A Class of Fuzzy Portfolio Optimization

Problems: E-S Models

Yankui Liu and Xiaoli Wu
College of Mathematics and Computer Science, Hebei University
Baoding 071002, Hebei, China
lyk@hbu.edu.cn, wxl861@126.com
Abstract. This paper adopts the spread of fuzzy variable as a new
criteria in practical risk management problems, and develops a novel
fuzzy expectation-spread (E-S) model for portfolio optimization prob-
lem. Since the spread is dened by Lebesgue-Stieltjes (L-S) integral, its
computation for general fuzzy variables is a challenge issue for research,
and usually depends on approximation scheme and soft computing. But
for frequently used trapezoidal and triangular fuzzy variables, the spread
can be represented as quadratic functions with respect to fuzzy param-
eters. These new representations facilitate us to turn the proposed E-S
model into its equivalent parametric programming problem. As a conse-
quence, given the fuzzy parameters, the E-S model becomes a quadratic
programming problem that can be solved by general purpose software or
conventional optimization algorithms. Finally, we demonstrate the de-
veloped modeling idea via two numerical examples.
Keywords: Portfolio, Fuzzy variable, Spread, E-S model, Parametric
programming.
1 Introduction
The mean-variance (M-V) model of Markowitz [1] is a cornerstone of modern
portfolio theory. The M-V model has received widespread acceptance as a prac-
tical tool for portfolio optimization. Therefore, Markowitzs seminal work has
been widely extended in the literature, including mean-semivariance model [2],
mean-absolute-deviation model [3], and mean-VaR model [4]. All the models
mentioned above belong to bi-criteria optimization problems, in which a reason-
able trade-o between return and risk is concernedeither minimizing risk for
a given level of expected return, or maximizing expected return for a given level
of risk.
In fuzzy environments, with the development of fuzzy set and possibility the-
ories [5,6], more and more researchers realized the importance to handle possi-
bilistic uncertainty in decision systems, and applied the fuzzy theory to portfolio
optimization problems. Abiyev and Menekay [7] presented the development of
fuzzy portfolio selection model in investment, where fuzzy logic was utilized in
the estimation of expected return and risk, Parra et al. [8] discussed the optimum
Y. Tan, Y. Shi, and K.C. Tan (Eds.): ICSI 2010, Part II, LNCS 6146, pp. 4350, 2010.
c Springer-Verlag Berlin Heidelberg 2010
44 Y. Liu and X. Wu
portfolio for a private investor, taking into account three criteria: return, risk
and liquidity, and Qin et al. [9] established a novel data envelopment analysis
model with type-2 fuzzy inputs and outputs.
Recently, based on the concepts of credibility, expected value and variance
dened in [10], an axiomatic approach called credibility theory has been devel-
oped [11]. Some interesting applications about credibility in fuzzy optimization
problems can be found in the literature such as [12,13,14,15,16,17,18]. The pur-
pose of this paper is to develop the E-S model for fuzzy portfolio optimization
problems, in which we adopt the spread of fuzzy variable as a new risk index to
measure the variation of fuzzy returns. In [12], the investment return is quan-
tied by the expected value of a portfolio and investment risk by the variance.
However, since the variance of a fuzzy variable is dened by nonlinear fuzzy inte-
gral, the established portfolio selection problem is neither linear nor convex that
have to be solved by heuristic algorithms [12]. In the current development, the
spread is dened by Lebesgue-Stieltjes (L-S) integral [19], although its compu-
tation for general fuzzy variables is a challenge issue for research, for frequently
used trapezoidal and triangular fuzzy variables, their spreads can be represented
as quadratic functions with respect to fuzzy parameters. These new representa-
tions facilitate us to turn the proposed E-S model into its equivalent parametric
programming problem. As a consequence, given the fuzzy parameters, the E-S
model becomes a quadratic convex programming problem that can be solved by
general purpose software or conventional optimization algorithms [20].
The plan of this paper is as follows. Section 2 gives the parametric represen-
tation for the spreads of trapezoidal and triangular fuzzy variables. In Section 3,
we rst formulate a new E-S model for portfolio selection problem with fuzzy
returns. Then, according to the parametric representation of spread, we turn the
proposed E-S model into its equivalent parametric programming problem. Given
the parameters, the equivalent parameter programming becomes a quadratic
convex programming problem. Since the K-T conditions of the quadratic pro-
gramming can be written as a linear complementary problem, we can solve it
by conventional optimization algorithms. In Section 4, we demonstrate the de-
veloped modeling idea via two numerical examples. One is solved by Lemkes
complementary pivoting algorithm, another is solved by Lingo software. Sec-
tion 5 concludes the paper.
2 Parametric Representation for Spread
If is a fuzzy variable with a possibility distribution function

