
and Brailsford (2013) employed a Clayton C-vine copula for
testing the portfolio performance (accumulation wealth)
based on minimizing the conditional value-at-risk. Two
portfolio sizes are considered, namely 12 and 3 dimensions.
They find that the use of this model is more appropriate for
the portfolio with more assets.
Following Huang and Hsu (2015) and Wang, Chen et al.
(2010), we use the GARCH-EVT-copula and ARMA-GARCH-
EVT-copula models for performing out-of-sample forecast-
ing and portfolio allocation. We begin by applying rolling
window estimation and using univariate GARCH(1,1) and
ARMA(1,1)-GARCH(1,1) models separately to obtain the
parameters for one-day-ahead forecasts, then use EVT for
tail modeling and for obtaining the uniforms. As for the de-
pendency structure, we consider five d-dimensional cop-
ula models, namely Student-t, Gaussian, Clayton, Frank
and Gumbel. Finally, we use the parameters from ARMA-
GARCH (or GARCH) models and the dependency structures
from copula models to simulate one-day-ahead returns.
We capture the performances of these models fully by
applying them to stock markets, and also evaluate different
re-balancing frequencies.
Our work contributes to the existing literature in several
ways. First, the addition of CET and GMV portfolios allows
us to present novel results. As was mentioned earlier, the
GARCH-EVT-copula and ARMA-GARCH-EVT-copula mod-
els are used in the first step of portfolio optimization by
forecasting future returns and volatilities. In contrast to
previous studies, we use the simulated returns from the
copula model not only in the Min-CVaR, but also for the
CET and GMV portfolios. Moreover, the aim of our study
is to answer the question of how much of a reduction in
risk (or gain in returns) can be achieved by combining
the different forecasting models with EVT and the above-
mentioned portfolio optimization techniques. To the best
of our knowledge, this is the only study to do so by es-
timating the contribution of each part in risk modeling
using a regression analysis based on the sample of portfolio
returns obtained from back-testing. We find that almost all
of the risk models decrease the portfolio risk significantly.
Overall, GARCH forecasting models in combination with
EVT and copula models appear to be particularly suitable
for the CET optimization framework.
The rest of the paper is organized as follows. Section 2
presents the methodology, including the ARMA-GARCH
model, extreme value theory, copula models and opti-
mization methods. The data set is described in Section 3.
Section 4 provides details of our empirical results. We
describe the robustness analysis in Section 5. Finally, con-
cluding remarks are provided in Section 6.
2. Methodology
The GARCH-EVT-copula approach assumes that the re-
turns are ergodic processes (Boltzmann, 1896) and the
residuals are independently identically distributed (i.i.d.)
random variables.
 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506 499

2.1. ARMA-GARCH forecasting model Table 1

The parameter θ and generator ψ (uj ) for Archimedean copulas.

In the ARMA-GARCH approach, the mean equation is Copula θ ψ (uj ), j = 1, 2, . . . , d

1
driven by the recursive volatility process. In line with pre- Clayton θ ∈ (0, ∞) (1 + uj )− θ
vious studies, we assume that the conditional mean µjt Frank θ ∈ (0, ∞) − log(1 − (1 − e−θ ) exp(−uj ))/θ
1
follows an ARMA(1,1) process and that the conditional Gumbel θ ∈ (1, ∞) exp(−ujθ )
variance hjt follows a GARCH(1,1) process (Kim & Jung,
2016; Pircalabu, Hvolby, Jung, & Høg, 2017; Righi, Schlen-
der, & Ceretta, 2015). The ARMA(1,1)-GARCH(1,1) can be there exists a d-dimensional copula C such that:
modeled as:
rjt = µjt + ϕj (rj,t −1 − µjt ) + θi ϵj,t −1 + ϵjt ∀z ∈ ℜd : F (z1 , z2 , . . . , zd )
⎧
⎪
= C (F1 (z1 ), F2 (z2 ), . . . , Fd (zd )) = C (u1 , u2 , . . . , ud ).
⎪
(4)
ϵjt = zjt hjt
⎪
⎨ √
(1)
⎪
⎪zjt ≈ (i.i.d.) Note that the copula parameter vector is not necessary
⎩h = ω + α ϵ 2 + β h
j j,t −1 ,
for the proof of Sklar’s theorem, and is therefore sup-
⎪
jt j i j,t −1
pressed here. The parameter vector will be introduced be-
where rjt denotes the actual returns for asset j = 1, 2, . . . , low. If all margins are continuous, then C is unique, and the
d, zjt is the standardized residuals, and the parameter re- converse is also true; i.e., if C is a d-dimensional copula and
strictions are ωj > 0, αj ≥ 0, βj ≥ 0, αj + βj < 1, F1 , F2 , . . . , Fd are distribution functions, then F is a mul-
ϕj + θj ̸= 0. On the other hand, the autoregressive part of tivariate distribution function with margins F1 , F2 , . . . , Fd .
the mean equation can be replaced by a constant, in which Note that zj = Fj−1 (uj ), uj ∈ [0, 1], ∀j and therefore, by
case the univariate GARCH(1,1) is defined as: Eq. (4),
rjt = µjt + ϵjt
⎧
⎪
⎪ C (u1 , u2 , . . . , ud ) = F (F1−1 (u1 ), F2−1 (u2 ), . . . , Fd−1 (ud ))
ϵjt = zjt hjt
⎪
⎨ √
(2) = F (z1 , z2 , . . . , zd ). (5)
⎪zjt ≈ (i.i.d.)
