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Multi-period mean-variance portfolio selection with Markov regime

switching and uncertain time-horizon

Article  in  Journal of Systems Science and Complexity · February 2011

DOI: 10.1007/s11424-011-9184-z

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Huiling Wu Zhong-Fei Li
Central University of Finance and Economics Sun Yat-Sen University
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J Syst Sci Complex (2011) 24: 140–155

MULTI-PERIOD MEAN-VARIANCE PORTFOLIO

SELECTION WITH MARKOV REGIME SWITCHING
AND UNCERTAIN TIME-HORIZON∗
Huiling WU · Zhongfei LI

DOI: 10.1007/s11424-011-9184-z
Received: 1 July 2009 / Revised: 6 May 2010
The
c Editorial Office of JSSC & Springer-Verlag Berlin Heidelberg 2011

Abstract This paper investigates a multi-period mean-variance portfolio selection with regime switch-
ing and uncertain exit time. The returns of assets all depend on the states of the stochastic market
which are assumed to follow a discrete-time Markov chain. The authors derive the optimal strategy and
the efficient frontier of the model in closed-form. Some results in the existing literature are obtained
as special cases of our results.
Key words Dynamic programming, Markov regime switching, mean-variance, portfolio selection,
uncertain time-horizon.

1 Introduction
Portfolio selection is to search a best allocation of wealth among different assets in markets.
The mean-variance model pioneered by Markowitz[1] provides a fundamental basis for portfolio
selection and has stimulated hundreds of extensions and applications. One of them is to ex-
tend the original static mean-variance model to discrete-time dynamic mean-variance models.
This line is full of challenges and enormous difficulties and has not made a great breakthrough
until the paper of Li and Ng[2] , which derived the analytical optimal portfolio policy by us-
ing an embedding technique. Since then, there has been a fast development in the dynamic
mean-variance theory. For instance, Guo and Hu[3] investigated a multi-period mean-variance
portfolio optimization problem with uncertain exit time. Leippold, Trojani, and Vanini[4] stud-
ied a multi-period mean-variance model for asset-liability management. Zhu, Li, and Wang[5]
investigated multi-period mean-variance portfolio with risk control over bankruptcy. Some
other generalizations can be found in [6].
The works mentioned above only consider one state of the market mode that reflects the
state of the underlying economy, the mood of investors in the market, and other economic fac-
tors. In the real world, however, the market mode may have a finite number of states, such as
Huiling WU
School of Mathematics and Computational Science, Sun Yat-sen University, Guangzhou 510275, China.
Email: angelling168@163.com.
Zhongfei LI
Corresponding author. Lingnan (University) College, Sun Yat-sen University, Guangzhou 510275, China.
Email: lnslzf@mail.sysu.edu.cn.
∗ This research is supported by the National Science Foundation for Distinguished Young Scholars under Grant

No. 70825002, the National Natural Science Foundation of China under Grant No. 70518001, and the National
Basic Research Program of China 973 Program, under Grant No. 2007CB814902.
 This paper was recommended for publication by Editor Shouyang WANG.
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 141

“bullish” and “bearish”, and could switch among them. This is so called regime switching. In
a market with regime switching, the market parameters, such as the bank interest rate, stocks
appreciation rates, and volatility rates, depend on the market mode and can be quite different
in different states. Recently, there has been a growing interest in portfolio selection with regime
switching. For example, Zhou and Yin[7] investigated a continuous-time mean-variance port-
folio selection model with regime switching while Yin and Zhou[8] and Çakmak and Özekici[9]
considered a discrete-time version. Çelikyurt and Özekici[10] generalized the model of Çakmak
and Özekici[9] by considering quadratic utility function and safety-first rule. Wei and Ye[11]
studied a multi-period mean-variance portfolio optimization model with bankruptcy control in
a stochastic market. Chen, Yang, and Yin[12] investigated an asset-liability management prob-
lem with regime switching by adopting the techniques of Zhou and Yin[7] . For more detailed
discussions on this subject, the interested readers are referred to Costa and Araujo[13] .
In the above mentioned mean-variance models with regime switching, the time horizon of
the whole investment process is always assumed to be certain. But an investment horizon is
practically never known with certainty at the beginning of initial investment decisions because
the investor might be forced to abandon his/her original investment plan for some unexpected
affairs. Therefore, recently some researchers pay their attention to mean-variance portfolio
selection with uncertain time horizon. For instance, Martellini and Urošević[14] generalized
Markowitz[1] to the situations involving an uncertain exit time and get some useful conclusions
when the exit time is either independent of or dependent on the asset returns. Yi, Li, and Li[15]
derived an analytical optimal strategy and efficient frontier for the mean-variance model of a
multi-period asset-liability management problem under the assumption that the uncertain exit
time follows a given distribution. For some early works on uncertain time horizon, one can refer
to Yaari[16] , Hakansson[17], Merton[18] , and Richard[19] .
As far as we know, there is no literature on dynamic mean-variance portfolio selection with
both regime switching and uncertain exit time. This paper will focus on this study. We derive
the optimal strategy and the efficient frontier in closed-form for a multi-period mean-variance
portfolio selection problem with both regime switching and uncertain exit time.
This paper proceeds as following. In Section 2, our problem and primary notations are
described. An auxiliary problem is also constructed. Section 3 is devoted to the optimal
strategy of the auxiliary problem. Sections 4 and 5 are concerned with the explicit expressions
of the optimal strategy and the efficient frontier for the original problem, respectively. The
same known results in the literature are given as special cases in Section 6. Section 7 concludes
the paper.

