*In part 2 our mean-variance optimal FX portfolio is allowed to choose from multiple models each week based on a measure of goodness (MSSE). The risk-adjusted return improves as a result with the annualized Sharpe Ratio rising to 0.86 from 0.49.*

In part 1 we estimated a sequential multivariate stochastic volatility model on a portfolio of five FX pairs (EURAUD, EURCAD, EURGBP, EURJPY, and EURUSD) and constructed a mean-variance optimized portfolio. Using non-optimized settings the portfolio produced an annualized return of 5.4% compared with 4.1% for the benchmark, but this outperformance was due to higher volatility, and the annualized Sharpe Ratio (SR) of 0.49 failed to match the benchmark’s SR of 0.68.

Our non-optimized model in part 1 did not include autoregressive lags (that is, *d = 0*) and used discount factors close to one (*beta = delta = 0.99)*, resulting in slow evolution of the intercepts and covariance matrix. Today, we will adjust these three parameters in an attempt to improve on the (risk-adjusted) return. Concretely, we let *beta = {0.80, 0.85, 0.90, 0.95, 0.99}*, *delta = {0.95, 0.96, …, 0.99}*, and *d = {0, 1, 3, 5}* resulting in 100 model combinations. This is where sequential estimation shines as we do not need to re-estimate 100 models in batch for every time period in our evaluation period (574 weeks). Our use of weekly data makes batch estimation (much) less of a problem in terms of speed than if we have used higher-frequency data, but imagine if we used 1-minute prices instead (>7,000 observations per week).

Out of the 100 model combinations, in terms of total return the best model delivers 81% (see chart above). This model, which uses *d = 0*,* beta = 0.99 *and* delta = 0.98*, is very close to our original when it comes to both total return performance and the settings used, suggesting that from a total return point of view the parameters we used in part 1 were close to optimal.

However, if we sort by the Sharpe Ratio instead (see chart below), the best model is the one with *beta = 0.80*, *delta = 0.98*, and *d = 3*, which delivers a SR of 0.80, higher than the benchmark’s SR of 0.68. This model includes three autoregressive terms for each FX pair and allows for a very fast evolution of the covariance matrix (i.e. *beta = 0.80*) resulting in a degrees of freedom of just 4. Therefore this model allows much wider tails than a normal distribution – a reasonable feature, we would expect a priori, given that we are dealing with price return data.

Interestingly, the chart also reveals that those models with autoregressive terms generally perform worse than those without (at least with respect to SR). The first (left-most) 25 combinations, which generally have annualized Sharpe Ratios close to 0.6, are those combinations where we are simply fitting a multivariate stochastic volatility mode (i.e. *d = 0*) for combinations of *beta* and *delta*. However, there are some combinations with higher SR which do include autoregressive terms, including the ‘best model’ mentioned in the previous paragraph.

The performance of the 100 combinations are of course only known in hindsight and hence would not have been of much help at the start of any given week (*n = 1, 2, …, 574*) where we would have had to decide on which model – and hence which expected return vector and predictive covariance matrix – to feed into our mean-variance optimizer.

We could calculate a performance statistic such as annualized SR or total return on a rolling basis and choose our model each week accordingly. Instead, each week we calculate the mean squared standardized 1-step forecast errors (MSSE) over a lookback window of 52 weeks (see Triantafyllopoulos [2008], page 7, for details) – similar to the lookback window used in the calculations for the benchmark portfolio in part 1. We then average the MSSE across the five FX pairs to arrive at a measure of goodness. If the model performs well across both lookback window and FX pairs then the measure should be close to one. If it is below one then the model generally predicts too large variances and it is above one then the model generally predicts too small variances.

The portfolio delivers a total return of 43.7% which translates to an annualized return of around 3.3%. This is well below the annualized return of 5.4% achieved with the ‘default settings’, but that was produced via high leverage and high volatility. The drawdowns – as should be clear from the chart above – are much smaller in this portfolio with the largest drawdown at 4.4% and the annualized SR is 0.86 – even higher than the ‘best SR model’ found above.

Because our portfolio is allowed to switch between combinations according to the goodness measure (average MSSE) it can switch between models with high or low predicted covariances and between models with and without autoregressive lags depending on the best average MSSE each week.

The selected model includes five autoregressive lags per FX pair in 287 of the 574 weeks (50%), three lags in 131 weeks, one lag in 101 weeks and zero lags (i.e. a multivariate stochastic volatility model) in 55 weeks. The VAR parameters are allowed to evolve at a moderate pace (*delta = 0.95*) in 271 weeks while the covariance matrix mostly evolves at a moderate-to-slow pace with 522 weeks spent in combinations where *beta >= 0.95*. However, in 52 weeks the selected model has a *beta* of less than or equal to 0.9.

