Some Financial Problems in the Light of EMM Results: Asset Pricing and Efficient Portfolio Allocation

Discussing results in asset pricing and efficient portfolio allocation, we show that mixed success and errors in these results often follow from a lack of information about the asset return distribution and wrong assumptions about its properties. Some mistakes in asset pricing come from the assumption of symmetry in return distributions. Some errors in efficient portfolio allocation follow from Markowitz’s approach when applying it to portfolio optimization of skewed asset returns. The Extended Merton model (EMM), generating skewed return distributions, demonstrates that (i) in skewed asset returns, the variance is not an adequate measure of risks and (ii) positive skewness in the asset returns comes together with a high default probability. Thus, the maximization of the mean portfolio returns and skewness with controlled variance used in mainstream papers can critically increase portfolio risks. We present the new settings of the optimal portfolio allocation problem leading to less risky efficient portfolios than the solutions suggested in all previous papers.