Using Eq. (5) and the notation F = φ for the multivariate
⎪ ∑
⎩h = ω + α ϵ 2 + β h
j j,t −1 ,
⎪
jt j j j,t −1
standard normal distribution and Fj (uj ) = φ (uj ), j =
where rjt denotes the actual returns for asset j = 1, 2, . . . , 1, 2, . . . , d, for the univariate standard normal distribution,
d, and zjt is the standardized residuals with ωj > 0, αj ≥ we can write the (standardized) Gaussian copula as fol-
0, βj ≥ 0, αj + βj < 1. Note that we formulate the lows:
two ARMA(1,1)-GARCH(1,1) and GARCH(1,1) models here
because we are interested in comparing forecasting models C Gaussian (u1 , u2 , . . . , ud )
that are based on a ARMA(1,1) term in the mean equation = φ∑ (φ −1 (u1 ), φ −1 (u2 ), . . . , φ −1 (ud ))
with those that merely consider a constant mean. = φ∑ (z1 , z2 , . . . , zd ), (6)
where φ denotes
∑
∑ the standard multivariate normal dis-
2.2. Tail behavior
tribution, and and φ −1 are the correlation matrix and
the inverse of the normal cumulative distribution function,
The tail behavior of the asset returns can be modeled
respectively.
via extreme value theory. The method is known as peak
If we consider tν ∑ as the standard
∑ multivariate t dis-
over threshold (POT), and, in combination with GARCH(1,1)
tribution with correlation matrix , then the Student-t
or ARMA(1,1)-GARCH(1,1) models, the jth marginal dis-
copula can be written analogously as:
tribution function Gj (zj ) can be obtained based on two
distributions, namely the generalized Pareto (GPD) for the C t (u1 , u2 , . . . , ud )
upper and lower tail and the Gaussian kernel for the middle
part:
= tν ∑ (tν−1 (u1 ), tν−1 (u2 ), . . . , tν−1 (ud ))
⎧ = tν ∑ (z1 , z2 , . . . , zd ), (7)
N L uL − zj − 1L
⎪ u {1 + ξ L } ξ , z j < − uL
⎪
where ν and tν−1 are degrees of freedom and the inverse
⎪
⎨ N
⎪
⎪ βL
of the t cumulative distribution function respectively. In
Gj (zj ) = φ (zj ), uL < zj < uR (3)
⎪ the case of Archimedean copulas, we can estimate the
N R uR − zj − 1R parameter θ as follows:
⎪
⎪
⎩1 − u {1 + ξ L } ξ , zj > uR ,
⎪
⎪
N βR
C Archimedean (u1 , u2 , . . . , ud )
where ξ , β , u and u denote the shape, scale, and upper
R L
= ψ (ψ −1 (u1 ), ψ −1 (u2 ), . . . , ψ −1 (ud ))
and lower thresholds, respectively.
= ψ (z1 , z2 , . . . , zd ), (8)
2.3. Copula models where ψ is the generator of the Archimedean copula and
ψ −1 is the inverse of the generator. Table 1 gives the
Sklar (1959) proved that, for any d-dimensional distri- parameter θ and the generator ψ for Archimedean copu-
bution function F with marginal distributions F1 , . . . , Fd , las (Hofert, Maechler, & McNeil, 2012).
500 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506

2.4. Maximum likelihood estimation on Markowitz’s mean-variance portfolio characterization,

there is an enormous body of literature focusing on im-
Since the copula in Eq. (4) is a distribution function, it is proving the portfolio allocation methods. One important
a multiple integral in uj ∈ [0, 1], ∀j: extension is the maximization of the Sharpe ratio, as sug-
gested by Sharpe (1963, 1994). The Sharpe ratio (SR) is
C (u1 , u2 , . . . , ud ) defined as the expected return of the portfolio over its stan-
uj ud
∂ d C (z1 , . . . , zd )
∫ ∫
dard deviation. For a d-dimensional portfolio with asset
= ... dz1 , . . . , dzd
returns rt = (rt1 , rt2 , . . . , rtd ), j = 1, . . . , d, asset weights
∫0 uj ∫0 ud ∂ z1 , . . . , ∂ zd
wt = (wt1 , wt2 , . . . , wtd ) and a d × d covariance matrix
= ... c(z1 , . . . , zd )dz1 , . . . , dzd . (9) Σ at time t, the portfolio expected return and variance are
0 0
wTt rt and wTt Σ wt , respectively. The CET portfolio can be
The copula density in the interior (u1 , . . . , ud )T ∈ ]0, 1[d is expressed as:
defined as: wTt rt
maximize Sharpe ratio
∂ d C (u1 , . . . , ud ) wt
√
wTt Σ wt
c(u1 , . . . , ud ) = . (10)
∂ u1 , . . . , ∂ ud subject to wTt 1 = 1, full investment (15)
Introducing the copula parameter as the generic vector Ω , ∀j ∈ {1, 2, . . . , d} :
we can write the multivariate distribution function Eq. (4) wt ,j ≥ 0, long positions only.
