Slides by

John
Loucks
St. Edward’s
University

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
 Chapter 5, Part A:
Advanced Optimization Applications

 Data Envelopment Analysis

 Revenue Management
 Portfolio Models and Asset Allocation

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
 Data Envelopment Analysis

 Data envelopment analysis (DEA) is an LP application

used to determine the relative operating efficiency of
units with the same goals and objectives.
 DEA creates a fictitious composite unit made up of an
optimal weighted average (W1, W2,…) of existing units.
 An individual unit, k, can be compared by determining
E, the fraction of unit k’s input resources required by
the optimal composite unit.
 If E < 1, unit k is less efficient than the composite unit
and be deemed relatively inefficient.
 If E = 1, there is no evidence that unit k is inefficient,
but one cannot conclude that k is absolutely efficient.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
 Data Envelopment Analysis

 The DEA Model

Min E
s.t. Weighted outputs > Unit k’s output
(for each measured output)
Weighted inputs < E [Unit k’s input]
(for each measured input)
Sum of weights = 1
E, weights > 0

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
 Data Envelopment Analysis

The Langley County School District is trying to

determine the relative efficiency of its three high
schools. In particular, it wants to evaluate Roosevelt
High.
The district is evaluating performances on SAT
scores, the number of seniors finishing high school,
and the number of students who enter college as a
function of the number of teachers teaching senior
classes, the prorated budget for senior instruction,
and the number of students in the senior class.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
 Data Envelopment Analysis

 Input

Roosevelt Lincoln Washington

Senior Faculty 37 25 23
Budget ($100,000's) 6.4 5.0
4.7
Senior Enrollments 850 700 600

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6
 Data Envelopment Analysis

 Output

Roosevelt Lincoln Washington

Average SAT Score 800 830
900
High School Graduates 450 500
400
College Admissions 140 250
370

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
 Data Envelopment Analysis

 Define the Decision Variables

E = Fraction of Roosevelt's input resources required
by the composite high school
w1 = Weight applied to Roosevelt's input/output
resources by the composite high school
w2 = Weight applied to Lincoln’s input/output
resources by the composite high school
w3 = Weight applied to Washington's input/output
resources by the composite high school

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
 Data Envelopment Analysis

 Define the Objective Function

Minimize the fraction of Roosevelt High School's input
resources required by the composite high school:
Min E

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
 Data Envelopment Analysis

 Define the Constraints

Sum of the Weights is 1:
(1) w1 + w2 + w3 = 1

Output Constraints:
Since w1 = 1 is possible, each output of the composite
school must be at least as great as that of Roosevelt:
(2) 800w1 + 830w2 + 900w3 > 800 (SAT Scores)
(3) 450w1 + 500w2 + 400w3 > 450 (Graduates)
(4) 140w1 + 250w2 + 370w3 > 140 (College Admissions)

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
 Data Envelopment Analysis

 Define the Constraints (continued)

Input Constraints:
The input resources available to the composite school is
a fractional multiple, E, of the resources available to
Roosevelt. Since the composite high school cannot use
more input than that available to it, the input constraints
are:
(5) 37w1 + 25w2 + 23w3 < 37E (Faculty)
(6) 6.4w1 + 5.0w2 + 4.7w3 < 6.4E (Budget)
(7) 850w1 + 700w2 + 600w3 < 850E (Seniors)
Nonnegativity of variables:
E, w1, w2, w3 > 0
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
 Data Envelopment Analysis

 Computer Solution

Objective Function Value = 0.765

Variable Value Reduced Cost
E 0.765 0.000
W1 0.000 0.235
W2 0.500 0.000
W3 0.500 0.000

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
 Data Envelopment Analysis

 Conclusion
The output shows that the composite school is made
up of equal weights of Lincoln and Washington.
Roosevelt is 76.5% efficient compared to this composite
school when measured by college admissions (because
of the 0 slack on this constraint #4).
It is less than 76.5% efficient when using measures
of SAT scores and high school graduates (there is
positive slack in constraints 2 and 3.)

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
 Revenue Management

 Another LP application is revenue management.