2 Notations and Problem Formulation

We assume that an investor joins the market at time 1 with an initial wealth x1 and plans
to process his/her investment in planed T consecutive time periods. But he/she has to abandon
his/her investment plan at an uncertain time τ for some reasons. We assume that it is known
that
Pt = P (τ = t), t = 1, 2, · · · , T ; PT +1 = P (τ ≥ T + 1).
We let Sn denote the state of the market at the beginning of period n (i.e., the time interval
[n, n+1]) and suppose that {Sn , n = 1, 2, · · · } is a time-homogeneous Markov chain with regime
space S = {1, 2, 3, · · · , L} and transition matrix Q. To make readers better understand the
economic meaning of market states and transition matrix, here we can give a realistic example.
As we know, the movements of a market on the whole can be viewed as a composition of a
primary movement and secondary movement. In the primary movement, the market trends
142 HUILING WU · ZHONGFEI LI

include broad upward and broad downward which might last several years. In the secondary
market movement, the market trends include significant decline in a bull market and strong
recovery in a bear market which might last several weeks or months. Let Sn = (Sn,1 , Sn,2 ),
where Sn,1 ∈ {a, b} represents the primary market trend at time n (state a and b represent
up-trend and down-trend, respectively) and Sn,2 ∈ {c, d} represents the secondary market
trend at time n (state c and d represent decline in a bull market and recovery in a bear
market, respectively). Let 1, 2, 3, 4 denote the state (a, c), (a, d), (b, c), (b, d), respectively, then
the market states could switch among {1, 2, 3, 4}. If the market state is 1, it means that the
primary market trend is broad upward but has significant decline, and so on. Market states
will change over time, when market state at time n is i, it will switch to j (i, j ∈ {1, 2, 3, 4})
at time n + 1 with probability Q(i, j). One-step transition probability Q(i, j), an element of
transition matrix Q, can be determined by historical data.
There are m + 1 assets in the market whose returns depend on the states of the market. The
riskless asset has deterministic and positive return rf (i) and the m risky assets have random
returns Rn (i) = (Rn,1 (i), Rn,2 (i), · · · , Rn,m (i)) in period n at state Sn = i, where Rn,k (i)
denotes the random return of the kth asset in period n at state Sn = i, and the superscript 
stands the transpose of a matrix or vector.
We make the following assumptions throughout this paper.
A1 For any i ∈ S, the random returns R1 (i), R2 (i), · · · , RT (i) are identically distributed
with the same distribution function. In different periods, the random returns are independent,
i.e., as long as n = m, Rn (i) is independent to Rm (j) for all i, j ∈ S.
A2 The Markov chain S and the returns are mutually independent in the following sense:

Pn (Sn+1 = j, Rn (Sn ) ∈ B) = Pn (Sn+1 = j) Pn (Rn (Sn ) ∈ B)

for all B ∈ B(Rm ), j ∈ S and n = 1, 2, · · · , T ;

   
Pn Sn+1 = j, rnf (Sn ) ∈ (a, b) = Pn (Sn+1 = j) Pn rnf (Sn ) ∈ (a, b)
for all (a, b) ∈ R, j ∈ S and n = 1, 2, · · · , T , where Pn is the probability based on the information
up to time n and B(Rm ) is the Borel σ-algebra on Rm .
A3 0 < PT +1 ≤ 1. It’s a rational assumption because if PT +1 = 0, then the investor
will definitely quit his/her investment before time T + 1 and it’s not necessary to consider the
investment in T consecutive time periods.
A4 Short selling is allowed for all risky assets in all periods. Unlimited borrowing and
lending are permitted for the riskless asset with the interest rate equal to the rate of return of
the riskless asset during that period. Transaction costs are not taken into account.
A5 Capital additions or withdrawals are forbidden for all assets in all periods.
Furthermore, we use the following notations in this paper.
N1 Q(i, j): an element of transition matrix Q, is the one-step transition probability from
i to j (i, j ∈ S). Qm (i, j) is the m-step transition probability, which can be obtained as an
element of matrix Qm , the mth power of Q.
rk (i) = E[Rn,k (i)]: the mean return of the kth risky asset at state i;
σkl (i) = Cov (Rn,k (i), Rn,l (i)): The covariance between the kth and lth risky assets at state
i;
e
Rn,k (i) = Rn,k (i) − rf (i): the excess return of the kth risky asset at period n at state i;
 e 
Rne (i) = Rn,1 e
(i), Rn,2 e
(i), · · · , Rn,m (i) ;
 e 
rke (i) = E Rn,k (i) = rk (i) − rf (i);

re (i) = (r1e (i), r2e (i), · · · , rm
e
(i)) , which is assumed to be nonzero.
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 143

