Dynamic asset allocation for varied financial markets under regime switching framework

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

Research output: Contribution to journalArticle

37 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)450-458
Number of pages9
JournalEuropean Journal of Operational Research
Volume234
Issue number2
DOIs
StatePublished - Apr 16 2014

All Science Journal Classification (ASJC) codes

  • Computer Science(all)
  • Modeling and Simulation
  • Management Science and Operations Research
  • Information Systems and Management

Keywords

  • Hidden Markov model
  • Investment analysis
  • Portfolio optimization
  • Regime identification
  • Stochastic programming

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