as:
Another portfolio optimization method is that proposed
∀z ∈ ℜd : F (z1 , z2 , . . . , zd ) by Merton (1980), who showed that the variance and co-
= C (F1 (z1 ), F2 (z2 ), . . . , Fd (zd )|Ω ) variance estimates from the asset returns are reliable when
= C (u1 , u2 , . . . , ud |Ω ), (11) considering optimization. The GMV portfolio is based on
minimizing the variance of the portfolio wTt Σ wt , which is
and the density function is obtained by differentiating the ideal for risk-averse investors who are not interested in
copula as: maximizing the expected return (Bodnar, Mazur, & Okhrin,
∂ d C (u1 , . . . , ud |Ω ) 2017). In this case, the GMV can be solved as:
c(u1 , . . . , ud |Ω ) = . (12)
∂ u1 , . . . , ∂ ud minimize wTt Σ wt variance
wt
Differentiating Eq. (11) and using Eq. (12) yields Sklar’s subject to wTt 1 = 1, full investment (16)
theorem in terms of density functions: ∀j ∈ {1, 2, . . . , d} :
∂ d F (z1 , . . . , zd ) wt ,j ≥ 0, long positions only.
∀z ∈ ℜd :
∂ z1 , . . . , ∂ zd On the other hand, downside risk is another risk mea-
∂ d C (F1 (z1 ), . . . , Fd (zd )|Ω ) sure that has been considered in many studies regarding
= f (z1 , . . . , zd ) = = optimal portfolio allocation. For instance, VaR has been
∂ z1 , . . . , ∂ zd
d employed as the risk measure in combination with the
classic Markowitz’s mean-variance portfolio, leading to
∏
c(F1 (z1 ), F2 (z2 ), . . . , Fd (zd )|Ω ) fj (zj ), (13)
an optimal mean-VaR portfolio (Consigli, 2002). However,
j=1
CVaR is an alternative when the objective is to minimize
where fj denotes the derivative of the distribution function losses beyond the VaR threshold (Xu, Zhou, Jiang, Yu, & Niu,
Fj w.r.t zj ; i.e., fj is the jth density function. Using Sklar’s 2016). Based on the algorithm proposed by Rockafellar and
theorem in terms of density functions (Eq. (13)) gives the Uryasev (2000), the integral form for CVaR is:
log-likelihood function: 1
∫
CVaRβ (wt ) = f (wt , rt )p(rt )drt , (17)
l(z1 , z2 , . . . , zd ) 1−β f (wt ,rt )≥αβ (wt )
n d
∑ ( ∏ ) where f (wt , rt ) is the loss function for asset weights wt and
= log c(F1 (zi1 ), F2 (zi2 ), . . . , Fd (zid )|Ω ) fj (zij ) = p(rt ) is the probability of rt at time t. The Min-CVaR portfo-
i=1 j=1 lio can be solved by linear programming (see Rockafellar &
n [
∑ Uryasev, 2000, 2002, for more details). The use of Monte
log(c(F1 (zi1 ), F2 (zi2 ), . . . , Fd (zid )|Ω )) Carlo integration allows the CVaR to be minimized for a
i=1 given level of return (rt ):
d
1
∑ ]
+ log(fj (zij )) . (14) minimize fα (wt , β ) = α +
(wt ,α ) q(1 − β )
j=1 q
∑
× [−wTt rkt − α]+ conditional
k=1
2.5. Allocation methods
Value-at-Risk (18)
Markowitz (1952) considered two characteristics in subject to wTt 1 = 1, full investment
portfolio optimization, namely the expected return and ∀j ∈ {1, 2, . . . , d} :
the risk measure. In Markowitz’s optimal portfolio, the wt ,j ≥ 0, long positions only
risk measure is considered to be the variance. Based µ(wt ) ≤ −R,
 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506
where q is the number of Monte Carlo draws, α is the VaR
at the β threshold value (here, 0.9), and rkt is the kth vector
of the simulated returns at time t. From the optimization,
wt is the vector of asset weights that minimizes the CVaR
for a given R.
2.6. Steps
In this section, we begin by defining the following pa-
rameters: L = window length, t0 = starting point for the
iterations, T = length of the out-of-sample interval, and
M = number of drawings from the multivariate return
distribution estimated for each iteration [t0 + 1, T ]. We use
a rolling window estimation for the out-of-sample period,
in which we iterate steps 1 to 8 for each time point in
[t0 + 1, T ], meaning that we reestimate all of the param-
eters at each iteration. The first set of observations, needed
for the one-period out-of-sample prediction at t0 + 1, is
[t0 − L + 1, t0 ], and the next set is [t0 − L + 2, t0 + 1]. We
initialize t1 = t0 . The whole procedure can be summarized
as follows.
1. Use Eq. (1) for ARMA(1,1)-GARCH(1,1) or Eq. (2) for
GARCH(1,1) to estimate the parameters by maxi-
mum likelihood estimation (MLE), and obtain stan-
dardized residuals:
x̂t = (x̂t1 , x̂t2 , . . . , x̂td ), x̂tj ≈ i.i.d., ∀j,
t ∈ [t0 − L + 1, t0 ].