 e e

Cov Rn,k (i), Rn,l (i) = Cov (Rn,k (i), Rn,l (i)) = σkl (i),
σ(i) = (σkl (i))k,l=1,2,··· ,m , which is assumed to be positive definite.
Here we might remind that in the notations σ(i) and re (i), i doesn’t denote the ith row of a
matrix or the ith entry of a vector but means that the matrix or vector depends on the market
state i, which is different from the notations about matrix or vector in N3–N6 as below.
N2 Ei (Z) = E(Z|S1 = i), Di (Z) = Ei (Z 2 ) − [Ei (Z)]2 .
N3 Denote by Q(i) the ith row of Q. In a general way, we let a(i) be the ith component of
a vector a except the notations in N1, and let diag(a) be the diagonal matrix whose diagonal
elements are the components of a. Further let 1 = (1, 1, · · · , 1) .
N4 For transition matrix Q and a L-dimension column vector a, we define the matrix
n
Qa = Qdiag(a), the matrix Qna = nth power of Qa , and the vector Qa = Qna 1. In particular,
0 1
we define Qa = 1, Qa = Qa = Qa 1 = Qa.
N5 If vectors a, b, c have the same dimension, then a · c/b denotes a vector whose ith entry
2
is a(i)c(i)/b(i) and a2 a vector with (a2 )(i) = [a(i)] .
N6 h, g and q are L-dimension column vectors whose ith component are, respectively,

h(i) = re (i) E −1 [Rne (i)Rne (i) ] re (i),

g(i) = rf (i) (1 − h(i)) ,
q(i) = rf2 (i) (1 − h(i)) .

hm , hm and αm (m = 2, 3, · · · , T +1) are column vectors whose ith component are, respectively,
T +1 k−m
Pk Qg (i)
hm (i) = k=m k−m
h(i),
T +1
k=m Pk Qq (i)
 T +1 k−m 2
k=m Pk Qg (i)
hm (i) =  h(i),
k−m
T +1
k=m Pk Qq
(i)
 k−m

2
T +1
k=m Pk Qg (i)
αm (i) =  k−m
h(i).
T +1
k=m Pk Qq (i)

In addition, we define
αT +1 (i) = PT +1 h(i),
αT +2 (i) = 0.
n
For the sake of convenience, we set k=m Ak = 0 if n < m for any {Ak }.
Now, we define Wn as the wealth available for investment at time n (n = 1, 2, · · · , T + 1)
and un = (un,1 , un,2 , · · · , un,m ) as the amounts invested in the risky assets (1, 2, · · · , m) at
time n (n = 1, 2, · · · , T ). Then, the wealth dynamics is

Wn+1 = rf (Sn )Wn + Rne (Sn ) un , n = 1, 2, · · · , T.

The investor wants to find an optimal investment strategy in the uncertain time-horizon to
maximize his/her final wealth while minimize his/her risk. Given S1 = i ∈ S, we formulate the
portfolio selection problem as:
  
max Ei (W(T +1)∧τ ) − ωDi (W(T +1)∧τ )
P (ω)
s.t. Wn+1 = rf (Sn )Wn + Rne (Sn ) un , n = 1, 2, · · · , T,
144 HUILING WU · ZHONGFEI LI

where ω > 0 is a given real number and represents the risk aversion factor.
Since the objective function of problem P (ω) contains the term Di (W(T +1)∧τ ), the stochastic
dynamics approach cannot be applied directly. We introduce the following auxiliary problem:
⎧  
⎨ max Ei λW 2
(T +1)∧τ − ωW(T +1)∧τ
A(λ, ω)
⎩ s.t. W = r (S )W + Re (S ) u , n = 1, 2, · · · , T.
n+1 f n n n n n


Let d(u, ω) = 1 + 2ωEi (WT +1∧τ )u , and define

Π A (λ, ω) = {u|u is an optimal policy of A(λ, ω)},

Π (ω) = {u|u is an optimal policy of P (ω)}.

The relationship between ΠA (λ, ω) and Π (ω) is summarized in the theorem below.
Theorem 1 For any u∗ ∈ P (ω), then u∗ ∈ ΠA (d(u∗ , ω), ω); Conversely, if u∗ ∈ ΠA (λ∗ , ω),
then a necessary condition for u∗ ∈ Π (ω) is λ∗ = 1 + 2ωEi (WT +1∧τ )|u∗ .
The proof is similar to that of Liand Ng[2] and hence omitted here.
Theorem 1 implies that Π (ω) ⊆ ΠA (λ, ω). It is clear that the optimal portfolio policy of
λ
P (ω) can be generated by solving the auxiliary problem A(λ, ω) which is separable in the sense
of dynamic programming. Therefore, we can find a suitable λ∗ which can make u ∈ ΠA (λ∗ , ω)
become the optimal strategy of problem P (ω). The second part of Theorem 1 gives the necessary
condition that λ∗ should satisfy.

3 Solution to the Auxiliary Problem A(λ, ω)

It is obvious that the auxiliary problem can be equivalently written as
⎧ T +1 
⎪
⎪ 
⎨ max E 2
Pn (λWn − ωWn )
i
A(λ, ω)
⎪
⎪
n=1
⎩ s.t. W e 
n = 1, 2, · · · , T.
n+1 = rf (Sn )Wn + Rn (Sn ) un ,

We first demonstrate the properties of E [Rne (i)Rne (i) ], h(i), g(i) and q(i) to show the exis-
tence of the optimal strategy of A(λ, ω).
Lemma 1 E [Rne (i)Rne (i) ] is a positive definite matrix for i ∈ S and n = 1, 2, · · · , T .
Proof This is straightforward because E [Rne (i)Rne (i) ] = σ(i) + re (i)re (i) and σ(i) is
assumed to be positive definite.
Lemma 2 0 < h(i) < 1, g(i) > 0 and q(i) > 0 for i ∈ S.
Proof Since
σ(i)−1 re (i)re (i) σ(i)−1
E −1 [Rne (i)Rne (i) ] = σ(i)−1 − ,
1 + re (i) σ(i)−1 re (i)
we have
re (i) σ(i)−1 re (i)
h(i) = .
1 + re (i) σ(i)−1 re (i)
Hence, 0 < h(i) < 1 because re (i) = 0 and σ(i) is positive definite. This together with the
definition of g(i) and q(i) immediately implies that g(i) > 0 and q(i) > 0.
We introduce the following lemma to achieve some primary results of this paper.
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 145

