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Markov Financial Model

# Markov Financial Model

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Published by: Becky Glymph on Feb 10, 2012

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In previous sections we derived the exponentially weighted estimation rules for the parameters

of the HMGM. We show the formulas with the exponential discount weight η. However,

there is still one problem regarding η: how is the time-dependent variable η deﬁned? In fact

η can be taken as a density function whose distribution is prior knowledge. Our task now

is to ﬁnd an expression of time for η.

A nice property about the exponentially weighted intermediate parameters is that, when

calculating this weighted average, while the large part of weight is given to the recent data,

the information from the early data are not lost. The old data are also included in the ﬁnal

CHAPTER 4. EXPONENTIALLY WEIGHTED EM ALGORITHM FOR HMM

59

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0

2

4

6

8

10

12

14

16

18

20

daily data percentage

daily data

Figure 4.3: The portion of each of the 20 days’ actual data in calculating the EMA for the 20th
day. The last day account for 1/3 of the EMA at day 20. The data earlier than day 10 take up a
very small portion but they are still included in the overall calculation

CHAPTER 4. EXPONENTIALLY WEIGHTED EM ALGORITHM FOR HMM

60

average, by a discounted weight. The older the data, the less important they become, and

thus take up less portion in the average. But their impact never disappear.

Giving more recent data more weight makes the HMM getting sensitive to trend changes

in time series. The HMM will ride on the new trend quickly, without having to make too

many mistakes at the beginning of a new trend before it gets ﬁt for the new trend. That is

one important motivation of replacing the arithmetic average with EMA in the EM update

rule.

Originally, the EMA was invented as a technical analysis tool that deals with ﬁnancial

time series data, such as prices, volume, etc directly. In the EM algorithm for HMM

parameters re-estimation, there are a set of middle variables: αi(t),βi(t),δim(t),δi(t). These

middle variables all have their actual meanings: they indicate the probabilities of some

events at a certain point of time. So these model variables are also related to the time series

data. This is another motivation we rewrite the re-estimation formulas in the form of EMA

of the model variables. We take the denominator of the µ re-estimation for example. From

T

t=1ηtδim(t) we can see each δim(t) at a timing point t is associated with one value of ηt.
The sum can be extended as:

T

t=1 ηtδim(t)

= η1δim(1) +η2δim(2) +···+ηT−1δim(T1) +ηTδim(T) (4.38)

Let ρ = 2

1+k where k is for the multiplier in a k-EMA. Then set ηt by the following rules:

1. If 1tk,ηt = (1ρ)(T−k)

· 1

k;

2. If k < t < T,ηt = ρ·(1ρ)(T−t)
;

3. If t = T,ηt = ρ.

Let δim(t) represent the k-EMA of δim at time t. Based on these rules, the expression

(4.38) is turned into a form of the EMA of the intermediate variable δim(t):

η1δim(1) +η2δim(2) +···+ηT−1δim(T1) +ηTδim(T)

CHAPTER 4. EXPONENTIALLY WEIGHTED EM ALGORITHM FOR HMM

61

= (1ρ)(T−k)

· 1

k ·δim(1) +···+ (1ρ)(T−k)

· 1

k ·δim(k)

·(1ρ)·δim(T1) +ρ·δim(T)

= (1ρ)(T−k)

·δim(k) +ρ·(1ρ)(n−(k+1))

·δim(k + 1)

·(1ρ)(n−(k+2))

·δim(k + 2) +···
·(1ρ)·δim(T1) +ρ·δim(T)

(4.39)

The ﬁrst k terms work together to generate the EMA for the ﬁrst k periods, then from

k + 1 to T, apply Formula (4.35) to δim and induction on Equation (4.39), we can get the

following result:

(1ρ)·

ρ·δim(T1) + (1ρ)·δim(T2)

= (1ρ)·δim(T1) +ρ·δim(T)

= δim(T)

(4.40)

Therefore, the re-estimation formulas ﬁnally came into a form of EMA of some intermediate

variables.

µ im =

T

t=1ηtδim(t)ot

δim(T)

(4.41)

σ im =

T

t=1ηtδim(t)(otµ im)(otµ im)

δim(T)

(4.42)

wim = δim(T)
δi(T)

(4.43)

a ij =

T

t=1ηtαi(t)aijbj(ot+1)βj(t + 1)

αi(T)βi(T)

(4.44)

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