Conditional Value at Risk (CVaR) Optimization helps banks determine which investments and trades to make in order to be able to pass bank stress tests.
Typical users are investment banks.
Problem: The 2008 Financial Crisis introduced the public to the concept of fat tails and black swans. Fat tails describe the extreme tails of a probability distribution. By being “fat”, they have a higher probability of taking place than is otherwise given by theory. Black swans are unforeseen events that have a sizeable impact and their occurrence is rationalized after the fact. Given that most securities do not have price fluctuations that can be assumed to have Gaussian distributions, what is the best way to structure a portfolio investments in order to achieve a desired return and protect the company against black swans?
Solution: CVaR optimization is a relatively new form of portfolio optimization that does not rely on the assumption of any standard distribution. The result is a more robust portfolio that is more likely to pass regulatory stress tests.
Resources on CVaR Optimization:
Optimization of Conditional Value-at-Risk
Credit risk optimization with conditional value-at-risk criterion