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Dynamic asset allocation strategy using a state-dependent Markov model: Applications to international equity markets

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  • Hematizadeh, Roksana
  • Tajaddini, Reza
  • Hallahan, Terrence

Abstract

This paper investigates the performance of an asset allocation strategy that relies on the state-dependent correlation between emerging and developed markets. We utilize a state-dependent Markov Model that employs a time-varying transition probability and uses the U.S. term spread differential as a market phase identifier. We show that by relying on the spillover effect of U.S. monetary policies on international equity markets, international investors can optimize returns on their investments by using a state-dependent model when diversifying their portfolios towards less volatile markets. Two states and optimal tangency portfolios reveal superior performance even after consideration of transaction costs. The effect of the U.S. term spread on equity returns is more apparent after the Global Financial Crisis; when positive (negative) term spread differentials are associated with an increased likelihood of being in a bull (bear) market.

Suggested Citation

  • Hematizadeh, Roksana & Tajaddini, Reza & Hallahan, Terrence, 2022. "Dynamic asset allocation strategy using a state-dependent Markov model: Applications to international equity markets," Journal of International Money and Finance, Elsevier, vol. 128(C).
  • Handle: RePEc:eee:jimfin:v:128:y:2022:i:c:s0261560622001085
    DOI: 10.1016/j.jimonfin.2022.102705
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    More about this item

    Keywords

    Dynamic asset allocation; State-dependent strategy; Transaction costs; International markets; Financial crisis;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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