LINEAR OPTIMIZATION MODELS IN FINANCE

BY CHIRAYU K TRIVEDI(207943087) & ALANNA ELBAUM(206459119)

INTRODUCTION
Many situations involve the necessity to choose repeatedly between a given set of options. In the real world, decisions must be made in a sequential (discrete or continuous) manner over time. Earlier decisions may affect the outcome, feasibility, and performance of a later decision. These decisions may be based on past data, the history and behaviour of the situation, as well as certain assumptions that are made to simplify a complex problem. To facilitate these decisions, optimization models from mathematics are applied.

"The subject of optimization is a fascinating blend of heuristics and rigour, of theory and experiment. Roger Fletcher 1987

What is optimization and why is it needed? In mathematics, computer science and economics, optimization, or mathematical programming, refers to choosing the best element from some set of available alternatives. Bad decisions cost time and money.

What is Linear Programming?

Linear programming is a structured procedure that incorporates defined decision variables that are significant in determining the maximizing or minimizing of an objective function. It is subject to linear equality and linear inequality constraints. The optimal solution can be found using numerous mathematical algorithms.

History of LP
Arose as a mathematical model developed during World War II to plan expenditures and returns in order to reduce costs to the army and increase losses to the enemy. It was kept secret until 1947. Postwar, many industries found its use in their daily planning. Many practical problems in operations research can be expressed as linear programming problems. Certain special cases of linear programming, such as network flow problems and multicommodity flow problems are considered important enough to have generated much research on specialized algorithms for their solution. Historically, ideas from linear programming have inspired many of the central concepts of optimization theory, such as duality, decomposition, and the importance of convexity and its generalizations. Although the modern management issues are ever-changing, most companies would like to maximize profits or minimize costs with limited resources. Therefore, many issues can be characterized as linear programming problems.

Applications of LP

Setting up a LP
Decision Variables: the decision variables represent decisions to be made Objective: minimize or maximize Constraints: constraints that limit feasible decisions

PRIMAL SIMPLEX

PRIMAL SIMPLEX

DUAL SIMPLEX

Dual Simplex

Dual Simplex III

Dual Simplex IV

 Finance is the science of management of money. A financial instrument is either cash or an evidence of an ownership interest in an entity Cash instruments are financial instruments whose value is determined directly by markets Derivative instruments are financial instruments which derive their value from the value and characteristics of one or more underlying assets. Mathematics helps establish models which are to be used to analyze and implement optimal decisionmaking

OPTIMIZATION MODELS IN FINANCE Optimization models in finance, involves applying robust mathematical optimization techniques to solve financial problems. We limit our approach to one such method known as linear programming

Selected Problems in Finance

An options problem A portfolio optimization problem A capital budgeting problem

An options Problem
What is an option? a financial instrument that conveys the right, but not the obligation, to engage in a future transaction (for example, on some underlying security or on a parcel of real property), or in a futures contract What is a bond? A bond is a formal contract to repay borrowed money with interest at fixed intervals.

The Options problem

You have $20000 to invest. Stock Y sells at $20 per share today. A option to buy a share of stock XYZ at $15 exactly six months from today sells for $10. A 6-month riskless zero coupon bond sells for with $100 face value sells for $90. You have decided to limit the number of call options bought and sold to 5000. You consider three scenarios for the price of stock Y six months from today: - the price remains the same - the price goes upto $40 or drops to $12 Each scenario is equally likely

Model define the decision variables B= number of bonds purchased S=number of shares of stock Y purchased C=number of call options purchased(if>0) or sold (if <0) The expected profit(per investment) is as follows: Bonds: 10 Stock Y: 1/3(20+0-8)=4 Call option:1/3(15-5-10)=0 LP model max 10*B+4*S s.t. 90*B+20*C<20000 (budget constraint) C<5000 (limit on number of call options purchased) C>-5000 (limit of number of call options sold) B>=0, S>=0 LINGO CODE max 10B+4S s.t. 90B+20S+10C<20000 C<5000 C>-5000 end

