Portfolio optimization for inventory financing: Copula-based approaches

Abstract Portfolio optimization has long been used in asset management to mitigate risks of fluctuating asset prices. In this study, we use copula models and portfolio optimization to investigate how inventory financing providers (IFP) can utilize the timely market information of collaterals to optimize their portfolios of collaterals to mitigate default risks. Through comparing the predictive performance of copula strategies with that of the multivariate normal distribution (MVN) strategy, we find that the general canonical vine copula can characterize the dependence structure among collateral return series and has superior predictive performance over the MVN and other copulas. Our findings suggest that the general canonical vine copula can be constructed into portfolio strategies that can be adopted by the IFP to mitigate default risks and improve their risk profile.