Factor Estimation: Filtering and Black-Litterman

Mark H. A. Davis and Sebastien Lleo

Chapter 15 in Risk-Sensitive Investment Management, 2014, pp 367-383 from World Scientific Publishing Co. Pte. Ltd.

Abstract: We mentioned in Chapter 2 that the factor process X(t) in our models has two possible interpretations. Its components Xi(t) may represent observable data series, either financial data such as stock indices, bond yield spreads etc., or macroeconomic data such as GDP growth, employment data or confidence indices. Alternatively, Xi(t) may be an unobserved ‘latent variable’ factor whose role is to represent the inherent uncertainty of asset growth rates. In previous chapters we have always assumed that the X(t) process is observable, so implicitly we are adopting the first interpretation. In this chapter we outline what to do if the factors are not observable, in the context of the diffusion factor model $$\hat X(t)$$ used in Chapters 2–7. In a word, we can use the Kalman filter to estimate X(t) and then replace (15.1) by the Kalman filter equation and the asset price model by the so-called innovations representation. We are then back in a ‘completely observable’ world where X(t) has been replaced by its Kalman filter estimate $$\hat X(t)$$, and can apply all the results for the ‘observable’ models of the preceding chapters. This idea was used by Nagai and Peng (2002) and Nagai (2004), but in concept goes back at least to work by Wonham (1968) on the ‘separation theorem’ of stochastic control…

Keywords: Stochastic Control; Risk Sensitive Control; Dynamic Investment Management; Benchmarked Asset Management; Asset and Liability Management; Jump Diffusion Processes; Lévy Processes; Hamilton–Jacobi–Bellman Equations; Classical Solutions; Viscosity Solutions; Kelly Criterion (search for similar items in EconPapers)
Date: 2014
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.worldscientific.com/doi/pdf/10.1142/9789814578059_0015 (application/pdf)
https://www.worldscientific.com/doi/abs/10.1142/9789814578059_0015 (text/html)
Ebook Access is available upon purchase.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:wschap:9789814578059_0015

Ordering information: This item can be ordered from

Access Statistics for this chapter

More chapters in World Scientific Book Chapters from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().