Lemma 3 For any vector a in N 6,

 n 
 n−1
Ei a(Sk ) = Qa (i), n = 2, 3, · · ·.
k=2

Proof When n = 2,
 2

  1
Ei a(Sk ) = Ei [a(S2 )] = Q(i, j)a(j) = Qa (i).
k=2 j∈S

Suppose the conclusion holds for n. Then for n + 1,

n+1   n+1  
   

Ei a(Sk ) = Q(i, j)a(j)E a(Sk ) S2 = j

k=2 j∈S k=3
 n 
 
= Q(i, j)a(j)Ej a(Sk )
j∈S k=2
 n−1 n−1
= Qa (i, j)Qa (j) = (Qa Qa )(i)
j∈S
n
= (Qa Qn−1
a 1)(i) = (Qna 1)(i) = Qa (i),
that is, the conclusion is true for N + 1. By induction, the conclusion holds for all n ≥ 2.
Now, we begin to derive the optimal policy of the auxiliary problem by using the dynamic
programming approach. Define the value functions
 T +1  
 
2 
fn (i, xn ) = max E Pk (λWk − ωWk ) Sn = i, Wn = xn , n = 1, 2, · · · , T + 1.
un ,··· ,uT 
k=n

Then we have the Bellman’s equation

  
fn (i, xn ) = max E Pn (λxn − ωx2n ) + fn+1 (Sn+1 , Wn+1 ) Sn = i, Wn = xn
un
  
2 e 
= max E Pn (λxn − ωxn ) + Q(i, j)fn+1 (j, rf (i)xn + Rn (i) un ) (1)
un
j∈S

for n = T, T − 1, · · · , 1, with the boundary condition

fT +1 (i, xT +1 ) = PT +1 (λxT +1 − ωx2T +1 ). (2)
Theorem 2 The value functions are given by
fm (i, xm ) = −ωm (i)x2m + λm (i)xm + αm (i), m = 1, 2, · · · , T + 1, (3)
where
T
 +1
k−(m+1)
ωm (i) = ωq(i) Pk Qq (i) + ωPm , (4)
k=m+1
T
 +1
k−(m+1)
λm (i) = λg(i) Pk Qg (i) + λPm , (5)
k=m+1

λ2   k−(m+2) 
T +1
λ2
αm (i) = αm+1 (i) + Q Qαk (i). (6)
4ω 4ω
k=m+2
146 HUILING WU · ZHONGFEI LI

The corresponding optimal policy is given by

⎡  ⎤
T +1 k−(m+1)
λ k=m+1 Pk Qg (i)
um (i, xm ) = ⎣  k−(m+1)
− rf (i)xm ⎦ E −1 [Rm
e e
(i)Rm (i) ]re (i) (7)
2ω Tk=m+1
+1
Pk Qq (i)

for m = 1, 2, · · · , T and i ∈ S.
Proof Obviously, (3) holds true for m = T + 1. For m = T ,
 
fT (i, xT ) = max E PT (λxT − ωx2T ) + Q(i, j)PT +1
uT
j∈S


2
· λ (rf (i)xT + RTe (i) uT ) − ω (rf (i)xT + RTe (i) uT )
 
= max PT (λxT − ωx2T ) + PT +1 λrf (i)xT − ωrf2 (i)x2T
uT

+λre (i) uT − 2ωrf (i)xT re (i) uT − ωuT E [RTe (i)RTe (i) ] uT ]} . (8)

The optimization problem in (8) gives the first order condition

λre (i) − 2ωrf (i)xT re (i) − 2ωE [RTe (i)RTe (i) ] uT = 0.

Since E [RTe (i)(RTe (i)) ] is positive definite according to Lemma 1, the optimal solution of (8)
exists and is  
λ
uT (i, xT ) = − rf (i)xT E −1 [RTe (i)RTe (i) ]re (i). (9)
2ω
Substituting (9) into (8) yields

λ2
fT (i, xT ) = −ω [PT +1 q(i) + PT ] x2T + λ[PT +1 g(i) + PT ]xT + PT +1 h(i)
4ω
= −ωT (i)x2T + λT (i)xT + αT (i), (10)

where
ωT (i) = ωPT +1 q(i) + ωPT ,
λT (i) = λPT +1 g(i) + λPT ,
λ2 λ2
PT +1 h(i) =
αT (i) = αT +1 (i).
4ω 4ω
Hence, (3) and (7) hold true for m = T . Now, we assume that (3) and (7) are true for m = n+1.
Then for m = n,

fn (i, xn )
  