 Revenue management involves managing the short-
term demand for a fixed perishable inventory in order
to maximize revenue potential.
 The methodology was first used to determine how
many airline seats to sell at an early-reservation
discount fare and many to sell at a full fare.
 Application areas now include hotels, apartment
rentals, car rentals, cruise lines, and golf courses.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
 Revenue Management

LeapFrog Airways provides passenger service for

Indianapolis, Baltimore, Memphis, Austin, and Tampa.
LeapFrog has two WB828 airplanes, one based in
Indianapolis and the other in Baltimore.
Each morning the Indianapolis based plane flies to
Austin with a stopover in Memphis. The Baltimore based
plane flies to Tampa with a stopover in Memphis. Both
planes have a coach section with a 120-seat capacity.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
 Revenue Management

LeapFrog uses two fare classes: a discount fare D

class and a full fare F class. Leapfrog’s products, each
referred to as an origin destination itinerary fare (ODIF),
are listed on the next slide with their fares and
forecasted demand.
LeapFrog wants to determine how many seats it
should allocate to each ODIF.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
 Revenue Management
Fare ODIF
ODIF Origin Destination Class Code Fare Demand
1 Indianapolis Memphis D IMD 175 44
2 Indianapolis Austin D IAD 275 25
3 Indianapolis Tampa D ITD 285 40
4 Indianapolis Memphis F IMF 395 15
5 Indianapolis Austin F IAF 425 10
6 Indianapolis Tampa F ITF 475 8
7 Baltimore Memphis D BMD 185 26
8 Baltimore Austin D BAD 315 50
9 Baltimore Tampa D BTD 290 42
10 Baltimore Memphis F BMF 385 12
11 Baltimore Austin F BAF 525 16
12 Baltimore Tampa F BTF 490 9
13 Memphis Austin D MAD 190 58
14 Memphis Tampa D MTD 180 48
15 Memphis Austin F MAF 310 14
16 Memphis Tampa F MTF 295 11

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
 Revenue Management

 Define the Decision Variables

There are 16 variables, one for each ODIF:

IMD = number of seats allocated to Indianapolis-Memphis-

Discount class
IAD = number of seats allocated to Indianapolis-Austin-
Discount class
ITD = number of seats allocated to Indianapolis-Tampa-
Discount class
IMF = number of seats allocated to Indianapolis-Memphis-
Full Fare class
IAF = number of seats allocated to Indianapolis-Austin-Full
Fare class

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18
 Revenue Management

 Define the Decision Variables (continued)

ITF = number of seats allocated to Indianapolis-Tampa-
Full Fare class
BMD = number of seats allocated to Baltimore-Memphis-
Discount class
BAD = number of seats allocated to Baltimore-Austin-
Discount class
BTD = number of seats allocated to Baltimore-Tampa-
Discount class
BMF = number of seats allocated to Baltimore-Memphis-
Full Fare class
BAF = number of seats allocated to Baltimore-Austin-
Full Fare class

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
 Revenue Management

 Define the Decision Variables (continued)

BTF = number of seats allocated to Baltimore-Tampa-
Full Fare class
MAD = number of seats allocated to Memphis-Austin-
Discount class
MTD = number of seats allocated to Memphis-Tampa-
Discount class
MAF = number of seats allocated to Memphis-Austin-
Full Fare class
MTF = number of seats allocated to Memphis-Tampa-
Full Fare class

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
 Revenue Management

 Define the Objective Function

Maximize total revenue:
Max (fare per seat for each ODIF)
x (number of seats allocated to the ODIF)
Max 175IMD + 275IAD + 285ITD + 395IMF
+ 425IAF + 475ITF + 185BMD + 315BAD
+ 290BTD + 385BMF + 525BAF + 490BTF
+ 190MAD + 180MTD + 310MAF + 295MTF

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
21
 Revenue Management

 Define the Constraints

There are 4 capacity constraints, one for each flight leg:
Indianapolis-Memphis leg
(1)   IMD + IAD + ITD + IMF + IAF + ITF < 120
Baltimore-Memphis leg
(2)    BMD + BAD + BTD + BMF + BAF + BTF < 120
Memphis-Austin leg
(3)    IAD + IAF + BAD + BAF + MAD + MAF < 120
Memphis-Tampa leg
(4)    ITD + ITF + BTD + BTF + MTD + MTF < 120