To demonstrate the robustness of the portfolio’s performance to specific model combinations we randomly exclude 10% of the combinations and re-run the optimization. We do this 1,000 times and find that the portfolio continues to perform well with 90% of the annualized Sharpe Ratios in the interval from 0.76 to 0.97 and 95% in the interval from 0.73 to 1.00. We need to exclude well north of 50% of the combinations before we see a material effect on the SR.

The portfolio changes its leverage based on the predicted covariance, the predicted return vector and the required return (10% at an annualized rate). No less than 448 weeks (78%) are spent with a leverage of less than 1 while the portfolio is leveraged at least two times (gross exposure of at least 200%) in 73 weeks. This helps explain the relatively smooth cumulative return chart above.

Leverage reached a high of 4.38 on August 23, 2013 and net exposure (to EUR) climbed to 1.49, meaning that the portfolio had nearly 150% of net long exposure to the Euro during the following week. Similarly, net exposure reached a low of -1.33 on June 21, 2013, indicating that the portfolio was heavily biased against the Euro during the following week.

These figures compare with an average leverage of 0.71 and an average net exposure of 0.00. The fact that net exposure is (very close to) zero is positive given that we have chosen an unconstrained mean-variance optimization. Had we constrained the portfolio weights to sum to one as is typically done, we would in effect have placed a long bet on the Euro relative to the five other currencies (AUD, CAD, JPY, GBP, and USD), thereby assuming – or at least betting on – a positive drift in the five FX pairs during our test period (2005-2015).

In this part 2 we have shown how to (estimate and) select a model sequentially based on a measure of goodness (average MSSE). Based on this measure we can choose the best model each week and use the model’s output (prediction return vector and prediction covariance matrix) for determining the mean-variance optimal weights. One can test many more combinations than the 100 used above and also use another (or multiple) measure(s) of goodness. Furthermore, one can add complexity to the model by incorporating an autoregressive process for the volatility precision covariance matrix (see Triantafyllopoulos, 2013) or move over to particle filters (and perhaps include regime switching, see e.g. Bao et al., 2012).

