A Markov-Switching VSTOXX Trading Algorithm for Enhancing EUR Stock Portfolio Performance

Oscar V De La Torre-Torres,Evaristo Galeana-Figueroa,José Álvarez-García

doi:10.3390/math9091030

Oscar V De La Torre-Torres, Evaristo Galeana-Figueroa + Show 1 more

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https://doi.org/10.3390/math9091030

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Abstract

In the present paper, we test the benefit of using Markov-Switching models and volatility futures diversification in a Euro-based stock portfolio. With weekly data of the Eurostoxx 50 (ESTOXX50) stock index, we forecasted the smoothed regime-specific probabilities at T + 1 and used them as the weighting method of a diversified portfolio in ESTOXX50 and ESTOSS50 volatility index (VSTOXX) futures. With the estimated smoothed probabilities from 9 July 2009 to 29 September 2020, we simulated the performance of three theoretical investors who paid different trading costs and invested in ESTOXX50 during calm periods (low volatility regime) or VSTOXX futures and the three-month German treasury bills in distressed or highly distressed periods (high and extreme volatility regimes). Our results suggest that diversification benefits hold in the short-term, but if a given investor manages a two-asset portfolio with ESTOXX50 and our simulated portfolios, the stock portfolio’s performance is enhanced significantly, in the long term, with the presence of trading costs. These results are of use to practitioners for algorithmic and active trading applications in ESTOXX50 ETFs and VSTOXX futures.

Highlights

Volatility futures are a type of security whose development started in the decade of the 1990s [1,2,3] with the inception of Volatility indexes (VSTOXX )
Once we present our aim and motivations for this paper, we structure it as follows: we make a literature review of the previous works that motivated the use of MS-Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models for volatility futures trading
Our aim in this paper is to prove that the use of MS-GARCH models in an ESTOXX50 stock portfolio, diversified with VSTOXX volatility futures, led to better performance against an ESTOXX50 buy-and-hold strategy

Summary

Introduction

Volatility futures are a type of security whose development started in the decade of the 1990s [1,2,3] with the inception of Volatility indexes (VSTOXX ). The term is a cornerstone in security asset pricing models and the rational (quantitative) investment selection process. The focus of the present paper is not to make a formal description of the role of volatility, proxied with either the standard deviation σ or the variance σ2 of a given security’s return time series. It must be mentioned that the expected return of that given security or investment is closely related (and determined) by the risk or volatility level. Financial derivatives have had a special interest in asset pricing since their ancient origins in the Ancient Greek and Japanese cultures [4,5,6], or their more recent origins during the development of the Dutch, French, or English agricultural exchanges from the

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