CIRJE-F-1038 "Creating Investment Scheme with State Space Modeling "
Author Name

Nakano, Masafumi, Akihiko Takahashi and Soichiro Takahashi

Date February 2017
Full Paper  
Remarks  Subsequently published in Expert Systems With Applications.

This paper proposes a unified approach to creating investment strategies with various desirable properties for investors. Particularly, we provide a new interpretation and the resulting formulations for state space models to attain our investment objectives, which are possibly specified as achieving target mean-variance portfolios or Sharpe ratios, and generating alphas (additional returns) over benchmark indexes.
More concretely, in state space modeling to financial time-series data, we can apply the system model to representing portfolio weight processes with various constraints, as well as the standard underlying state variables such as volatility processes. Moreover, we may formulate the observation model to stand for target value processes with non-linear functions of observed and latent variables.
Numerical experiments demonstrate the effectiveness of our methodology through alpha-creation against S&P 500 futures, and substantial improvement of the performance on mean-variance portfolios.