Global optimal solution found. Objective value: 4000.000 Infeasibilities: 0.000000 Total solver iterations: 0 Variable Value B 0.000000 S 1000.000 C 0.000000 Reduced Cost 8.000000 0.000000 2.000000

Row Slack or Surplus Dual Price 1 4000.000 1.000000 2 0.000000 0.2000000 3 5000.000 0.000000 4 5000.000 0.000000 From the output above, we get the optimal solution B=0, S=1000, C=-5000 and the expected profit is $4000

Portfolio Optimization Problem

Mortgage: a loan secured by real property. Loan: is a type of debt whose details are worked out between the lender and the borrower. Government Securities: Governments usually borrow by issuing securities, government bonds and bills. Security: negotiable financial instrument representing financial value. Portfolio optimization: process of changing the set of financial instruments held to meet various criteria, which is not limited to Financial risk and leverage The optimality of a portfolio depends heavily on the model used for defining risk and other aspects of financial instruments.

Portfolio Optimization Problem

Consider a mortgage team with $100000000 to finance various investments. There are five categories of loans, each with an associated return and risk [1-10,1 best:
Loan/Investment Commercial Loans Second Mortgages Personal Loans Commercial Loans Government Securities Return(%) 9 12 15 8 6 Risk 3 6 8 2 1

Any uninvested money goes into a savings account with no risk and 3% return. The goal for the mortgage team is to allocate the money to the categories so as to: a) Maximize the average return per dollar b) Have an average risk of no more than 5(all averages and fractions taken over the invested money(not over the saving account)) c) Invest at least 20% in commercial loans d) The amount in second mortgages and personal loans combined should be no higher than the amount in first mortgages.

Model
Model Let xi for all i from 1 to 5 be the amount invested in investment i Maximize 9x1+12x2+15x3+8x4+6x5+3x6 s.t. x1+x2+x3+x4+x5+x6=100000000 Now lets look at the average risk. Since we want to take average over only the invested, a direct translation of this constraint is Constraint for risk 3x1+6x2+8x3+2x4+x5 <= 5 x1+x2+x3+x4+x5 Rearrange above to get: -.2x1-.2x2-.2x3+.8x4-.2x5>=0 Final Constraint: x2+x3-x1<0

maximize 9x1+12x2+15x3+8x4+6x5+3x6 s.t. x1+x2+x3+x4+x5+x6=100000000 -2x1+x2+3x3-3x4-4x5<0 -.2x1-.2x2-.2x3+.8x4-.2x5>0 x2+x3-x1<0 end

Global optimal solution found. Objective value: 0.1120000E+10 Infeasibilities: 0.000000 Total solver iterations: 4 Variable X1 X2 X3 X4 X5 X6 Value Reduced Cost 0.4000000E+08 0.000000 0.000000 3.000000 0.4000000E+08 0.000000 0.2000000E+08 0.000000 0.000000 6.000000 0.000000 8.200000

Row Slack or Surplus Dual Price 1 0.1120000E+10 1.000000 2 0.000000 11.20000 3 0.2000000E+08 0.000000 4 0.000000 -4.000000 5 0.000000 3.000000

Hence, we can achieve a return of 11.2% by investing 40% of the assets in First Mortgages, 40% in Personal Loans and 20% in Commercial Loans

NET PRESENT VALUE Net Present Value: Net present value (NPV): sum of the present values (PVs) of the individual cash flows.

Investment 1 @r=.05 Investment 2@r=.05 Time Cashflow Time Cashflow 1 -400 1 2 -500 2 3 6000 3 4 70000 4 5 780000 5 6 7890000 6 7 12200000 7 8 14500000 8 9 19877777 9 10 20000000 10 $50,136,867.96

-900 -200 -600 -600000 -4500000 100000000 1000000000 1340000000 1456000000 1976000000 $3,839,889,739.84

The NET present value problem You are considering five different investment opportunities. The cash outflows and net present values (in millions of dollars) are given in Table 1. You have $40 million available for investment now (time 0); it estimates that one year from now (time 1) $20 million will be available for investment. You may purchase any fraction of each investment. In this case, the cash outflows and NPV are adjusted accordingly. For example, if you purchase one-fifth of investment 3, then a cash outflow of 1/5(5) = $1 million would be required at time 0, and a cash outflow of 1/5(5) = $1 million would be required at time 1. The one-fifth share of investment 3 would yield an NPV of 1/5(16) = $3.2 million. You want to maximize the NPV that can be obtained by investing in investments 15. Formulate an LP that will help achieve this goal. Assume that any funds left over at time 0 cannot be used at time 1.

