Portfolio Selection: Optimizing an Error

Assignment #1 (Based on case from textbook)

Louis R. Piccotti
Assistant Professor of Finance
Director, MS Quantitative Financial Economcis
Spears School of Business
Oklahoma State University
Portfolio optimization review
• Consider the complete probability space Ω, ℱ, ℙ , which a standard 𝐷-
′
1 𝐷
dimensional Brownian motion 𝑊𝑡 = 𝑊𝑡 , … , 𝑊𝑡 is given. 𝑊0 = 0.
• The time period of interest is 𝑡 ∈ 0, 𝑇 and the filtration generated by 𝑊
is:
• Let 𝔽 = ℱ𝑡 0≤𝑡≤𝑇 denote the filtration, where ℱ𝑠 ⊆ ℱ𝑡 for 𝑠 ≤ 𝑡.
• There are 𝑁 risky assets that can be invested in and 1 risk-free asset.
• The evolution of the risk-free asset is governed by:

𝑑𝑆0,𝑡 = 𝑟𝑡 𝑆0,𝑡 𝑑𝑡, with 𝑆0,0 = 1.

Portfolio optimization review (cont.)
• The 𝑁 risky asset price yields evolve according to:

𝑑𝑆𝑛,𝑡 = 𝑆𝑛,𝑡 𝑏𝑛,𝑡 𝑑𝑡 + 𝑑𝑍𝑛,𝑡

′
• where 𝑏𝑡 = 𝑏1,𝑡 , … , 𝑏𝑁,𝑡 is the vector of expected per annum returns and 𝑑𝑍𝑛,𝑡 =
𝑑
σ𝐷 𝜎
𝑖=1 𝑛,𝑑,𝑡 𝑑𝑊 𝑡 , where 𝜎𝑛𝑑,𝑡 is the 𝑁 × 𝐷 volatility matrix.
• Markets are complete iff 𝑁 = 𝐷.
• The yield process for the 𝑁 risky assets evolves according to:

𝑑𝑌𝑛,𝑡 = 𝑆𝑛,𝑡 (𝑏𝑛,𝑡 +𝛿𝑛,𝑡 ) 𝑑𝑡 + 𝑑𝑍𝑛,𝑡

′
• where 𝛿𝑡 = 𝛿𝑛,𝑡 , … , 𝛿𝑁,𝑡 is the vector of rates of dividend payments
Portfolio optimization review (cont.)
• The usual integrability conditions hold:
𝑇
න 𝑟𝑡 𝑑𝑡 < ∞ 𝑎. 𝑠.
0

𝑇
න 𝑏𝑡 𝑑𝑡 < ∞ 𝑎. 𝑠.
0

𝑇
න 𝛿𝑡 𝑑𝑡 < ∞ 𝑎. 𝑠.
0

𝑁 𝐷 𝑇
2
෍ ෍ න 𝜎𝑛𝑑 𝑑𝑡 < ∞ 𝑎. 𝑠.
𝑛=1 𝑑=1 0
Portfolio optimization review (cont.)
• The capital allocation line (CAL) is the convex set of combinations of the
risk-free asset and the risky portfolio made up of the 𝑁 risky assets (the
CAL is linear), such that:

𝔼𝑡 𝑑𝐺𝑡 = 𝑟𝑡 𝑑𝑡 + 𝑤𝑡 𝔼 𝜂𝑡′ 𝑑𝑌𝑛,𝑡 − 𝑟𝑡 𝑑𝑡

′
• where 𝑑𝐺𝑡 denotes the gains process, and 𝜂𝑡 = 𝜂𝑛,𝑡 , … , 𝜂𝑁,𝑡 are ℱ𝑡 -
measurable portfolio weights, such that 𝜂𝑡′ 1 = 1.
• 𝑤𝑡 ∈ 0,1 denotes the ℱ𝑡 -measurable fraction of wealth held in the risky
portfolio and 1 − 𝑤 is held in the risk-free asset.
Portfolio optimization review (cont.)
• The global minimum variance portfolio is the one, which solves the
following problem:

1 ′
min 𝜂𝑡 Σ𝑡 𝜂𝑡 , 𝑠. 𝑡. 𝜂𝑡′ 𝜇𝑡 = 𝜇, 𝜂𝑡′ 1 = 1
𝜂𝑡 2

• where Σ𝑡 = 𝜎𝑡 𝜎𝑡′ and 𝜇𝑡 = 𝔼 𝜂𝑡′ 𝑑𝑌𝑡 .