##################################################################### ### Time-varying Vector Autoregression with Stochastic Volatility ### ##################################################################### TVVARSV <- function(x, AR = 0, beta = 0.99, delta = 0.99, lookback = ceiling(NROW(x)/10)) { x <- as.matrix(x) N <- NROW(x) # The number of observations per time series J <- NCOL(x) # The number of time series # Constants q <- 1/(1 - beta) k <- (beta * (1 - J) + J)/(beta * (2 - J) + J - 1) # Prior specification m <- matrix(0, J * AR + 1, J) P <- diag(0.01, J * AR + 1, J * AR + 1) S <- diag(0.02, J, J) dinv <- diag(1/sqrt(delta), J * AR + 1, J * AR + 1) jnam <- paste("J", 1:J, sep = "") cnam <- "Int" if (AR > 0) for (a in 1:AR) cnam <- c(cnam, paste("AR", a, "_", jnam, sep = "")) # Storage out <- list(means = array(NA, dim = c(N, J, 4), dimnames = list(NULL, jnam, c("actual", "pred", "error", "scaled"))), cov = array(NA, dim = c(N, J, J), dimnames = list(NULL, jnam, jnam)), stats = array(NA, dim = c(N, J, 4), dimnames = list(NULL, jnam, c("ME", "MAE", "RMSE", "MSSE"))), df = q * beta, beta = beta, delta = delta, AR = AR) for (n in (AR + 1):N) { xn <- matrix(x[n, ], J, 1) fn <- matrix(1) if (AR > 0) fn <- rbind(fn, matrix(x[(n - 1):(n - AR), ], ncol = 1, byrow = TRUE)) # Prediction R <- dinv %*% P %*% dinv Q <- as.numeric(t(fn) %*% R %*% fn) + 1 ycov <- Q * (1 - beta)/(3 * beta * k - 2 * k) * S pred <- t(m) %*% fn # If xn contains missing values then use the predictions xn <- ifelse(is.na(xn), pred, xn) err <- xn - pred zrr <- solve(t(chol(ycov))) %*% err out$means[n, , "actual"] <- as.numeric(xn) out$means[n, , "pred"] <- as.numeric(pred) out$means[n, , "error"] <- as.numeric(err) out$means[n, , "scaled"] <- as.numeric(zrr) out$cov[n, , ] <- ycov # Update K <- R %*% fn / Q m <- m + K %*% t(err) P <- R - tcrossprod(K) * Q S <- S/k + tcrossprod(err)/Q } out$stats[, , "ME"] <- apply(out$means[, , "error", drop = F], 2, TTR::runMean, n = lookback) out$stats[, , "MAE"] <- apply(abs(out$means[, , "error", drop = F]), 2, TTR::runMean, n = lookback) out$stats[, , "RMSE"] <- apply(out$means[, , "error", drop = F]^2, 2, TTR::runMean, n = lookback) out$stats[, , "MSSE"] <- apply(out$means[, , "scaled", drop = F]^2, 2 ,TTR::runMean, n = lookback) return(out) } ######################## ### Unconstrained MV ### ######################## SeqMeanVar <- function(exp.returns, req.return = 0, covar) { icovar <- solve(covar) weights <- req.return * as.numeric(icovar %*% exp.returns) / (t(exp.returns) %*% icovar %*% exp.returns) return(weights) } #################### ### MAIN PROGRAM ### #################### #### Input: A matrix of FX prices (N x J) with dates as rownames freq <- 52 lookback <- freq * 1 start.date <- "2004-12-31" return.req <- 1.1^(1/52) - 1 N <- NROW(prices) J <- NCOL(prices) start.obs <- which(start.date == rownames(prices)) returns.log <- log(prices[-1, ]/prices[-N, ]) returns.ari <- prices[-1, ]/prices[-N, ] - 1 N <- N - 1 dates <- rownames(returns.log) # Run models comb <- expand.grid(beta = c(seq(0.80, 0.95, 0.05), 0.99), delta = seq(0.95, 0.99, 0.01), AR = c(0, 1, 3, 5)) # No. of combinations cnum <- NROW(comb) # Combination names comb.names <- c(paste("Comb_", 1:cnum, sep = ""), "BM", "Best") # Store all combinations (plus the best and the benchmark) stats.arr <- array(NA, dim = c(N, NROW(comb) + 2, 6), dimnames = list(dates, comb.names, c("Ret", "Exc", "AnnVol", "Lev", "Net", "Stat"))) # A list of models model.list <- vector("list", cnum) # Loop across combinations (cnum + 1 is the benchmark) for (i in 1:(cnum + 1)) { cat("Combination", i, "of", NROW(comb), "\n") if (i <= cnum) { model <- TVVARSV(x = returns.log, beta = comb[i, "beta"], delta = comb[i, "delta"], lookback = lookback, AR = comb[i, "AR"]) stats.arr[, i, "Stat"] <- apply(model$stats[, , "MSSE", drop = F], 1, mean, na.rm = T) model.list[[i]] <- model } for (n in (start.obs + 1):N) { if (i == cnum + 1) { # Historical mean and covariance model.mean <- exp(apply(log(1 + returns.ari[(n - lookback):(n - 1), ]), 2, mean)) - 1 model.cov <- exp(cov(log(1 + returns.ari[(n - lookback):(n - 1), ]))) - 1 } else { # Model mean and covariance model.mean <- exp(model$means[n, , "pred"]) - 1 model.cov <- exp(model$cov[n, , ]) - 1 } # Mean-variance optimization weights.MV <- SeqMeanVar(exp.returns = model.mean, req.return = return.req, covar = model.cov) # Predicted portfolio volatility at annual frequency stats.arr[n, i, "AnnVol"] <- log(sqrt(t(weights.MV) %*% model.cov %*% weights.MV) + 1) * sqrt(freq) # Gross and net exposure stats.arr[n, i, "Lev"] <- sum(abs(weights.MV)) stats.arr[n, i, "Net"] <- sum(weights.MV) # Return stats.arr[n, i, "Ret"] <- sum(weights.MV * returns.ari[n, ]) } } # Excess return stats.arr[, 1:(cnum + 1), "Exc"] <- stats.arr[, 1:(cnum + 1), "Ret"] - matrix(stats.arr[, "BM", "Ret"], N, cnum + 1) for (n in start.obs:N) { # Find the best model using MSSE (lagged one week) best <- which.min((1 - stats.arr[n - 1, 1:cnum, "Stat"])^2) stats.arr[n, "Best", ] <- stats.arr[n, best, ] } # Log returns log.ret <- matrix(log(1 + stats.arr[start.obs:N, , "Ret"]), ncol = cnum + 2) # Annualized returns ann.ret <- exp(apply(log.ret, 2, mean) * freq) - 1 # Annualized (log) Sharpe ratios (risk-free rate = 0%) ann.lSR <- apply(log.ret, 2, mean)/apply(log.ret, 2, sd) * sqrt(freq) # Cumulative returns cum.ret <- rbind(1, apply(1 + stats.arr[start.obs:N, , "Ret", drop = F], 2, cumprod)) tot.ret <- tail(cum.ret, 1) # Drawdowns drawdowns <- cum.ret/apply(cum.ret, 2, cummax) - 1

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