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Filter-based portfolio strategies in an HMM setting with varying correlation parametrizations

: Erlwein-Sayer, Christina; Grimm, Stefanie; Ruckdeschel, Peter; Sass, Jörn; Sayer, Tilman


Applied Stochastic Models in Business and Industry 36 (2020), No.3, pp.307-334
ISSN: 1524-1904
ISSN: 1526-4025
Deutsche Forschungsgemeinschaft DFG
RU 893/4-1
Deutsche Forschungsgemeinschaft DFG
SA 1883/4-1
Journal Article
Fraunhofer ITWM ()

We consider portfolio optimization in a regime‐switching market. The assets of the portfolio are modeled through a hidden Markov model (HMM) in discrete time, where drift and volatility of the single assets are allowed to switch between different states. We consider different parametrizations of the involved asset covariances: statewise uncorrelated assets (though linked through the common Markov chain), assets correlated in a state‐independent way, and assets where the correlation varies from state to state. As a benchmark, we also consider a model without regime switches. We utilize a filter‐based expectation‐maximization (EM) algorithm to obtain optimal parameter estimates within this multivariate HMM and present parameter estimators in all three HMM settings. We discuss the impact of these different models on the performance of several portfolio strategies. Our findings show that for simulated returns, our strategies in many settings outperform naïve investment strategies, like the equal weights strategy. Information criteria can be used to detect the best model for estimation as well as for portfolio optimization. A second study using real data confirms these findings.