Dynamic asset allocation for varied financial markets under regime switching framework

Geum Il Bae, Woo Chang Kim and John M. Mulvey

European Journal of Operational Research, 2014, vol. 234, issue 2, 450-458

Abstract: Asset allocation among diverse financial markets is essential for investors especially under situations such as the financial crisis of 2008. Portfolio optimization is the most developed method to examine the optimal decision for asset allocation. We employ the hidden Markov model to identify regimes in varied financial markets; a regime switching model gives multiple distributions and this information can convert the static mean–variance model into an optimization problem under uncertainty, which is the case for unobservable market regimes. We construct a stochastic program to optimize portfolios under the regime switching framework and use scenario generation to mathematically formulate the optimization problem. In addition, we build a simple example for a pension fund and examine the behavior of the optimal solution over time by using a rolling-horizon simulation. We conclude that the regime information helps portfolios avoid risk during left-tail events.

Keywords: Investment analysis; Regime identification; Hidden Markov model; Stochastic programming; Portfolio optimization (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (41)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:234:y:2014:i:2:p:450-458

DOI: 10.1016/j.ejor.2013.03.032

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