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Optimization of Portfolio Asset Allocation

CN5111 Ad Interim Report

Group 11

David (A0074327E)

Jansen Gunardi (U094220X)

Russell Mahmood (U094794H)

Valentino Yonathan Febianto D (U094281L)

1

I. Motivations

There has been a massive interest in optimization study of financial investment in the

past decades. The promise of substantial return appeals many investors despite the

underlying risk level of investment (Elton et al, 1998). To manage the risk, an investor

typically resorts to diversification in the form of a portfolio (Yitzhaki, 1982), that is, a

collection of investments owned by an investment company, a financial institution or an

individual.

Our main objective in this project can be summarized as follows:

1. To build different portfolio of different types of investors, i.e from risk-averse to

aggressive investors, from short-term to long-term investors.

2. Simulate the optimized asset in a particular timeline.

3. Comparison of different optimization solvers in the financial modeling context.

II. Background information about investment concepts

Long and short positions

In general, investors can be categorized according to the position they hold: long or

short (Jacobs,1993).

Long position refers to an investor who buys an asset with an expectation that the price

of the asset will rise in the future, earning him a profit. This is the conventional way of

investing in the financial market.

Short position, on the other hand, is a more unorthodox type of investment. An investor

(lets call him Peter) might predict that the value of a particular asset class would

decrease in the future. Therefore, it will not make sense for Peter to buy the asset now,

only to see its value shrinking. There is, however, an arrangement to take advantage of

this situation; Peter could borrow the asset from another investor who already owns the

asset and he can sell the borrowed asset now, earning him a certain amount of money

(say $100,000). After a certain period has passed, as predicted by Peter, the value of the

asset has in fact really gone down (say, to $70,000). The reader might recall that the

initial $100,000 proceeds came from the sales of a borrowed asset. Naturally, Peter has

2

to return this borrowed asset to the due owner. Hence, Peter could buy the asset back

with a price of $70,000 and return it to the original owner. Effectively, Peter has just

earned himself a profit of $30,000 ($100,000 minus $70,000). This is really the idea

behind a short position.

Thus, in terms of profit-making approach, both positions (long and short) starkly

contrast with each other. These positioning strategies are important in portfolio

investment and in our optimization modeling project.

Risk and return

Different types of asset classes have their own unique potential-risk-and-potential-return

profiles. As a rule of thumb, the higher the potential return of a certain investment, the

higher the potential risk will be. In our study, we have defined potential return and

potential risk as follows:

Potential return is defined as the average historical return that a certain asset

has displayed over the years. For example, if a particular asset has historically

had a yearly return of 10%, 8%, 5%, and 12% in year 2009, 2010, 2011 and 2012

respectively (and assuming that this asset only began to exist in year 2009), we

will say that this asset will offer a potential return of 8.7% annually.

Potential risk is defined as the standard deviation of the historical return

distribution. The higher the standard deviation, the riskier the investment is

(Karacabey, 2007). This is because high standard deviation implies the lack of

stability of profits to be earned from a particular investment (Artzner et al, 1999).

To illustrate, asset A had yearly returns of 15%, 30%, -10%, 5%, and -20% over

the past 5 years and asset B had yearly returns of 4%, 5%, 4.5%, 6% and 5%. It

can be easily observed that asset B offers much more stability than asset A and

hence, asset B has a lower risk associated with it.

Leveraged portfolio

An investor can in practice borrow a certain amount of money from his broker to

leverage his portfolio (Fama, 1965). An example will best explain this concept. Lets

come back to Peter, our investor friend. Say, he has $1,000,000 to be invested at his

disposal. Upon doing the calculations, his portfolio is expected to return him 20%

3

annually. If Peter only uses his initial capital, his wealth is expected to grow to

$1,200,000 next year.

Here comes the interesting part. Supposing Peter borrow $500,000 from his broker (with

an interest rate of 5% annually), he would now have $1,500,000 to be invested and with

20% expected return, his investment is expected to grow to $1,800,000 next year. He

will then pay $525,000 back to the broker (with the 5% interest), leaving him with

$1,275,000. Peter has just successfully earned $75,000 additional profit from leveraging.

The caveat, however, is that if the portfolio unexpectedly becomes unprofitable, the

amount of losses that Peter will incur will be higher. In the example above, if the

portfolio loses 10% next year, Peters investments worth will decrease to $1,350,000

and he still needs to return the borrowed $525,000 with interest. After paying all of his

obligations, Peter will be left with $825,000 (versus his initial net worth of $1,000,000).

III. Typical Constraints in Investment Optimization Problem

1. Acceptable risk level: Covariance.

As explained above, standard deviation is an indicator of risk that is inherent in an

investment. As a part of risk management, investors typically set a maximum value to

indicate the risk level they are ready to embrace (Leyffer et al, 2005).