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
 Revenue Management

 Define the Constraints (continued)

There are 16 demand constraints, one for each ODIF:
(5) IMD < 44 (11) BMD < 26 (17) MAD < 5
(6) IAD < 25 (12) BAD < 50 (18) MTD < 48
(7) ITD < 40 (13) BTD < 42 (19) MAF < 14
(8) IMF < 15 (14) BMF < 12 (20) MTF < 11
(9) IAF < 10 (15) BAF < 16
(10) ITF < 8 (16) BTF < 9

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
23
 Revenue Management

 Computer Solution

Objective Function Value = 94735.000

Variable Value Reduced Cost
IMD 44.000 0.000
IAD 3.000 0.000
ITD 40.000 0.000
IMF 15.000 0.000
IAF 10.000 0.000
ITF 8.000 0.000
BMD 26.000 0.000
BAD 50.000 0.000

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
 Portfolio Models and Asset Allocation

 Asset allocation involves determining how to allocate

investment funds across a variety of asset classes
such as stocks, bonds, mutual funds, real estate.
 Portfolio models are used to determine percentage of
funds that should be made in each asset class.
 The goal is to create a portfolio that provides the best
balance between risk and return.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25
 Portfolio Model

John Sweeney is an investment advisor who is

attempting to construct an "optimal portfolio" for a
client who has $400,000 cash to invest. There are ten
different investments, falling into four broad categories
that John and his client have identified as potential
candidate for this portfolio.
The investments and their important characteristics
are listed in the table on the next slide. Note that
Unidyde Corp. under Equities and Unidyde Corp. under
Debt are two separate investments, whereas First
General REIT is a single investment that is considered
both an equities and a real estate investment.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
26
 Portfolio Model
Exp. Annual
After Tax Liquidity Risk
Category Investment Return Factor Factor
Equities Unidyde Corp. 15.0% 100 60
(Stocks) CC’s Restaurants 17.0% 100 70
First General REIT 17.5% 100 75
Debt Metropolis Electric 11.8% 95 20
(Bonds) Unidyde Corp. 12.2% 92 30
Lewisville Transit 12.0% 79 22
Real Estate Realty Partners 22.0% 0 50
First General REIT ( --- See above --- )
Money T-Bill Account 9.6% 80 0
Money Mkt. Fund 10.5% 100 10
Saver's Certificate 12.6% 0 0
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
27
 Portfolio Model

Formulate a linear programming problem to

accomplish John's objective as an investment advisor
which is to construct a portfolio that maximizes his
client's total expected after-tax return over the next year,
subject to the limitations placed upon him by the client
for the portfolio. (Limitations listed on next two slides.)

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28
 Portfolio Model

Portfolio Limitations
1. The weighted average liquidity factor for the portfolio
must to be at least 65.
2. The weighted average risk factor for the portfolio must
be no greater than 55.
3. No more than $60,000 is to be invested in Unidyde
stocks or bonds.
4. No more than 40% of the investment can be in any one
category except the money category.
5. No more than 20% of the total investment can be in
any one investment except the money market fund.
continued
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
 Portfolio Model

Portfolio Limitations (continued)

6. At least $1,000 must be invested in the Money Market
fund.
7. The maximum investment in Saver's Certificates is
$15,000.
8. The minimum investment desired for debt is $90,000.
9. At least $10,000 must be placed in a T-Bill account.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30
 Portfolio Model

 Define the Decision Variables

X1 = $ amount invested in Unidyde Corp. (Equities)
X2 = $ amount invested in CC’s Restaurants
X3 = $ amount invested in First General REIT
X4 = $ amount invested in Metropolis Electric
X5 = $ amount invested in Unidyde Corp. (Debt)
X6 = $ amount invested in Lewisville Transit
X7 = $ amount invested in Realty Partners
X8 = $ amount invested in T-Bill Account
X9 = $ amount invested in Money Mkt. Fund
X10 = $ amount invested in Saver's Certificate