Table 1

Cash flows and Net Present Value Investment ($)

Time 0 cash outflow Time 1 cash outflow NPV

11 53 5 5 29 3 6 5 1 34

13 16 16 14 39

Solution You must determine what fraction of each investment to purchase. Let xi = fraction of investment i purchased by you (i = 1, 2, 3, 4, 5) Your goal is to maximize the NPV earned from investments. Now, (total NPV) = (NPV earned from investment 1) + (NPV earned from investment 2) +... (NPV earned from investment 5). Note that NPV from investment 1 = (NPV from investment 1)(fraction of investment 1 purchased) =13x1 Applying analogous reasoning to investments 25 shows that you want to maximize z = 13x1 + 16x2 + 16x3+ 14x4+ 39x5 Your constraints may be expressed as follows: Constraint 1 You cannot invest more than $40 million at time 0. Constraint 2 You cannot invest more than $20 million at time 1. Constraint 3 You cannot purchase more than 100% of investment i (i 1, 2, 3, 4, 5). Then Constraint 1 reduces to 11x1 + 53x2 + 5x3 +5x4 +29x5< = 40 Constraint 2 reduces to 3x1 +6x2 +5x3 +x4 +34x5<= 20 Constraints 37 may be represented by xi <=1

LP MODEL max z 13x1 + 16x2+ 16x3+ 14x4+ 39x5 s.t. 11x1 + 53x2+ 5x3+ 5x4+ 29x5<= 40 (Time 0 constraint) 3x1 + 6x2+ 5x3+ x4+ 34x5<= 20 (Time 1 constraint) x1 <= 1 x2<= 1 x3 <= 1 x4<= 1 x5<= 1 xi >=0 (i= 1, 2, 3, 4, 5)

Global optimal solution found. Objective value: 57.44902 Infeasibilities: 0.000000 Total solver iterations: 3 Variable Value X1 1.000000 X2 0.2008600 X3 1.000000 X4 1.000000 X5 0.2880835 Reduced Cost 0.000000 0.000000 0.000000 0.000000 0.000000

Row Slack or Surplus Dual Price 1 57.44902 1.000000 2 0.000000 0.1904177 3 0.000000 0.9846437 4 0.000000 7.951474 5 0.7991400 0.000000 6 0.000000 10.12469 7 0.000000 12.06327 8 0.7119165 0.000000

Hence, the optimal solution to this LP is x1=x3=x4=1, x2=.201,x5=.288,z=57.49. Hence you should purchase 100% of investments 1,3,and4; 20.1% of investment 2 28.8% of investment 5. All of this will result in a NPV of $57,449,900 being obtained.

 LP requires that the model to be optimized contains data that are perfectly forecast able Linearity Condition: algorithms will not produce optimality for non-linear problems Model complexity increases computational time and time is money in Finance ie..NPV model Tax rate changes are non-linear There are no readymade algorithms to reduce problem size other than heuristics

 Linear Programming is an excellent way of solving linear financial problems Computation time can be greatly reduced if redundant information is kept out from the model Linear Programming can be extended to other fields as well: Integer Programming and Mixed Integer Programming. Most commercial optimization software have in-built linear programming algorithm LINGO, SAS and MATLAB can be used to solve such problems In conclusion, Linear Programming helps reduce redundancy.

BIBLIOGRAPHY
Optimization Methods In Optimization , Gerard Cornuejols, 2003. Winston W.L. Operations Research: Applications and Algorithms, 2003. http://en.wikipedia.org/wiki/Bond http://en.wikipedia.org/wiki/Finance