Optimal portfolio management using neural networks - a case study

Neural networks are now a well-established tool for solving classification and forecasting problems in financial applications (compare, e.g., Bol et al., 1996, Evans, 1997, Rehkugler and Zimmermann, 1994, Refenes 1995, and Refenes et al. 1996a) though many practioners are still suspicious against too evident success stories. One reason may be that the construction of an appropriate network which provides a reasonable solution to a complex data-analytic problem is rarely made explicit in the literature. In this paper, we try to contribute to filling this gap by discussing in detail the problem of dynamically allocating capital to various components of a currency portfolio in such a manner that the average gain will be larger than for certain benchmark portfolios. We base our solution on feedforward neural networks which are constructed employing various statistical model selection procedures described in, e.g., (Anders, 1997, or Refenes et al., 1996b). Neural networks which are used as the basis of trading strategies in finance should be assessed differently than in technical applications. The task is not to construct a network which provides good forecasts with respect to mean-square error of some quantities of interest or to provide good approximation of some given target values, but to achieve a good performance in economic terms. For portfolio allocation, the main goal is to achieve on the average a large return combined with a small risk. Therefore, we do not consider forecasts of the foreign exchange (FX-) rate time series using neural networks, but we try to get the allocation directly as the output of a network. Furthermore, we do not minimize some estimation or prediction error, but we try to maximize an economically meaningful performance measure, the risk-adjusted return, directly (compare also Heitkamp, 1996). In the subsequent chapter, we describe the details of the portfolio allocation problem. The following two chapters provide some technical information on how the networks were fitted to the available data and how the network inputs and outputs were selected. In chapter 5, finally, we discuss the promising results.