2. Use the estimated standardized residual vector xˆt
from step 1 to estimate the center of the distribu-
tions as a Gaussian kernel and the upper/lower tails
as a GPD (Eq. (3)):
v̂tj = F̂k (x̂tj ), t ∈ [t0 − L + 1, t0 ], j ∈ [1, d],
v̂tj ∼ U(0, 1).
3. Apply Sklar’s theorem (see Eq. (4)) and insert the
estimated uniforms v̂tj , j ∈ [1, d] of step 2 in the
chosen multivariate copula, then estimate the pa-
rameter Ω of the distribution function using MLE
(see Eq. (14)). For the elliptical copulas∑
(i.e., Gaussian
(Eq. (6)) and Student-t (Eq. (7))), Ω = , and for the
Archimedean copulas (Eq. (8)), Ω = θ :
F̂ (v̂t1 , v̂t2 , . . . , v̂td )
= Ĉ (F̂1 (v̂t1 ), F̂2 (v̂t2 ), . . . , F̂d (v̂td )|Ω̂ ).
4. Generate M uniform random numbers (wi1 , wi2 , . . . ,
wid ), i = 1, . . . , M for each series j = 1, . . . , d
and insert them into the estimated empirical mul-
tivariate copula distribution of step 3 to obtain M
uniforms with the estimated dependency structure:
ûi = (ûi1 , ûi2 , . . . , ûid ) = Ĉ (F̂1 (wi1 ),
F̂2 (wi2 ), . . . , F̂d (wid )|Ω̂ ), ûij ∼ U(0, 1).
5. Insert the simulated uniform random numbers ûi =
ûi1 , ûi2 , . . . , ûid , i = 1, . . . , M, of step 4 with the esti-
mated dependency structure into the inverse of the
estimated marginal distribution functions of step 3
501
in order to estimate new standardized residuals for
use in portfolio optimization at time t:
Ẑ = [ẑi ] = (ẑi1 , ẑi2 , . . . , ẑid )
= (F̂1−1 (ûi1 ), F̂2−1 (ûi2 ), . . . , F̂d−1 (ûid )),
i = 1, . . . , M . (23)
6. Substitute the estimated residual vectors Ẑ from
step 5 in the estimated [ARMA]-GARCH forecasting
model in Eqs. (1) or (2) and generate M one-step
forecasts for time point t = t0 + 1:
r̂it = (r̂ti,1 , r̂ti,2 , . . . , r̂ti,d ), i = 1, . . . , M . (24)
7. Substitute the forecasts for returns in the opti- r̂it
mization methods explained in Section 2.5 to get
the optimal weights for the CET, Min-CVaR and GMV
portfolios.
8. Use the optimal weights wt together with the real
asset returns rt to compute an
∑destimate of the one-
period portfolio return Rt = j=1 wtj r tj = wT
t r t .
3. Data
Our data set includes daily adjusted prices of ten stock
indexes (S&P 500, FTSE 100, DAX 30, EURO STOXX, MSCI
World, CAC 40, OMXC 20, OMXH, OMXS 30 and TOPIX)
obtained from Thomson Reuters’ Datastream. We define
(19)
logarithmic returns. The sample period starts in August
1996 and ends in August 2016, giving a total of 5218
observations. Similarly to Huang and Hsu (2015) and Low
et al. (2013), we implement a rolling window of 1260
observations.1 Accordingly, the out-of-sample forecasting
is performed 3958 times.
Table 2 provides descriptive statistics for the returns
(20) of stock indexes. All series have positive average returns
except for TOPIX. Only OMXS30 has a positive skewness.
The positive kurtosis seen for all series indicates that they
are all more peaked than a standard normal distribution.
Finally, the results of Jarque–Bera’s test reject the null
hypothesis of normality for all series.
4. Results
We employ GARCH-EVT and ARMA-GARCH-EVT models
to define the marginal distribution for the innovations. We
(21) assume that the conditional distribution for residuals in
the GARCH(1,1) is Student-t. However, for the ARMA(1,1)-
GARCH(1,1), we use a normal distribution as the condi-
tional distribution.2 The parameter estimation results are
given in Table 3. The estimated parameters are significant
and suggest that the error terms follow a t distribution.
We use extreme value theory to fit GPD to the upper
and lower tails of the standardized residuals. The method
1 We select 1260 observations as the window length because we need
(22) enough observations for each series in order to fit the semi-parametric
distribution to the residuals and obtain the lower and upper thresholds.
2 Our intent is to examine the effects of changing the conditional
distribution in GARCH model specifications. However, we did not test
for other distributions, such as the skewed normal or skewed Student-t,
because this would add too many results for the current paper.
502 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506

Table 2
Descriptive statistics for the daily log returns of stock indexes.
