Portfolio selection under changing market conditions
by Cornelia Ernst, Martin Grossmann, Stephan Hocht, Stefan Minden, Matthias Scherer, Rudi Zagst
International Journal of Financial Services Management (IJFSM), Vol. 4, No. 1, 2009

Abstract: In this paper, an extensive portfolio optimisation case study is conducted. For this, in a first step, a Markov-Switching model is estimated to time series of three global stock indices. The estimation includes a new methodology for the search for realistic initial values and a large number of covariates that were tested for their ability to explain transition probabilities. In the second step, the model is used in an industry-standard portfolio optimisation environment and compared under realistic assumptions to a Black-Scholes model. The results indicate that risk measures are significantly reduced and performance measures improved when a Markov-Switching model is used. These improvements are especially due to the faster reallocations in turbulent market phases like the burst of the dot-com bubble or the current financial crisis.

Online publication date: Sun, 21-Jun-2009

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