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Ivan Peng, Jennifer Wong, Song Yang

Oct. 5th, 2012


Ivan Pdddddddd

MIE479 CAPSTONE PROJECT

LITERATURE REVIEW : PHASE LOCKING


Ivan Peng (996824842)
Jennifer Wong (996831772)
Song Yang (996808085)

The design of portfolios is a fundamental problem in finance. One of the most commonly accepted
optimization strategies is Markowitzs mean-variance model. The MVO formulation is based on
numerous assumptions, one of which is that asset correlations remain fixed over time in a single
state, or regime. However, numerous papers starting with Hamilton (1989) have presented
evidence of changing asset correlations and the existence of multiple regimes. It is worthwhile to
incorporate such regime changes into MVO, which can be accomplished through phase locking, and
will be the core of investigation in this capstone project.
One element of the phase locking method is estimating the number of regimes present. Hamilton
(1989) proposed a maximum likelihood estimation algorithm, with which he speculated two
distinct regimes - stable vs. volatile inflation/interest rates. Harris (2000) utilized a Bayesian
Markov-chain Monte Carlo estimation method, which also resulted in two regimes - a recessive
state and a growth state. Lo (2010) also interpreted the market as having two regimes, one during a
stable economy, the other during market catastrophe.
Billio, Getmansky, and Pelizzon (2006) proposed a model with three regimes, corresponding
to normal market, bear market, and bull market. Furthermore, they applied the phase locking
framework to a multi-factor model with arbitrage pricing theory, as opposed to MVO. This strategy
of using APT instead of MVO was also adapted by Lo (2010). Ma et al. (2011) also concluded that
three was the optimal number of regimes, using the Bayesian information criterion.
Selecting and using meaningful data is another key concern. Hamilton (1989) observed regime
changes in the US gross national product, and subsequently identified two distinct regimes. Harris
(2000) also identified two regimes using Australian financial market data. Billio, Getmansky, and
Pelizzon (2006) identified three regimes based on S&P 500 returns. Similarly, Ma et al. (2011) also
identified three regimes utilizing a portfolio of nine sector exchange-traded funds in the US. Ang
and Bekaert (2002) took a more international approach and conducted tests using assets from the
UK, US, and Germany.
Ang and Bekaert (2002) were also the first to include in their implementation the transaction costs
of rebalancing a portfolio between regime changes. Previous implementations had always assumed
little or no transaction costs. They found that it was not always beneficial to rebalance asset weights
in a portfolio after a regime change.
There are many unique aspects of regime switching in portfolio design. From this literature review,
we will strive to generate a model that will incorporate the important parts of the papers, from
estimating the number of regimes, to utilizing adequate market data, and incorporating transaction
costs to make it more realistic. We hope to improve the phase locking approach to portfolio
management.

Ivan Peng, Jennifer Wong, Song Yang

Oct. 5th, 2012


Ivan Pdddddddd

G. Harris. Regime Switching Vector Autoregressions: A Bayesian Markov Chain Monte Carlo Approach.
Australian Mutual Provident Society, Sydney, NSW, 2000.
E. Otranto and G.M. Gallo. A Nonparametric Bayesian Approach to Detect the Number of Regimes in Markov
Switching Models
A. Lo. Hedge funds. Princeton, NJ: Princeton University Press, 2010, pp. 18-22, 211-212.
J. D. Hamilton. A New Approach to the Economic Analysis of Nonstationary Time Series and the Business
Cycle. Econometrica, vol. 57, no. 2, pp. 357-384, Mar. 1989.
M. Billio, M. Getmansky, L. Pelizzon. Phase-Locking and Switching Volatility in Hedge Funds. Internet:
http://www.unive.it/media/allegato/DIP/Economia/Working_papers/Working_papers_2006/
WP_DSE_billio_getmansky_pelizzon_54_06.pdf, Nov. 2006. [Sept. 28, 2012]
A. Ang and G. Bekaert. International asset allocation with Regime Shifts. The Review of Financial Studies, vol.
15, no. 4, pp. 1137-1187, 2002.
Y. Ma, L. MacLean, K. Xu, Y. Zhao. A Portfolio Optimization Model with Regime-Switching Risk Factors for
Sector Exchange Traded Funds. University of Dalhousie, Halifax, NS, Mar. 2011.