Series Mean Std. dev. Skewness Kurtosis JB
S&P 500 0.023 0.012 −0.23 7.99 13 941***
FTSE 100 0.011 0.012 −0.15 5.63 6 926***
DAX 30 0.027 0.015 −0.14 4.05 3 583***
EURO STOXX 0.012 0.015 −0.09 4.22 3 876***
MSCI 0.015 0.010 −0.38 7.33 11 819***
CAC 40 0.015 0.015 −0.06 4.45 4 309***
OMXC 20 0.040 0.013 −0.28 5.13 5 786***
OMXH 0.026 0.018 −0.37 7.17 11 292***
OMXS 30 0.025 0.015 0.04 3.79 3 125***
TOPIX −0.004 0.014 −0.30 5.83 7 483***
Notes: The total number of observations is 5218 for each stock index. The mean is expressed as a percentage. JB shows the result of Jarque-Bera’s normality
test.
***
Denotes statistical significance at the 1% level.

Table 3
GARCH parameters for daily log returns of stock indexes.
Series GARCH(1,1) ARMA(1,1)-GARCH(1,1)
µ ω α1 β1 λ µ ϕ θ ω α1 β1
S&P 500 0.068 0.014 0.094 0.899 6.161 0.057 0.800 −0.837 0.018 0.095 0.892
FTSE 100 0.049 0.015 0.104 0.888 8.836 0.042 0.924 −0.950 0.017 0.103 0.887
DAX 30 0.096 0.021 0.094 0.900 8.358 0.082 0.869 −0.888 0.028 0.098 0.892
EURO STOXX 0.074 0.022 0.093 0.900 7.759 0.063 0.773 −0.807 0.027 0.093 0.896
MSCI 0.061 0.012 0.095 0.895 7.734 0.048 0.010 0.142 0.012 0.094 0.894
CAC 40 0.071 0.022 0.087 0.905 8.342 0.061 0.815 −0.852 0.026 0.089 0.900
OMXC 20 0.090 0.045 0.122 0.852 7.406 0.083 −0.296 0.340 0.048 0.105 0.863
OMXH 0.095 0.013 0.070 0.929 6.221 0.076 −0.137 0.174 0.013 0.061 0.936
OMXS 30 0.082 0.019 0.086 0.908 8.330 0.076 0.785 −0.822 0.024 0.090 0.902
TOPIX 0.040 0.040 0.089 0.891 6.966 0.037 0.115 −0.075 0.047 0.100 0.876
Note: The total number of observations used for each stock index is 5218.

Table 4
Estimates of EVT parameters for standardized residuals from both GARCH(1,1) and ARMA(1,1)-GARCH(1,1) models.
Series GARCH(1,1) ARMA(1,1)-GARCH(1,1)
Upper tail Lower tail Upper tail Lower tail
µR ξR βR µL ξL βL µR ξR βR µL ξL βL
S&P 500 1.148 −0.182 0.568 −1.325 0.059 0.592 1.154 −0.177 0.558 −1.326 0.032 0.631
FTSE 100 1.194 −0.066 0.481 −1.301 −0.095 0.699 1.185 −0.064 0.474 −1.316 −0.109 0.712
DAX 30 1.168 −0.052 0.479 −1.352 −0.019 0.608 1.170 −0.063 0.487 −1.355 −0.031 0.617
EURO STOXX 1.165 0.002 0.471 −1.329 −0.003 0.607 1.158 −0.011 0.477 −1.340 −0.008 0.613
MSCI 1.134 −0.116 0.542 −1.319 −0.017 0.644 1.165 −0.109 0.550 −1.285 −0.011 0.646
CAC 40 1.158 −0.045 0.510 −1.309 −0.036 0.641 1.160 −0.037 0.490 −1.326 −0.043 0.648
OMXC 20 1.198 −0.018 0.504 −1.291 0.045 0.573 1.210 −0.024 0.504 −1.282 0.037 0.581
OMXH 1.135 0.049 0.485 −1.262 0.087 0.598 1.148 0.055 0.483 −1.237 0.082 0.599
OMXS 30 1.160 −0.091 0.553 −1.285 −0.015 0.627 1.157 −0.099 0.547 −1.294 −0.025 0.643
TOPIX 1.190 −0.006 0.467 −1.318 0.071 0.560 1.190 −0.006 0.467 −1.318 0.071 0.560
Note: The total number of observations for each stock index is 5218.

is peak-over-threshold (POT), and the first step is to choose
appropriate thresholds. To do so, we follow Wang, Chen et
al. (2010) and choose the 10th percentile of the standard-
ized residuals.3 The estimated parameters µ (threshold),
ξ (scale) and β (location) for the upper and lower tails are
reported in Table 4.
As was mentioned earlier, after fitting the GPD to the
upper and lower tails of the standardized residuals and
3 We also check the mean excess function (MEF) and Hill plots. In
the Hill plot, the threshold is seen when the graph is horizontally stable.
In the case of MEF plot, a straight line with a positive slope shows the
threshold (see Gençay & Selçuk, 2004, and Karmakar & Shukla, 2015, for
the interpretation of the MEF and Hill plots).
obtaining the marginal distribution, we use copula mod-
els to estimate the dependency structure. Following that,
10,000 simulated uniforms are obtained and inserted into
the inverse function of the marginal distribution for each
series. Next, one-day-ahead returns are derived and the
optimal weights are computed based on the three opti-
mization methods (Min-CVaR, CET and GMV). We repeat
the whole procedure for each day in the out-of-sample
period and perform portfolio back-testing for each model
to obtain the portfolio returns. Fig. 1 illustrates the tan-
gency (CET) portfolio accumulation wealth with an initial
investment of $100. As we can see from the figure, all of
the forecasting models outperform the benchmark, which
is the tangency portfolio obtained by using historical data.
