Modeling and asset allocation for financial markets based on a discrete time microstructure model

On the basis of the market microstructure theory and the continuous time stochastic volatilitystyle microstructure model, a discrete time stochastic volatility microstructure model with stateobservability is proposed for describing the dynamics of financial markets. From the discrete time microstructure model proposed, estimates of two immeasurable state variables representing the market excess demand and liquidity respectively may be obtained. A simple trading strategy for dynamic asset allocation, based on the indirectly obtained excess demand information instead of the prediction for price, is presented. An approach to the estimation of the discrete time microstructure model using the extended Kalman filter and the maximum likelihood method is also presented. Case studies on financial market modeling and the estimated model-based asset dynamic allocation control for the JPY/USD (Japanese Yen/US Dollar) exchange rate and Japan TOPIX (TOkyo stock Price IndeX) show satisfactory modeling precision and control performance. PACS. 89.65.Gh Economics, business, and financial markets