• The solution for the GMV portfolio weights is:

𝐺𝑀𝑉 Σ𝑡−1 1
𝜂𝑡 = ′ −1
1 Σ𝑡 1
Portfolio optimization review (cont.)
• Let 𝔼 𝑑𝑌𝑡 − 𝑟𝑡 𝑑𝑡 = 𝜇𝑡𝑒 .
𝔼 𝜂𝑡′ 𝑑𝑌𝑡 −𝑟𝑡 𝑑𝑡
• The maximum Sharpe ratio ( 1 ) is the one, which solves the following problem:
𝜂𝑡′ Σ𝑡 𝜂𝑡 2

𝔼 𝜂𝑡′ 𝑑𝑌𝑡 − 𝑟𝑡 𝑑𝑡
max 1 , 𝑠. 𝑡. 𝜂𝑡′ 1 = 1
𝜂𝑡 ′
𝜂𝑡 Σ𝑡 𝜂𝑡 2

• which has the solution:

𝑀𝑆𝑅
Σ𝑡−1 𝜇𝑡𝑒
𝜂𝑡 =
1′ Σ𝑡−1 𝜇𝑡𝑒
Portfolio optimization review (cont.)
• The convex hull of the investment opportunity set (IOS) has the characteristic equation:

𝐴𝑡 ⋅ 𝔼 𝜂𝑡′ 𝑑𝑌𝑡 2
+ −2𝐵𝑡 ⋅ 𝔼 𝜂𝑡′ 𝑑𝑌𝑡 + 𝐶𝑡 − 𝐺𝑡 ⋅ 𝕊𝔻 𝜂𝑡′ 𝑑𝑌𝑡 2
=0

• where 𝐴𝑡 = 1′ Σ𝑡−1 1, 𝐵𝑡 = 1′ Σ𝑡−1 𝜇𝑡 , 𝐶𝑡 = 𝜇𝑡′ Σ𝑡−1 𝜇𝑡 , 𝐺𝑡 = 𝐴𝑡 𝐶𝑡 − 𝐵𝑡2 .

• which plots the expected portfolio return as a function of its associated standard
deviation.

− −2𝐵𝑡 ± −2𝐵 2 − 4𝐴𝑡 𝐶𝑡 − 𝐺𝑡 ⋅ 𝕊𝔻 𝜂𝑡′ 𝑑𝑌𝑡 2

𝔼 𝜂𝑡′ 𝑑𝑌𝑡 =
2𝐴𝑡

1
• For 𝕊𝔻 𝜂𝑡′ 𝑑𝑌𝑡 2
≥ .
𝐴𝑡
Portfolio optimization with errors
• Suppose, that 𝑏𝑡 and Σ𝑡 are not known with certainty, then possible
numerical issues that arise with the MSR portfolio include:
• Low degrees of diversification. There are often extreme position sizes.
• Large portfolio turnovers
• High sensitivities to changes in expected returns, variances, and covariances.
1
• In practice, the MSR portfolio often underperforms the naïve 𝜂𝑡 = 1
𝑁
strategy (equal asset weights).
• To address these issues, we would like to have a measure of risk
inherent in our MSR portfolio allocation.
Statistically equivalent IOS
• Let Γ be the set of possible covariance matrices, such that Σ ∈ Γ.
• Let ℬ be the set of possible drift terms, such that 𝑏 ∈ ℬ.
• Then, the statistically equivalent portfolio set is:

1
𝜎, 𝜇 : 𝑤 ′Σ 𝑇𝑤 2 = 𝜎, 𝜇′𝑇 1 = 𝜇, 𝑤 = 𝑓 𝑏, Σ , Σ ∈ Γ, 𝑏 ∈ ℬ

• That is, it is the set of portfolios which use the weights calculated using the
simulated mean vector and covariance matrix, but then use the original
sample’s mean vector and covariance matrix to calculate the portfolio
expected return and standard deviation.