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Markov Financial Model

# Markov Financial Model

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02/10/2012

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We now develop the EM algorithm for re-estimating the parameters of the multivariate

Gaussian mixture. Let θj = ( µj,Σj,πj) be the jth mixture component, then the parameters

of the model are deﬁned as Θ = (θ1,...,θk)T

. Also deﬁne a hidden variable E[zij] as the

probability of generating the ith observation with the jth mixture. The EM algorithm that

ﬁnds the parameters that maximize the probability of the observation sequence O consists

of the following two steps (we use a mixture of two θ1,θ2 to explain the algorithm):

CHAPTER 3. HMM FOR FINANCIAL TIME SERIES ANALYSIS

39

Estimation step:

Calculate the expected value E[zij] of each hidden variable zij, given that we know the

current values of Θ = (θ1,θ2).

Maximization step:

Calculate a new maximum likelihood value of Θ = (θ 1,θ 2), assuming the value taken on by

each hidden variable zij is the expected value in the ﬁrst step.

In the HMM context, the probability of the hidden variable zij is the intermediate

variable γij(t) we talked about in 3.2. Combining the EM algorithm for multivariate

Gaussian mixtures and the EM algorithm for HMMs, we develop the following formulas

for each of the parameters of the HMM with multivariate Gaussian mixtures as observation

density function:

µim

=

T

t=1δim(t) ot

T

t=1δim(t)

(3.12)

Σ j =

T

t=1δim(t)( oi

µ j)( oi

µ j)T

T

t=1δim(t)

(3.13)

wim =

T

t=1δim(t)

T

t=1δi(t)

(3.14)

a ij =

T

t=1αi(t)aijbj(ot+1)βj(t+ 1)
T

t=1αi(t)βi(t)

(3.15)

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