2 e 
= max E Pn (λxn − ωxn ) + Q(i, j)fn+1 (j, rf (i)xn + R (i) un )
un
j∈S
  
= max Pn (λxn − ωx2n ) n+1 (i) rf2 (i)x2n + 2rf (i)xn re (i) un + un E [Rne (i)Rne (i) ] un
−ω
un

n+1 (i) [rf (i)xn + re (i) un ] + α
+λ n+1 (i) , (11)
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 147

where

n+1 (i) =
ω Q(i, j)ωn+1 (j)
j∈S
 T +1

  k−(n+2)
= Q(i, j) ωq(j) Pk Qq (j) + ωPn+1
j∈S k=n+2
T
 +1  k−(n+2)
=ω Pk Q(i, j)q(j)Qq (j) + ωPn+1
k=n+2 j∈S
T
 +1  
=ω Pk Qq · Qk−(n+2)
q 1 (i) + ωPn+1
k=n+2
T
 +1
k−(n+1)
=ω Pk Qq (i),
k=n+1


n+1 (i) =
λ Q(i, j)λn+1 (j)
j∈S
 T +1

  k−(n+2)
= Q(i, j) λg(i) Pk Qg (j) + λPn+1
j∈S k=n+2
T
 +1
k−(n+1)
=λ Pk Qg (i),
k=n+1


n+1 (i) =
α Q(i, j)αn+1 (j)
j∈S
 
λ2   k−(n+3) 
 T +1
λ2
= Q(i, j) αn+2 (j) + Q Qαk (j)
4ω 4ω
j∈S k=n+3

λ2  λ2
T
 +1   
= Q(i, j)αn+2 (j) + Q(i, j) Qk−(n+3) Qαk (j)
4ω 4ω
j∈S k=n+3 j∈S

λ2
T
 +1  
= Qk−(n+2) Qαk (i).
4ω
k=n+2

We can find ω n+1 (i) > 0 according to Lemma 2 and the assumption PT +1 > 0. Hence, the
optimal solution of (11) exists and is
 
λn+1 (i)  
un (i, xn ) = − rf (i)xn E −1 Rne (i) (Rne (i)) re (i)
2
ωn+1 (i)
⎡  ⎤
T +1 k−(n+1)
λ k=n+1 Pk Qg (i)  
=⎣  k−(n+1)
− rf (i)xn ⎦ E −1 Rne (i) (Rne (i)) re (i). (12)
T +1
2ω k=n+1 Pk Qq (i)
148 HUILING WU · ZHONGFEI LI

Substituting (12) into (11), we get

 
  n+1 (i) 2
λ
fn (i, xn ) = − [ωPn + n+1 (i)q(i)] x2n
ω 
+ λPn + λn+1 (i)g(i) xn + n+1 (i)
h(i) + α
4ωn+1 (i)
= −ωn (i)x2n + λn (i)xn + αn (i), (13)
where
T
 +1
k−(n+1)
n+1 (i)q(i) = ωPn + ωq(i)
ωn (i) = ωPn + ω Pk Qq (i),
k=n+1
T
 +1
k−(n+1)
n+1 (i)g(i) = λPn + λg(i)
λn (i) = λPn + λ Pk Qg (i),
k=n+1
T +1
n+1 (i)]2
[λ λ2 λ2 
αn (i) = n+1 (i) =
h(i) + α αn+1 (i) + Qk−(n+2) Qαk (i).
4
ωn+1 (i) 4ω 4ω
k=n+2

Equations (12) and (13) means that (3) and (7) hold true for m = n + 1. By induction, the
conclusions of the theorem are true.

4 Solution to the Original Problem

In order to obtain the solution of the original problem, we introduce the following lemmas.
Lemma 4 Under the optimal strategy (7) of the auxiliary problem,
T +1 n  
T +1
  λ   n−k  n−2
Ei W(T +1)∧τ = Pn Qk−2 hk · Qg (i) + P1 x1 + g(i)x1 Pn Qg (i),
2ω n=2 n=2
k=2

  λ2 
T +1 n
  n−k

T
 +1
n−2
2 k−2 2 2
Ei W(T +1)∧τ = Pn Q hk · Q q (i) + P1 x1 + q(i)x1 Pn Qq (i).
4ω 2 n=2 n=2
k=2
Proof By (7), we have
Wn+1 =rf (Sn )Wn + Rne (Sn ) un

= 1 − Rne (Sn ) E −1 [Rne (Sn )Rne (Sn ) ] re (Sn ) rf (Sn )Wn
T +1 k−(n+1)
λ k=n+1 Pk Qg (Sn ) e
+ T +1 k−(n+1)
Rn (Sn ) E −1 [Rne (Sn )Rne (Sn ) ] re (Sn ),
2ω k=n+1 Pk Qq (Sn )
2
 2
Wn+1 = 1 − Rne (Sn ) E −1 [Rne (Sn )Rne (Sn ) ] re (Sn ) rf2 (Sn )Wn2
T +1 k−(n+1)
λ k=n+1 Pk Qg (Sn ) e
+  k−(n+1)
Rn (Sn ) E −1 [Rne (Sn )Rne (Sn ) ] re (Sn )
T +1
ω k=n+1 Pk Qq (Sn )

· 1 − Rn (Sn ) E [Rn (Sn )Rne (Sn ) ] re (Sn ) rf (Sn )Wn
e  −1 e

⎡ ⎤2
T +1 k−(n+1)
2 P Q (S )
λ ⎣ k=n+1 k g n
⎦
+
4ω 2 T +1 P Qk−(n+1) (S )
k=n+1 k q n

· re (Sn ) E −1 [Rne (Sn )Rne (Sn ) ] Rne (Sn )Rne (Sn ) E −1 [Rne (Sn )Rne (Sn ) ] re (Sn ).
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 149

