An Exact Solution Approach for Portfolio Optimization Problems Under Stochastic and Integer Constraints

Abstract

In this paper, we study extensions of the classical Markowitz' mean-variance portfolio optimization model. First, we consider that the expected asset returns are stochastic by introducing a probabilistic constraint imposing that the expected return of the constructed portfolio must exceed a prescribed return level with a high confidence level. We study the deterministic equivalents of these models. In particular, we define under which types of probability distributions the deterministic equivalents are second-order cone programs, and give exact or approximate closed-form formulations. Second, we account for real-world trading constraints, such as the need to diversify the investments in a number of industrial sectors, the non-profitability of holding small positions and the constraint of buying stocks by lots, modeled with integer variables. To solve the resulting problems, we propose an exact solution approach in which the uncertainty in the estimate of the expected returns and the integer trading restrictions are simultaneously considered. The proposed algorithmic approach rests on a non-linear branch-and-bound algorithm which features two new branching rules. The first one is a static rule, called idiosyncratic risk branching, while the second one is dynamic and called portfolio risk branching. The proposed branching rules are implemented and tested using the open-source framework of the solver Bonmin. The comparison of the computational results obtained with standard MINLP solvers and with the proposed approach shows the effectiveness of this latter which permits to solve to optimality problems with up to 200 assets in a reasonable amount of time.

Keywords: Market Risk, Portfolio Optimization, Stochastic Programming, Markowitz, Trading Constraints, Idiosyncratic risk, Integer Programming