Title: Portfolio selection under changing market conditions

Authors: Cornelia Ernst, Martin Grossmann, Stephan Hocht, Stefan Minden, Matthias Scherer, Rudi Zagst

Addresses: HVB Institute for Mathematical Finance, Technische Universitat Munchen, Boltzmannstrasse 3, 85748 Garching b. Munchen, Germany. ' HVB Institute for Mathematical Finance, Technische Universitat Munchen, Boltzmannstrasse 3, 85748 Garching b. Munchen, Germany. ' HVB Institute for Mathematical Finance, Technische Universitat Munchen, Boltzmannstrasse 3, 85748 Garching b. Munchen, Germany. ' HVB Institute for Mathematical Finance, Technische Universitat Munchen, Boltzmannstrasse 3, 85748 Garching b. Munchen, Germany. ' HVB Institute for Mathematical Finance, Technische Universitat Munchen, Boltzmannstrasse 3, 85748 Garching b. Munchen, Germany. ' HVB Institute for Mathematical Finance, Technische Universitat Munchen, Boltzmannstrasse 3, 85748 Garching b. Munchen, Germany

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.

Keywords: Markov switching; portfolio selection; financial crisis; market conditions; portfolio optimisation; performance measures; risk management; turbulent markets.

DOI: 10.1504/IJFSM.2009.026636

International Journal of Financial Services Management, 2009 Vol.4 No.1, pp.48 - 63

Published online: 21 Jun 2009 *

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