 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506 503

Fig. 1. The tangency portfolio (CET) accumulation wealth plot for an initial investment of $100. The plot is based on the results of the out-of-sample
portfolio back-testing, where the sample includes 5218 logarithmic daily returns for stock indexes. The portfolio returns are obtained based on a two-step
procedure. First, parameter estimation is performed and one-day-ahead returns are simulated using each forecasting model. Second, the simulated one-
day-ahead returns are inserted into each portfolio allocation strategy in order to obtain the optimal weights. This two-step procedure is employed based on
a rolling window estimation. The training sample size is 1260 days, which gives an out-of-sample period of 3958 iterations. The portfolio realized returns
are computed by applying the out-of-sample optimal weights to realized one-day-ahead returns. The benchmark portfolio includes tangency portfolio
based on the historical data. The portfolio back-testing is performed based on the daily rebalancing strategy.

5. Impact of risk modeling on the portfolio risk and
performance
We determine and evaluate the impact of model choice
on portfolio risk by summarizing the portfolio returns gen-
erated from each strategy, calculating the standard devi-
ation (SD), first percentile (P1) and 99th percentile (P99)
of the 3958 out-of-sample predicted portfolio returns. The
first two statistical measures SD and P1 describe the port-
folio risk, with the latter describing the downside risk
in particular, while P99 describes the positive (wanted)
potential in terms of the upper tail of portfolio returns.
Each combination of the portfolio optimization methods
and forecasting techniques reflects the performance of a
particular risk modeling strategy. Since we apply 96 fore-
casting techniques to each portfolio optimization method
(Min-CVaR, GMV and CET), this gives a total of 3 × 96 = 288
observations for each statistical measure (SD, P1, P99). The
regression estimates indicate the connection between the
portfolio risk —measured by SD, P1 and P99 —and specific
forecasting and risk modeling techniques. The statistical
measure of risk in the regression model is a function of
categorical variables that describe the respective modeling
strategy.
SDi = αSD + βSD,1 D1i + βSD,2 D2i + µi
{
P1i = αP1 + βP1,1 D1i + βP1,2 D2i + νi
P99i = αP99 + βP99,1 D1i + βP99,2 D2i + γi ,
where D1i and D2i (i = 1, 2, . . . , 96) denote sets of the
dummy variables for forecasting models and rebalancing
strategies. We report regression results for each portfolio
optimization approach separately, because the effects of
the modeling strategies can differ across portfolio methods,
and thus, each regression model uses 96 observations (see
Table 5).
The reference model for each portfolio optimization
method is based on historical returns using a rolling win-
dow of 1260 days. If a specific risk modeling strategy using
GARCH model forecasts reduces the portfolio risk or im-
proves portfolio returns, we should find significant effects
in the regression analysis. The strategies that are con-
sidered in the regression analyses are GARCH forecasting
models with and without ARMA terms, the application of
EVT to the modeling of extreme returns in the lower/upper
tail, various copula specifications for modeling the depen-
dence, including elliptical and Archimedean copulas, and
rebalancing the portfolio weights daily, weekly, monthly,
semi-annually or annually in the backtesting procedure
(note that annual rebalancing is the reference category).
Each risk modeling strategy is included as a categorical
variable in the regression model, and the reference cat-
egory is defined as the corresponding strategy based on
historical returns instead of GARCH model forecasts.
We focus in particular on the ability of risk modeling
techniques to reduce the portfolio risk, which means either
decreasing the portfolio return volatility (SD) or increasing
the first percentile (P1) of portfolio returns. We also test the
GARCH-STD-copula model in order to evaluate the effects
of using EVT for the transformation of the marginals.4
The main finding from the regression analysis is that
the Gaussian and Student-t copulas based on GARCH fore-
casting with or without EVT reduce the volatility (SD)
of the corresponding portfolio returns for the Min-CVaR
optimal portfolios. As the results of Table 5 show, these
models typically also increase the lower tail (P1) of the
(25) returns, meaning that a portfolio’s downside risk is reduced
on average. However, the significant negative coefficients
indicate that these models also reduce the P99 of portfolio
returns in many cases. This implies that, while the use
of these forecasting models can reduce the portfolio risk,
this also reduces the likelihood of high portfolio returns.
Thus, in terms of risk-modeling strategies, the benefits
4 In this model, after employing GARCH(1,1) to obtain the standard-
ized residuals, we simply use the probability function of the t distribution
to perform the transformation. We set the t distribution as the conditional
distribution in the GARCH(1,1) model and obtain the parameter required
for the transformation, which is degrees of freedom. Moreover, after sim-
ulating uniforms from copula models, we again use the quantile function
of the t distribution. This is the parametric method of transformation.