Hence,
λ
E ( Wn+1 | S1 , S2 , · · · , Sn ) = g(Sn )E ( Wn | S1 , S2 , · · · , Sn ) + hn+1 (Sn ),
2ω
 2      2
E Wn+1  S1 , S2 , · · · , Sn = q(Sn )E Wn2  S1 , S2 , · · · , Sn + λ hn+1 (Sn ).
4ω 2
Noting that
E ( Wn | S1 , S2 , · · · , Sn ) = E ( Wn | S1 , S2 , · · · , Sn−1 ) ,
     
E Wn2  S1 , S2 , · · · , Sn = E Wn2  S1 , S2 , · · · , Sn−1 ,
the above equations are recursive equations. By repeatedly using them we can obtain
n
 n+1 n
λ  
E ( Wn+1 | S1 , S2 , · · · , Sn ) = x1 g(Sk ) + hk (Sk−1 ) g(Sl ),
2ω
k=1 k=2 l=k

n
 n+1 n
 2 
  λ2  
E Wn+1 S1 , S2 , · · · , Sn = x21 q(Sk ) + hk (Sk−1 ) q(Sl ).
4ω 2
k=1 k=2 l=k

Under the assumption that S1 = i, we have

Ei (Wn+1 ) = Ei [E ( Wn+1 | S1 = i, S2 , · · · , Sn )]
 n  n+1 n

 λ  
= g(i)x1 Ei g(Sk ) + Ei hk (Sk−1 ) g(Sl )
2ω
k=2 k=2 l=k
n+1

n−1 λ n+1−k
= g(i)x1 Qg (i) + Qk−2 (i, j)hk (j)Qg (j) (by Lemma 3)
2ω
k=2 i∈S

λ  k−2  

n+1
n−1 n+1−k
= g(i)x1 Qg (i) + Q hk · Q g (i),
2ω
k=2

that is,

λ  k−2  

n
n−2 n−k
Ei (Wn ) = g(i)x1 Qg (i) + Q hk · Q g (i), n = 2, 3, · · · , T + 1. (14)
2ω
k=2

Similarly, we can get

λ2  k−2  

n
 2 2 n−2 n−k
Ei Wn = q(i)x1 Qq (i) + Q h k · Q q (i), n = 2, 3, · · · , T + 1. (15)
4ω 2
k=2

Substituting (14) and (15) into

T +1  T +1
   
Ei W(T +1)∧τ = Ei Pn Wn = Pn Ei (Wn )
n=1 n=1

and T +1 
   T
 +1
 
2
Ei W(T +1)∧τ = Ei Pn Wn2 = Pn Ei Wn2 ,
n=1 n=1
150 HUILING WU · ZHONGFEI LI

respectively, we get the conclusion of the lemma.

Lemma 5
T
 +1 n
  
T
 +1 n
  

n−k n−k
0< Pn Qk−2 hk · Qq (i) = Pn Qk−2 hk · Qg (i) < 1. (16)
n=2 k=2 n=2 k=2

Proof First, we have

T
 +1 n
  

n−k
Pn Qk−2 hk · Qg (i)
n=2 k=2
 +1 

T
 +1 T
 n−k

k−2
= Q (i) hk · Pn Qg
k=2 n=k
⎡  ⎤
1 T +1−k 2
T
 +1 P + P Q + . . . + P Q
⎢ k k+1 g T +1 g ⎥
= Qk−2 (i) ⎣ 1 T +1−k
· h⎦.
k=2 Pk + Pk+1 Qq + . . . + PT +1 Qq

Similarly,
T
 +1 n
  

n−k
Pn Qk−2 hk · Qq (i)
n=2 k=2
⎡  ⎤
1 T +1−k 2
T
 +1 P
⎢ k + P Q
k+1 g + · · · + P Q
T +1 g ⎥
= Qk−2 (i) ⎣ 1 T +1−k
· h⎦.
k=2 Pk + P Q
k+1 q + · · · + P Q
T +1 q

T +1 n  n−k


Hence, the equality in (16) holds and it’s obvious n=2 Pn k=2 Qk−2 hk · Qq (i) > 0.
T +1 n k−2  n−k


To prove the inequality n=2 Pn k=2 Q hk · Qq (i) < 1, we discuss the following
two cases.
When T = 1,
T
 +1 n
  
2
  

n−k 2−k
Pn Qk−2 hk · Qg (i) = P2 Qk−2 hk · Qg (i)
n=2 k=2 k=2
 0


= P2 Q0 h2 · Qg (i) = P2 h2 (i),
T +1 k−2 2−2
k=2 Pk Qg (i) P2 Qg (i)
h2 (i) = T +1 k−2
h(i) = 2−2 h(i) = h(i),
k=2 Pk Qq (i) P2 Qq (i)

then by Lemma 2, we have

T
 +1 n
  

n−k
Pn Qk−2 hk · Qg (i) = P2 h2 (i) = P2 h(i) ≤ h(i) < 1;
n=2 k=2

When T ≥ 2, the investment will process at least two periods. So we can claim that
Di (W(T +1)∧τ ) > 0 since Di (W(T +1)∧τ ) measures the risk of the investment at the terminal
time and the risk cannot be completely hedged when all the primal parameters, including the
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 151

return of the riskless asset, depend on the market states modulated by the Markov chain. By
Lemma 4 we have

Di (W(T +1)∧τ )
T +1 n  
T +1
λ2  
k−2 n−k 2 2
 n−2
= Pn Q h k · Qq (i) + P x
1 1 + q(i)x1 Pn Qq (i)
4ω 2 n=2 n=2
k=2
 #2
λ 
T +1 
n  n−k

