Dynamic portfolio optimization across hidden market regimes

Research output: Research - peer-reviewJournal article – Annual report year: 2017

Documents

DOI

View graph of relations

Regime-based asset allocation has been shown to add value over rebalancing to static weights and, in particular, reduce potential drawdowns by reacting to changes in market conditions. The predominant approach in previous studies has been to specify in advance a static decision rule for changing the allocation based on the state of financial markets or the economy. In this article, model predictive control (MPC) is used to dynamically optimize a portfolio based on forecasts of the mean and variance of financial returns from a hidden Markov model with time-varying parameters. There are computational advantages to using MPC when estimates of future returns are updated every time a new observation becomes available, since the optimal control actions are reconsidered anyway. MPC outperforms a static decision rule for changing the allocation and realizes both a higher return and a significantly lower risk than a buy-and-hold investment in various major stock market indices. This is after accounting for transaction costs, with a one-day delay in the implementation of allocation changes, and with zero-interest cash as the only alternative to the stock indices. Imposing a trading penalty that reduces the number of trades is found to increase the robustness of the approach.
Original languageEnglish
JournalQuantitative Finance
Volume18
Issue number1
Pages (from-to)83-95
Number of pages20
ISSN1469-7688
DOIs
StatePublished - 2017
CitationsWeb of Science® Times Cited: 0

    Research areas

  • Multi-period portfolio selection, Meanvariance optimization, Model predictive control, Hidden Markov model, Adaptive estimation, Forecasting
Download as:
Download as PDF
Select render style:
APAAuthorCBE/CSEHarvardMLAStandardVancouverShortLong
PDF
Download as HTML
Select render style:
APAAuthorCBE/CSEHarvardMLAStandardVancouverShortLong
HTML
Download as Word
Select render style:
APAAuthorCBE/CSEHarvardMLAStandardVancouverShortLong
Word

Download statistics

No data available

ID: 139272078