504 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506

Table 5
Regression results of risk modeling strategies on statistical measures of the portfolio return distribution for the three portfolio optimization methods (Min-
CVaR, GMV and CET).
Forecasting model Optimization: Min-CVaR Optimization: GMV Optimization: CET
SD P1 P99 SD P1 P99 SD P1 P99
ARMA-GARCH-EVT- 0.0523*** −0.131 ** 0.185*** 0.0527*** −0.108 * 0.227*** −0.0926 *** 0.292*** −0.208 **
Clayton (0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-EVT-Clayton 0.00495 0.0919 0.116** 0.0121 0.107 0.196*** −0.0228 0.255*** 0.191**
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-STD-Clayton 0.0125 0.0676 0.129*** 0.0123 0.109* 0.185*** −0.0934 *** 0.409*** 0.107
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
ARMA-GARCH-EVT- 0.0548*** −0.141 ** 0.232*** 0.0515** −0.132 ** 0.238*** −0.0958 *** 0.305*** −0.181 **
Frank (0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-EVT-Frank 0.0156 0.0335 0.159*** 0.0102 0.108* 0.182*** −0.0303 * 0.307*** 0.197**
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-STD-Frank 0.0102 0.0905 0.145*** 0.0102 0.110* 0.170*** −0.0904 *** 0.386*** 0.0806
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
ARMA-GARCH-EVT- −0.00792 0.0839 −0.00525 −0.0104 0.0192 0.0613 −0.113 *** 0.391*** −0.253 ***
Gaussian (0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-EVT-Gaussian −0.0476 ** 0.177*** −0.0256 −0.0434 ** 0.183*** 0.00738 −0.390 *** 1.157*** −1.148 ***
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-STD-Gaussian −0.0507 *** 0.162** −0.0568 −0.0454 ** 0.183*** −0.0348 −0.152 *** 0.540*** −0.136
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
ARMA-GARCH-EVT 0.0608*** −0.159 ** 0.250*** 0.0536*** −0.129 ** 0.230*** −0.103 *** 0.345*** −0.217 **
-Gumbel (0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-EVT-Gumbel 0.0216 0.0258 0.199*** 0.0119 0.107 0.181*** −0.0454 *** 0.299*** 0.0988
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-STD-Gumbel 0.0135 0.0864 0.162*** 0.0144 0.0626 0.183*** −0.0710 *** 0.326*** 0.111
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
ARMA-GARCH-EVT- −0.00842 0.118* 0.000114 −0.0121 0.0343 0.0223 −0.0934 *** 0.336*** −0.153 *
Student-t (0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-EVT-Student-t −0.0484 ** 0.218*** −0.0300 −0.0437 ** 0.210*** −0.00759 0.0214 −0.0377 0.398***
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
GARCH-STD-Student-t −0.0484 ** 0.188*** −0.0478 −0.0435 ** 0.202*** 0.00462 −0.0502 *** 0.0849 0.316***
(0.0187) (0.0612) (0.0438) (0.0195) (0.0648) (0.0415) (0.0157) (0.0560) (0.0848)
Rebalancing semi-annually −0.0294 ** 0.147*** −0.0641 ** −0.0284 ** 0.109*** −0.0766 *** 0.00296 −0.0301 0.0431
(0.0115) (0.0375) (0.0268) (0.0119) (0.0397) (0.0254) (0.00960) (0.0343) (0.0519)
Rebalancing quarterly −0.0352 *** 0.181*** −0.0926 *** −0.0351 *** 0.166*** −0.0935 *** 0.00485 −0.0236 0.218***
(0.0115) (0.0375) (0.0268) (0.0119) (0.0397) (0.0254) (0.00960) (0.0343) (0.0519)
Rebalancing monthly −0.0530 *** 0.269*** −0.175 *** −0.0538 *** 0.268*** −0.184 *** 0.00163 −0.0460 0.141***
(0.0115) (0.0375) (0.0268) (0.0119) (0.0397) (0.0254) (0.00960) (0.0343) (0.0519)
Rebalancing weekly −0.0799 *** 0.357*** −0.190 *** −0.0821 *** 0.322*** −0.223 *** −0.0169 * 0.0919*** 0.141***
(0.0115) (0.0375) (0.0268) (0.0119) (0.0397) (0.0254) (0.00960) (0.0343) (0.0519)
Rebalancing daily −0.138 *** 0.569*** −0.331 *** −0.140 *** 0.548*** −0.333 *** −0.0793 *** 0.321*** 0.136**
(0.0115) (0.0375) (0.0268) (0.0119) (0.0397) (0.0254) (0.00960) (0.0343) (0.0519)
Constant 0.995*** −3.080 *** 2.367*** 0.988*** −3.061 *** 2.319*** 1.293*** −3.852 *** 3.210***
(0.0152) (0.0496) (0.0355) (0.0158) (0.0525) (0.0336) (0.0127) (0.0454) (0.0687)
Observations 96 96 96 96 96 96 96 96 96
R2 0.795 0.835 0.832 0.776 0.811 0.842 0.939 0.918 0.879
Notes: The portfolio returns are obtained by applying rolling window estimation (L = 1260) and portfolio back-testing. The dependent variables are the
standard deviation (SD), first percentile (P1) and 99th percentile (P99) of portfolio returns. The risk modeling strategies are included as categorical variables
(dummy variables) in the regressions. The reference category (benchmark) is the respective optimal portfolio based on historical returns using a 1260-day
rolling window. The reference category for the rebalancing of portfolio weights is annually. Standard errors are shown in parentheses.