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
31
 Portfolio Model

 Define the Objective Function

Maximize the total expected after-tax return over the
next year:
Max .15X1 + .17X2 + .175X3 + .118X4 + .122X5
+ .12X6 + .22X7 + .096X8 + .105X9 + .126X10

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32
 Portfolio Model

 Define the Constraints

Total funds invested must not exceed $400,000:
(1) X1 + X2 + X3 + X4 + X5 + X6 + X7 + X8 + X9 + X10 =
400,000
Weighted average liquidity factor must to be at least 65:
(2) 100X1 + 100X2 + 100X3 + 95X4 + 92X5 + 79X6 + 80X8 + 100X9
> 65(X1 + X2 + X3 + X4 + X5 + X6 + X7 + X8 + X9 + X10)
Weighted average risk factor must be no greater than 55:
(3) 60X1 + 70X2 + 75X3 + 20X4 + 30X5 + 22X6 + 50X7 + 10X9
< 55(X1 + X2 + X3 + X4 + X5 + X6 + X7 + X8 + X9 + X10)
No more than $60,000 to be invested in Unidyde Corp:
(4) X1 + X5 < 60,000

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
33
 Portfolio Model

 Define the Constraints (continued)

No more than 40% of the $400,000 investment can be
in any one category except the money category:
(5) X1 + X2 + X3 < 160,000
(6) X4 + X5 + X6 < 160,000
(7) X3 + X7 < 160,000
No more than 20% of the $400,000 investment can be
in any one investment except the money market fund:
(8) X2 < 80,000 (12) X7 < 80,000
(9) X3 < 80,000 (13) X8 < 80,000
(10) X4 < 80,000 (14) X10 < 80,000
(11) X6 < 80,000

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
34
 Portfolio Model

 Define the Constraints (continued)

At least $1,000 must be invested in the Money Market fund:
(15) X9 > 1,000
The maximum investment in Saver's Certificates is $15,000:
(16) X10 < 15,000
The minimum investment the Debt category is $90,000:
(17) X4 + X5 + X6 > 90,000
At least $10,000 must be placed in a T-Bill account:
(18) X8 > 10,000
Non-negativity of variables:
Xj > 0 j = 1, . . . , 10

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35
 Portfolio Model

 Solution Summary

Total Expected After-Tax Return = $64,355

X1 = $0 invested in Unidyde Corp. (Equities)
X2 = $80,000 invested in CC’s Restaurants
X3 = $80,000 invested in First General REIT
X4 = $0 invested in Metropolis Electric
X5 = $60,000 invested in Unidyde Corp. (Debt)
X6 = $74,000 invested in Lewisville Transit
X7 = $80,000 invested in Realty Partners
X8 = $10,000 invested in T-Bill Account
X9 = $1,000 invested in Money Mkt. Fund
X10 = $15,000 invested in Saver's Certificate

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
36
 Conservative Portfolio

A portfolio manager has been asked to develop a

portfolio for the firm’s conservative clients who express a
strong aversion to risk. The manager’s task is to
determine the proportion of the portfolio to invest in each
of six mutual funds so that the portfolio provides the best
return possible with a minimum risk.
The annual return (%) for five 1-year periods for the
six mutual funds are shown on the next slide. The
portfolio manager thinks that the returns for the five years
shown in the table are scenarios that can be used to
represent the possibilities for the next year.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
 Conservative Portfolio

Planning Scenarios
Mutual Fund Year 1 Year 2 Year 3 Year 4 Year 5
Foreign Stock 10.06 13.12 13.47 45.42 -21.93
Intermediate-Term Bond 17.64 3.25 7.51 -1.33 7.36
Large-Cap Growth 32.41 18.71 33.28 41.46 -23.26
Large-Cap Value 32.36 20.61 12.93 7.06 -5.37
Small-Cap Growth 33.44 19.40 3.85 58.68 -9.02
Small-Cap Value 24.56 25.32 -6.70 5.43 17.31
S&P 500 Return 25.00 20.00 8.00 30.00 -10.00

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38
 Conservative Portfolio

 Define the Decision Variables

FS = proportion invested in foreign stock mutual fund
IB = proportion invested in intermediate-term bond fund
LG = proportion invested in large-cap growth fund
LV = proportion invested in large-cap value fund
SG = proportion invested in small-cap growth fund
SV = proportion invested in small-cap value fund