T+1
n−2
k−2
− Pn Q hk · Qg (i) + P1 x1 + g(i)x1 Pn Qg (i) . (17)
2ω n=2 n=2
k=2

In particular, when x1 = 0 we have

0 < Di (W(T +1)∧τ )

n
 #2
λ2 
T +1   n−k

T +1
λ 
n
  n−k


k−2 k−2
= Pn Q h k · Qq (i) − Pn Q hk · Q g (i) ,
4ω 2 n=2 2ω n=2
k=2 k=2

i.e.,
T +1 n
#2
   n−k

T
 +1 n
  n−k


Pn Qk−2 hk · Qg (i) < Pn Qk−2 hk · Qq (i). (18)

n=2 k=2 n=2 k=2

This together with the equality in (16) implies that the second inequality in (16) is true.
Now, we begin to seek the optimal strategy of the original problem P (ω).
Define the function
   
U (λ) = Ei W(T +1)∧τ − ωDi W(T +1)∧τ ,

where W(T +1)∧τ is the terminal wealth under the optimal strategy of the auxiliary problem.
By Lemma 4, we have
T +1 n  
T +1
λ   n−k  n−2
U (λ) = Pn Qk−2 hk · Qg (i) + P1 x1 + g(i)x1 Pn Qg (i)
2ω n=2 n=2
k=2
 n
λ2 T +1   n−k

T
 +1
n−2
k−2 2 2
−ω P n Q h k · Qq (i) + P1 x1 + q(i)x1 Pn Qq (i)
4ω 2 n=2 n=2
k=2
 2 #
λ 
T +1 n  n−k

T
 +1
n−2
k−2
− Pn Q hk · Qg (i) + P1 x1 + g(i)x1 Pn Qg (i) .
2ω n=2 n=2
k=2

Differentiating it with respect to λ, we obtain

T +1 n  
T +1 n  

1   n−k λ   n−k
U  (λ) = Pn Qk−2 hk · Qg (i) − Pn Qk−2 hk · Qq (i)
2ω n=2 2ω n=2
k=2 k=2
T +1 n
#2
λ  
k−2 n−k
+ Pn [Q (hk · Qg )](i)
2ω n=2
k=2
T +1 n
# 
   n−k

T
 +1
n−2
k−2
+ Pn Q hk · Q g (i) P1 x1 + g(i)x1 Pn Qg (i) .
n=2 k=2 n=2
152 HUILING WU · ZHONGFEI LI

In view of Lemma 5, we have

U  (λ)
 n  n−k

2  n  n−k


T +1 T +1
n=2 Pn k=2 Qk−2 hk · Qg (i) − n=2 Pn k=2 Qk−2 hk · Qq (i)
= < 0.
2ω
Letting U  (λ) = 0, we get the optimal solution of max U (λ) as
λ∈R
 +1 n−2

1 + 2ω P1 x1 + g(i)x1 Tn=2 Pn Qg (i)

λ∗ = T +1 n  n−k

. (19)
1 − n=2 Pn k=2 Qk−2 hk · Qg (i)

Substituting (19) back into (7) gives the optimal policy of the primal problem P (ω), which
is summarized in the following theorem.
Theorem 3 The optimal policy of the primal problem P (ω) is given by
⎡  ⎤
∗ T +1 k−(n+1)
λ P Q
k g (i)  
u∗n (i, xn ) = ⎣ k=n+1 k−(n+1)
− rf (i)xn ⎦ E −1 Rne (i) (Rne (i)) re (i) (20)
2ω Tk=n+1
+1
Pk Qq (i)

for n = 1, 2, · · · , T and i ∈ S.
We remark that it can be verified that solving the equation λ∗ = 1 + 2ω Ei (WT +1∧τ )|u∗
given in Theorem 1 yields the same expression of λ∗ as Equation (19).

5 The Efficient Frontier of the Original Problem

Referring to Lemma 4, we have
T +1 n−2
λ Ei (WT +1∧τ ) − P1 x1 − g(i)x1 n=2 Pn Qg (i)
= T +1 n  
. (21)
2ω k−2 h · Qn−k
n=2 Pn k=2 Q k g (i)

Substituting it into (17) and noting Lemma 5, we get

Di (W(T +1)∧τ )
T +1 n  n−k


1 − n=2 Pn k=2 Qk−2 hk · Qg (i)

=  n  

T +1 k−2 h · Qn−k
n=2 Pn k=2 Q k g (i)
⎧ ⎫2
⎨ T +1 n−2 ⎬
P1 x1 + g(i)x1 n=2 Pn Qg (i)
· Ei (W(T +1)∧τ ) − T +1 n  

⎩ 1 − n=2 Pn k=2 Qk−2 hk · Qg

n−k
(i) ⎭
⎧
2 ⎫
⎪ T +1 n−2 ⎪
⎨ T +1 P 1 + g(i) P
n=2 n g Q (i) ⎬
n−2
+ P1 + q(i) Pn Qq (i) − T +1 n  
x21 . (22)
⎪
⎩ 1 − n=2 Pn k=2 Q k−2 n−k
hk · Q g (i) ⎪
⎭
n=2

Hence, we get
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 153

Theorem 4 The efficient frontier of the original problem is given by (22) for
 +1 n−2
P1 x1 + g(i)x1 Tn=2 Pn Qg (i)
Ei (W(T +1)∧τ ) ≥ T +1 n  n−k

.
1 − n=2 Pn k=2 Qk−2 hk · Qg (i)

Clearly, the efficient frontier is an increasing parabola in the mean-variance plane if we note
Lemma 5.
One can find the tradeoff between the return and risk at the terminal from the efficient
frontier (22). Quite different from the case without Markov regime-switching mechanism, one
cannot obtain a riskless investment in the efficient frontier in the present case since it isn’t a
perfect square any more. It is an anticipated result. Since the interest rate process now is
modulated by a Markov chain, at the beginning of investment one can’t foresee the value of
interest rate which depends on the market states in the future. Thus, the interest rate risk
cannot be completely hedged.