*
p < 0.1.
**
p < 0.05.
***
p < 0.01.

come at the cost of reducing the risk (opportunities) in the
upper tail as well, implying lower performances. Another
finding from the regression analysis is that the main results
for the GMV and Min-CVaR portfolios are quite similar.
According to our study, the gains from using Min-CVaR
optimal portfolios instead of GMV portfolios, in terms of
reducing the portfolio risk (P1), are minor in most cases, as
is shown by the small differences between the regression
intercepts for the two portfolio optimization methods. To
the best of our knowledge, no previous study has provided
evidence on this issue. When it comes to CET portfolios,
almost all of the risk models decrease the portfolio risk
significantly; on the other hand, though, all techniques also
decrease the 99th percentile of portfolio returns. Overall,
GARCH forecasting models in combination with EVT and
copula models appear to be particularly well suited for the
CET optimization framework. As expected, we find that a
more frequent rebalancing of portfolio weights decreases
the portfolio risk for different rebalancing strategies,5 but
5 This corresponds to the results of Huang and Hsu (2015).
 M. Sahamkhadam et al. / International Journal of Forecasting 34 (2018) 497–506
again also decreases the 99th percentile of portfolio re-
turns.
6. Conclusions
This study uses GARCH-EVT-copula and ARMA-GARCH-
EVT-copula models to forecast and simulate the one-day-
ahead returns of ten stock indexes. Using the forecasts,
we employ three portfolio optimization techniques (Min-
CVaR, GMV and CET) to compute the optimal weights
and perform portfolio back-testing for the out-of-sample
period based on different rebalancing strategies. Further-
more, we perform regression analyses to examine how, on
average, the various risk modeling strategies affect three
statistical measures of the portfolio return distribution: the
return volatility and lower and upper tails of the portfolio
returns.
In terms of wealth accumulation, we find that GARCH-
EVT-copula forecasting models are not able to outperform
models that are based on historical returns (our bench-
mark) for Min-CVaR and GMV portfolios. However, for
CET, the use of forecasting models improves the portfolio
wealth.
In addition, our regression analyses provide evidence
that elliptical copulas (Gaussian and Student-t) reduce
the return volatility of Min-CVaR portfolios better than
Archimedean copulas. Overall, the improvement in portfo-
lio risk reduction from using risk modeling and forecasting
techniques in combination with Min-CVaR and GMV port-
folios appears to be modest. As minimizing the risk already
forms part of determining the optimal weights for MinC-
VaR and GMV portfolios, combining them with risk mod-
eling techniques might not improve the results further.
However, there is a strong indication that risk modeling
strategies based on return forecasts in combination with
the optimal tangency portfolio can reduce the portfolio risk
significantly.
Future research should try to improve the forecasting
ability of the ARMA-GARCH models by including explana-
tory factors in both the mean and conditional volatility
parts. Fama–French factors and volatility indexes (VIX) are
natural candidates for this.
Acknowledgments
Some of the computations for this study were done
using the R packages ‘‘rugarch’’ and ‘‘spd’’ (Ghalanos, 2015,
2018). We want to thank Bernhard Pfaff for his guidance
in the use of GARCH-copula models (Pfaff, 2016). In addi-
tion, we are grateful to seminar participants at the 10th
International Conference on Computational and Financial
Econometrics (CFE 2016) in Seville. Finally, we thank Scott
Hacker, Kristofer Månsson, Gazi Salah Uddin and Pär Sjö-
lander for their helpful comments and suggestions on a
previous version of this paper. The usual disclaimer applies.
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Maziar Sahamkhadam is a Ph.D. student at the School of Business and
Economics, Linnaeus University, Sweden. His research is in the area of
portfolio optimization and risk modeling. He holds a master degree in
International Financial Analysis from Jönköping International Business
School, Sweden.
Andreas Stephan studied industrial engineering, statistics and economics
at TU Berlin and received a Ph.D. in economics at the Humboldt University
Berlin. He previously held positions at the Social Science Research Center
in Berlin (WZB), at the German Institute for Economic Research (DIW
Berlin) and as an Assistant Professor of economics at the European Uni-
versity Viadrina in Frankfurt/Oder. His main areas of interest are financial
economics including financial engineering. Previous work includes the
estimation of implicit betas from option prices. He is affiliated with CESIS
- Centre of Excellence for Science and Innovation Studies at the Royal
Institute of Technology, Stockholm, and with CeFEO - Centre for Family
Enterprise and Ownership, Jönköping.
Ralf Östermark studied accounting and economics at Turku School of
Buiness Economics and Åbo Akademi University (ÅAU). He has held po-
sitions in business economics and accounting at ÅAU. He is currently
Professor in accounting and optimization systems at ÅAU. His main areas
of interest are high performance computing and financial engineering.
Previous work includes multiperiod portfolio management systems and
scalability testing of challenging numerical problems.