FIN-01-015

Risk Management with Benchmarking

October 2001

Suleyman Basak, Alex Shapiro and Lucie Tepla

ABSTRACT

Portfolio theory must address the fact that in reality, portfolio managers are evaluated relative to a benchmark, and therefore adopt risk management practices to account for the benchmark performance. We capture this risk management consideration by allowing a prespecified shortfall from a target benchmark-linked return, consistent with growing interest in such practice. In a dynamic setting, we demonstrate how a risk averse portfolio manager optimally under- or overperforms a target benchmark under different economic conditions, depending on his attitude towards risk and choice of the benchmark. Investors can therefore achieve their desired gain/loss characteristics for funds under management through an appropriate combined choice of the benchmark and money manager.

Subject: Investments/Portfolio Choice; Risk Management

Classification: Theoretical

Suleyman Basak
Institution: London Business School, UK
Telephone: (0)20 7706-6847
Email: sbasak@london.edu

Alex Shapiro
Institution: Leonard N. Stern School of Business, New York University
Telephone: 212-998-0362
Email: ashapiro@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~ashapiro/

Lucie Tepla
Institution: INSEAD
Telephone: (33) 1-6072-4485
Email: lucie.tepla@insead.fr

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