6 Special Cases
Special Case 1 If the exit time is certain, i.e., P1 = P2 = · · · = PT = 0, PT +1 = 1, then
(19) reduces to
T −1
∗
2ωx1 g(i)Qg (i) + 1
λ = ,
1 − b(i)
the optimal strategy (20) reduces to
 T −1 T −n 
2ωx 1 g(i)Qg (i) + 1 Q g (i)
u∗n = T −n
− xn rnf (i) E −1 (Rne (i)Rne (i) ) rne (i),
2ω (1 − b(i)) Q (i)q

and the efficient frontier (22) reduces to

 T −1 2
1 − b(i) x1 g(i)Qg (i)
Di (WT +1 ) = Ei (WT +1 ) −
b(i) 1 − b(i)
  2 
T −1 1 T −1
+ q1 (i)Qq (i) − g(i)Qg (i) x21 ,
1 − b(i)
where 
T
 '  T −k 2 (
k−1
Qg
b(i) = Q T −k
· h (i).
k=1 Qq
We have verified these results are essentially the same as the ones in [9]. Making further
reduction on this condition, we get special case 2.
Special Case 2 When P1 = P2 = · · · = PT = 0, PT +1 = 1 and there is no Markov regime
switching, (19) reduces to
1 + 2ωrfT (1 − h)T x1
λ∗ = ,
(1 − h)T
the optimal strategy (20) reduces to
 
1 + 2ωrfT (1 − h)T x1  
∗
un (xn ) = T −n
− rf xn E −1 Rne (Rne ) re , n = 1, 2, · · · , T,
2ωrf (1 − h) T
154 HUILING WU · ZHONGFEI LI

and the efficient frontier (22) reduces to

(1 − h)T  2
D(W(T +1) ) = E(WT +1 ) − x1 rfT .
1 − (1 − h)T

We have checked these results are essentially the same as the ones in [2] when the riskless return
is a constant and the random excess returns are statistically independent among different time
periods with the same distribution function.
Special Case 3 When there is an uncertain time-horizon but no Markov regime switching
and when there exists only one risk-free asset and one risky asset in the market, then (19)
reduces to T +1

1 + 2ω P1 x1 + x1 n=2 Pn g n−1
λ∗ = T +1 n  T +1 Ps gs−k n−k ,
1 − n=2 Pn k=2  s=k T +1
P qs−k
hg
s=k s

the optimal strategy (20) reduces to

T +1
λ∗ k=n+1 Pk g k−(n+1) re re
u∗n (xn ) = T +1 e 2
− rf xn , n = 1, 2, · · · , T,
2ω k=n+1 Pk q k−(n+1) E[(Rn ) ] E[(Rne )2 ]

and the efficient frontier (22) reduces to

T +1 n  T +1 #2
1 − n=2 Pn k=2 hk · g n−k P1 x1 + x1 n=2 Pn g n−1
D(W(T +1)∧τ ) = T +1 n E(WT +1∧τ ) −  +1 
n=2 Pn k=2 hk · g
n−k 1 − Tn=2 Pn nk=2 hk · g n−k
⎧
2 ⎫
⎪ T +1 ⎪
⎨ T+1 P1 + n=2 Pn g n−1 ⎬
+ P1 + Pn q n−1 − T +1 n x2 ,
⎪ − · n−k ⎪ 1
⎩ n=2 1 P
n=2 n h
k=2 k g ⎭

 T +1
Ps gs−k
where hk =  s=k
T +1 s−k
h .
s=k Ps q
We have verified that these results are essentially the same as the ones in [15] when there
is no liability. The return of risk-free asset rt0 is a constant r0 and the random returns of the
risk asset are statistically independent among different time periods with the same distribution
function.

7 Conclusions
This paper has investigated a multi-period mean-variance portfolio selection problem with
regime switching and uncertain exit time. Where the market regime follows a discrete-time
homogenous Markov chain and the uncertain exit time follows a given distribution. By applying
the embedding techniques of Li and Ng[2] and the dynamic programming approach, we derive
closed-form expressions for the optimal policy and the efficient frontier of the portfolio selection
problem. These results unify some existing ones in literature on discrete-time mean-variance
portfolio selection.
Despite our model is rather general, it still deserves further extension as future research.
For example, 1) as most existing literature, this paper assume that the return distributions of
risky assets at each time period only depend on the market state of that period. However, in
practice, market parameters would depend on both market states and time periods, that is,
 MULTI-PERIOD MEAN-VARIANCE PORTFOLIO SELECTION 155

the distributions in different time period would be different even if the market states in these
periods are identical. So a further research topic should be this case. 2) in this paper, the
uncertain exit time follows a given distribution that is independent of market states and asset
returns. But a more realistic consideration is that the exit decision will have relation to the
investment environments. It is worth to study this situation.

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