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Long-term strategic asset allocation with inflation risk and regime switching

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  • Tak Kuen Siu

Abstract

Long-term strategic asset allocation is an important problem in both finance and actuarial science. There are two key issues in long-term strategic asset allocation, namely, the presence of inflation risk and the impact of changes in (macro)-economic conditions on model dynamics. In this article, we take into account the two key issues in our model formulation and develop a quantitative model for long-term strategic asset allocation. A continuous-time, regime-switching market with the presence of inflation risk is considered. There are three tradeable assets in the market, namely, a fixed interest security, an ordinary share and an inflation-linked bond. We assume that the nominal rate of interest on the fixed interest security, the expected rate of return from the ordinary share and the appreciation rate of inflation are modulated by a continuous-time, finite-state, hidden Markov chain. The states of the chain represent different states of an economy. With knowledge about the price of the ordinary share and the price index level, an investor wishes to maximize the expected utility of real terminal wealth. By making use of the separation principle, we solve the optimal portfolio selection problem and the estimation problem independently. We derive a robust estimate of the hidden state of the chain and develop a robust, filter-based, EM algorithm for the on-line recursive estimates of the key model parameters.

Suggested Citation

  • Tak Kuen Siu, 2011. "Long-term strategic asset allocation with inflation risk and regime switching," Quantitative Finance, Taylor & Francis Journals, vol. 11(10), pages 1565-1580.
    • Handle: RePEc:taf:quantf:v:11:y:2011:i:10:p:1565-1580
    DOI: 10.1080/14697680903055588
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    Citations

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    Cited by:

    1. Curatola, Giuliano, 2022. "Price impact, strategic interaction and portfolio choice," The North American Journal of Economics and Finance, Elsevier, vol. 59(C).
    2. Agostino Capponi & José Figueroa-López & Andrea Pascucci, 2015. "Dynamic credit investment in partially observed markets," Finance and Stochastics, Springer, vol. 19(4), pages 891-939, October.
    3. Nick James & Max Menzies & Kevin Chin, 2022. "Economic state classification and portfolio optimisation with application to stagflationary environments," Papers 2203.15911, arXiv.org, revised Sep 2022.
    4. Shen, Yang & Siu, Tak Kuen, 2012. "Asset allocation under stochastic interest rate with regime switching," Economic Modelling, Elsevier, vol. 29(4), pages 1126-1136.
    5. Dong-Mei Zhu & Jiejun Lu & Wai-Ki Ching & Tak-Kuen Siu, 2019. "Option Pricing Under a Stochastic Interest Rate and Volatility Model with Hidden Markovian Regime-Switching," Computational Economics, Springer;Society for Computational Economics, vol. 53(2), pages 555-586, February.
    6. Krishnamurthy, Vikram & Leoff, Elisabeth & Sass, Jörn, 2018. "Filterbased stochastic volatility in continuous-time hidden Markov models," Econometrics and Statistics, Elsevier, vol. 6(C), pages 1-21.
    7. James, Nick & Menzies, Max & Chin, Kevin, 2022. "Economic state classification and portfolio optimisation with application to stagflationary environments," Chaos, Solitons & Fractals, Elsevier, vol. 164(C).
    8. Nick James & Kevin Chin, 2021. "On the systemic nature of global inflation, its association with equity markets and financial portfolio implications," Papers 2111.11022, arXiv.org, revised Jan 2022.
    9. James, Nick & Chin, Kevin, 2022. "On the systemic nature of global inflation, its association with equity markets and financial portfolio implications," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 593(C).
    10. Kwak, Minsuk & Lim, Byung Hwa, 2014. "Optimal portfolio selection with life insurance under inflation risk," Journal of Banking & Finance, Elsevier, vol. 46(C), pages 59-71.
    11. Cai, Jun & Ge, Chenliang, 2012. "Multi-objective private wealth allocation without subportfolios," Economic Modelling, Elsevier, vol. 29(3), pages 900-907.
    12. Liang, Zongxia & Zhao, Xiaoyang, 2016. "Optimal mean–variance efficiency of a family with life insurance under inflation risk," Insurance: Mathematics and Economics, Elsevier, vol. 71(C), pages 164-178.

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