Dynamic Portfolio Optimization under Regime-Based Firm Strength

Chanaka Edirisinghe and Xin Zhang
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Chanaka Edirisinghe: College of Business, Austin Peay State University, Clarksville, TN 37044, USA
Xin Zhang: College of Business, University of Tennessee, Knoxville, TN 37996, USA

Chapter 6 in Stochastic Programming:Applications in Finance, Energy, Planning and Logistics, 2013, pp 129-154 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractThis chapter presents a dynamic optimization model under regime-switching market uncertainty to manage stock portfolios. The novelty of the approach is that stocks for long and short investments are selected based on the notion of fundamental business strength and consistent with specific regime scenarios. Firm-strength is determined via the quarterly financial statements of a firm, relative to other firms in the same market sector/industry. Referred to as Relative Firm Strength (RFS), it is determined using Data Envelopment Analysis (DEA) in which various financial metrics from accounting statements are specified as inputs and outputs. It is shown that such an RFS measure has predictive power of stock returns in the historical data period 1971–2010. The regime-switching market model is combined with the RFS metric of stock selections to test the performance of a two-quarter stochastic portfolio optimization model during Jan–Jun, 2011. The out-of-sample results demonstrate that the proposed methodology is superior to using sector-based ETF portfolios or the market index itself.

Keywords: Stochastic Programming; Optimization with Scenarios; Finance; Energy; Production and Logistics Applications (search for similar items in EconPapers)
Date: 2013
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