In order to calculate the overall standard deviation of the combined portfolio, it is not

sufficient to only consider each individual assets historical standard deviation alone.

This is because an assets behaviour might be correlated to the others. For example, the

price of gold and stocks tend to be negatively correlated; and the price of gold and silver

tend to be positively correlated.

Therefore, to calculate the overall standard deviation of the combined asset, covariance

(

jk

) that reflects the correlations between any two assets must be introduced.

Covariance measures how much two variables change together. If the price of a stock

rises as the other falls, they are said to have negative covariance. Conversely, if the price

of two stocks rise or fall together, they are said to have positive covariance.

4

For example: From 25

th

July to 8

th

August, SPDR S&P 500 depreciated in value while a

Barclays Treasury Bond appreciated in value. Therefore, they are said to have a negative

correlation within that time span.

Figure 01: The graph showed that in the time spanning from 25

th

July to 8

th

August, the Portfolio

(SPY/SPDR S&P 500) has a negative correlation (i.e. negative covariance) with the Bond (IEF/

iShares Barclays 7-10 Year Treasury Bond Fund).

2. Maximum investment amount.

No investor has an infinite fund for investment. For portfolio planning, investors usually

state the amount they are going to spend for investment.

3. Positioning Constraint

When an investor can only adopt one position given a type of asset, i.e. if he goes short

for gold, he cannot go long for gold. The constraint only allows an investor to take either

one position or not to take any at all. This will be modeled using binary variables.

100

105

110

115

120

125

130

135

140

94

95

96

97

98

99

100

101

102

P

r

i

c

e

(

i

n

$

)

Date

Price of IEF & SPY over 11 July 2011 to 8

August 2011

IEF

SPY

5

4. Piece-wise function of transaction cost:

Every time an investor makes an investment, the broker typically charges a transaction

cost. The transaction cost changes with the volume of transaction. At lower transaction

value, a fixed price is charged and at higher transaction value, a percentage value is

applied as the transaction cost (Konno, 1990).

In this project, the transaction cost used is illustrated by Figure 02, and is

mathematically described as the following piece-wise function:

c(x

j

) = 50, 0 < x

j

$5,000

150, $5,000 < x

j

$20,000

(0.5% x

j

), $20,000 < x

j

$100,000

(0.4% x

j

), $100,000 < x

j

Figure 02: Plot of the Transaction Cost (in Dollars) versus Transaction Volume (in thousands of

Dollars) used in this project.

5. Upper and Lower Bound

Investors usually place upper and lower bound of the amount of money invested in

various assets of their portfolio. Lower bound is usually set at zero while upper bounds

will typically depend on the investors appetite of risk. For example, high-risk investors

generally have higher upper bound for risky investments while low risk investors will

have lower upper bound on the risky investment.

6

6. Regulation-T constraint

Although leveraged portfolio can potentially multiply the returns earned, excessive

leverage can prove detrimental (Mulvey, 1999). As such, various governments have

regulated the amount of leverage that an investor could incur. In the United States, this

is governed by Regulation T; which governs the extension of credit by securities

brokers and dealers in the United States. It controls the margin requirements for stocks

bought on margin. Essentially, Regulation T only allows 50% of the asset purchase to be

done on credit.

These constraints will be mathematically expressed in Model Development section

below. For the ease of perusal, the mathematical expression of the constraints to which

the optimizations model is subjected are numbered corresponding to the sequence of

discussion in this section.

IV. Model Development

Parameters:

r

j

: Expected rate of return of asset j.

jk

: Covariance of asset j and asset k.

u

j

: Maximum amount invested in asset j.

M : Maximum investment amount.

: allowable level of risk (overall portfolios standard deviation.

r

r

: Expected rate of return of riskless asset

j : index of an asset type.

Variables:

x

Lj

: Amount invested in a long asset j.

x

Sj

: Amount invested in a short asset j.

x

C

: cash balance.

x

B

: amount borrowed.

c(x

j

) : cost of purchasing x

j

.

b : Initial amount of cash in riskless asset (e.g. T-bill).

Lj

: Binary variable whether to go long (1) or not (0).

Sj :

Binary variable whether to go short (1) or not (0).

d

1

, d

2

, d

3

, d

4 :

Binary variable for determination of transaction cost function

7

Objective function

Maximize (expected total return total cost):

j = 1, 2, n

subject to:

1. Portfolios overall standard deviation

When j = k,

jk

= 1 (i.e. covariance of the same asset is 1)

2. Sum of Investments

3. Piece-wise function of transaction cost.

To model the piecewise function mathematically, binary variables d

1

, d

2

, d

3

and d

4

are introduced:

(

8

4. Binary Variables Constraint

Lj

+

Sj

1

5. Upper and Lower Bound

Lj

L

Lj

x

Lj

Lj

U

Lj

Sj

L

Sj

x

Sj

Sj

U

Sj

6. Regulation-T constraint.

V. Methodology

The model will be solved in GAMS with four different solvers: CPLEX, GUROBI,

DICOPT and Couenne. CPLEX and GUROBI (MILP solvers) will solve the linearized

version of the model. DICOPT and Couenne will solve the original model, which is

mixed integer and nonlinear (MINLP solvers). This allows us to compare the linearized

model with the original nonlinear problem and also the performance between the

different solvers.

a. MILP solvers:

CPLEX: Cplex is a powerful Linear Programming (LP) and Mixed Integer

Programming (MIP) solver. For solving LP models, the following algorithms are used:

Primal Simplex algorithm

Dual Simplex algorithm

Network algorithm

Barrier algorithm

Sifting algorithm

CPLEX is a very stable and reliable LP solver and the default settings are almost always

sufficient to get an optimum solution with excellent solution time. However, the user

can also finetune the algorithm by changing the tuning parameters.

9

The MIP algorithm of CPLEX is an implementation of branch-and-bound search with

modern algorithmic features such as cuts and heuristics.

GUROBI: Gurobi solves LP problems using several alternate algorithms such as: dual

simplex algorithm, primal simplex algorithm etc. Gurobi solves MILP problem by

decomposing it into a series of LP sub-problems and then solve each sub-problem using

Branch and cut algorithm. Gurobi is currently the performance benchmark winner, as it

provides the fastest solving times. It exploits the modern multi core processors. The

disadvantage of Gurobi is the interface. It allows only the usage of restricted set of

functions, parameters and attributes, which can be accessed via the programming

languages C, C++, Java, .NET, Python or GAMS. Despite these restrictions its a

powerful solver.

b. MINLP solvers:

DICOPT: DICOPT program is used to solve mixed integer non-linear programming

that involves linear binary or integer variables and linear and non-linear continuous

variables. The program is based on the extensions of the outer-approximation algorithm

for the equity relaxation strategy. The MINLP algorithm inside DICOPT solves a series

of NLP and MIP sub-problems. These sub-problems can be solved using any NLP

(Nonlinear Programming) or MIP (Mixed Integer Programming) solver that runs under

GAMS.

Couenne: Couenne is a branch and bound algorithm to solve Mixed Integer Nonlinear

Programming (MINLP) problems. It aims at finding global optima of non-convex

MINLPs. It implements linearization, and branching methods within a branch and bound

framework.

VI. Future Works

The next steps of our project will mainly consist of five parts.

Firstly, we will process the historical prices of various asset classes in different period

and we will process the data to obtain the parameters needed for our optimization

analysis e.g., average historical return, average historical standard deviation,

covariance between any two assets, etc.

10

Secondly, we will attempt to introduce other constraints to make our model as realistic

as possible. For example, other risk measures such as Value at Risk (VaR) and

conditional Value at Risk (CvaR) will be introduced in our model, in addition to overall

standard deviation of the portfolio; so that the risk profile of the investment portfolio

could be accurately depicted (Uryasev,2000).

Thirdly, we will write the optimization programs and solve them using the

abovementioned solvers. Subsequently, we will compare and analyse the performance of

the different solvers to determine the suitability of these solvers for our particular

problem.

Fourthly, we will simulate our optimized portfolio in a particular timeline to test the

performance and robustness of our optimized assets.

Last but not least, we will also discuss about potential applications of our model outside

the realm of finance.

11

VII. References

Artzner, P., Delbaen, F., Eber, J. M., and Heath, D. (1999). Coherent measures of risk.

Mathematical Finance 9, 203228.

Elton, J.E. and Gruber, M.J. (1998), Modern Portfolio Theory and Investment Analysis

(6th edition), John Wiley & Sons, New York.

Fama, E. F. (1965), The Behavior of Stock-Market Prices, The Journal of Business,

38, No. 1, 34-105.

Jacobs, B. I., and Levy, K. N. (1993). Long/short equity investing. Journal of Portfolio

Man- agement 20, 5263.

Karacabey, A. A. (2007), Risk and Investment Opportunities in Portfolio

Optimization, European Journal of Finance and Banking Research, 1, No. 1.

Konno, H. (1990), Piecewise linear risk functions and portfolio optimization, Journal of

the Operations Research Society of Japan 33, 139156.

Leyffer, S., and Pang, J. S. (2005). On the global minimization of the value-at-risk.

Optimization Methods and Software 19, 611631.

Mulvey, J.M. (1999), Incorporating transaction costs in models for asset allocation. In:

Ziemba, W. et al., (eds.), Financial Optimization, Cambridge University Press, New

York pp. 243259.

Uryasev, S. (2000), Conditional Value-at-Risk: Optimization Algorithms and

Applications, Computational Intelligence for Financial Engineering, 49-57.

Yitzhaki, S. (1982). Stochastic dominance, mean variance and Ginis mean difference.

American Economic Review 72, 178185.

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