Asset allocation with Markovian regime switching: efficient frontier and tangent portfolio with regime switching

Abstract

Asset allocation is important for diversifying risk and realizing gains in the financial market. It involves decisions taken under uncertainty based on statistical methods. Returns on financial assets generally present regime switching and there are different distributions of returns in bull and bear markets. Regime switching in the data generating process for returns makes it necessary to reformulate the asset allocation problem. This paper develops asset allocation models with regime switching. Due to the comparative study of asset allocation, portfolios with regime switching enable the space of risk and return to be increased, reduce the risk for each level of return at the mean variance efficient frontier, and have the best risk-return relationship over time.