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39
 Conservative Portfolio

 Constraints
Minimum returns for five scenarios:
– M + 10.06FS + 17.64IB + 32.41LG + 32.36LV + 33.44SG + 24.56SV ≥ 0
– M + 13.12FS + 3.25IB + 18.71LG + 20.61LV + 19.40SG + 25.32SV ≥ 0
– M + 13.47FS + 7.51IB + 33.28LG + 12.93LV + 3.85SG – 6.70SV ≥ 0
– M + 45.42FS – 1.33IB + 41.46LG + 7.06LV + 58.68SG + 5.43SV ≥ 0
– M – 21.93FS + 7.36IB – 23.26LG – 5.37LV – 9.02SG + 17.31SV ≥ 0
Sum of the proportions must equal 1:
FS + IB + LG + LV + SG + SV = 1
Non-negativity
M, FS, IB, LG, LV, SG, SV ≥ 0
 Objective Function
Maximize the minimum return for the portfolio:
Max M
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
 Conservative Portfolio

 Optimal Solution
The optimal value of the objective function is 6.445.
(The optimal portfolio will earn 6.445% in the worst-
case scenario.)
55.4% of the portfolio should be invested in the
intermediate-term bond fund.
13.2% of the portfolio should be invested in the
large-cap growth fund.
31.4% of the portfolio should be invested in the
small-cap value fund.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
 Moderate Risk Portfolio

A portfolio manager would like to construct a portfolio

for clients who are willing to accept a moderate amount
of risk in order to attempt to achieve better returns.
Suppose that clients in this risk category are willing to
accept some risk, but do not want the annual return for
the portfolio to drop below 2%.
The annual return (%) for five 1-year periods for the
six mutual funds are shown on the next slide. The
portfolio manager thinks that the returns for the five years
shown in the table are scenarios that can be used to
represent the possibilities for the next year.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
42
 Moderate Risk Portfolio

 Constraints
Minimum returns for five scenarios:
– M + 10.06FS + 17.64IB + 32.41LG + 32.36LV + 33.44SG + 24.56SV ≥ 2
– M + 13.12FS + 3.25IB + 18.71LG + 20.61LV + 19.40SG + 25.32SV ≥ 2
– M + 13.47FS + 7.51IB + 33.28LG + 12.93LV + 3.85SG – 6.70SV ≥ 2
– M + 45.42FS – 1.33IB + 41.46LG + 7.06LV + 58.68SG + 5.43SV ≥ 2
– M – 21.93FS + 7.36IB – 23.26LG – 5.37LV – 9.02SG + 17.31SV ≥ 2
Sum of the proportions must equal 1:
FS + IB + LG + LV + SG + SV = 1
Non-negativity
M, FS, IB, LG, LV, SG, SV ≥ 0

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
43
 Moderate Risk Portfolio

 Objective Function
The coefficient of FS in the objective function is given by:
0.2(10.06) + 0.2(13.12) + 0.2(13.47)
+ 0.2(45.42) + 0.2( – 21.93) + 12.03

The coefficient of IB is given by:

0.2(17.64) + 0.2(3.25) + 0.2(7.51)
+ 0.2( – 1.33) + 0.2(7.36) + 6.89

… and so on. Thus, the objective function is:

Maximize the minimum return for the portfolio:
Max 12.03FS + 6.89IB + 20.52LG
+ 13.52LV + 21.27SG + 13.18SV

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
44
 Moderate Risk Portfolio

 Optimal Solution
Invest 10.8% of the portfolio in a large-cap growth
mutual fund.
Invest 41.5% in a small-cap growth mutual fund.
Invest 47.7% in a small-cap value mutual fund.
This allocation provides a maximum expected return
of 17.33%.
The portfolio return will only be 2% if scenarios 3 or 5
occur (constraints 3 and 5 are binding).
The portfolio return will be 29.093% if scenario 1
occurs, 22.149% if scenario 2 occurs, and 31.417% if
scenario 4 occurs.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
45
 End of Chapter 5, Part A

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
46