: [0, 1],
then its spread is dened by the following L-S integral
Sp[] =
_
(,+)
(r E[])
2
d(r), (1)
where E[] is the expected value of fuzzy variable (see [10]), and (r) is the
credibility distribution of the fuzzy variable (see [11]).
A Class of Fuzzy Portfolio Optimization Problems: E-S Models 45
For a trapezoidal fuzzy variable, its spread can be represented as a quadratic
function with respect to fuzzy parameters.
Theorem 1. If is a trapezoidal fuzzy variable (r
1
, r
2
, r
3
, r
4
), then
Sp[] =
1
48
r
T
Dr, (2)
where r = (r
1
, r
2
, r
3
, r
4
)
T
, and
D =
_

_
5 1 3 3
1 5 3 3
3 3 5 1
3 3 1 5
_

_
. (3)
For a triangular fuzzy variable, its spread can also be represented as the quadratic
function of fuzzy parameters, which is stated as
Theorem 2. If is a triangular fuzzy variable (r
1
, r
2
, r
3
), then
Sp[] =
1
48
r
T
Br, (4)
where r = (r
1
, r
2
, r
3
)
T
, and
B =
_
_
5 2 3
2 4 2
3 2 5
_
_
. (5)
3 Fuzzy Portfolio Optimization
3.1 Model Formulation
Every investor must decide on an appropriate mix of assets to include in his
investment portfolio. Given a collection of potential investments indexed from
1 to n, let
i
denote the fuzzy return in the next time period on investment i,
i = 1, . . . , n. A portfolio is determined by specifying what fraction of ones assets
to put into each investment. That is, a portfolio is a collection of nonnegative
numbers x
i
, i = 1, . . . , n that sum to one.
The return the investor would obtain by using a given portfolio is expressed as

n
i=1
x
i

i
, which is also a fuzzy variable. Thus the reward associated with such a
portfolio is dened as the expected return E[

n
i=1
x
i

i
]. If reward were the only
concern, it is simple for the investor to put all his assets in the investment with
the highest expected return. However, it is known that investments with high
reward usually result in a high level of risk. Therefore, there is a need to dene
a risk measure for the reward

n
i=1
x
i

i
. In this section, we will dene the risk
associated with an investment to be the spread of the fuzzy return

n
i=1
x
i

i
,
which is the quadratic deviation from the expected value. The investor would
like to minimize the risk while at the same time not incur too small reward. In
46 Y. Liu and X. Wu
our portfolio selection problem, we formally build the following E-S model by a
linear combination of the risk and the reward
_
_
_
min Sp[

n
i=1
x
i

i
] E[

n
i=1
x
i

i
]
s.t.

n
i=1
x
i
= 1
x
i
0, i = 1, 2, . . . , n,
(6)
where is a positive parameter. The parameter describes the importance of
risk relative to reward, low values of attempt to minimize risk, while high
values of tend to maximize reward regardless of risk.
3.2 Equivalent Parametric Programming
In this section, we discuss the equivalent parametric programming problem of
E-S model (6). For this purpose, suppose
i
= (r
i1
, r
i2
, r
i3
), i = 1, 2, . . . , n are
mutually independent triangular fuzzy variables. In this case, fuzzy variable

n
i=1
x
i

i
can be represented as
n

i=1
x
i

i
= (
n

i=1
x
i
r
i1
,
n

i=1
x
i
r
i2
,
n

i=1
x
i
r
i3
) = (y
1
, y
2
, y
3
).
As a consequence, we have the following relationships between y
k
, k = 1, 2, 3,
and x
i
, i = 1, . . . , n,
_
_
y
1
y
2
y
3
_
_
=
_
_
r
11
r
21
r
31
r
n1
r
12
r
22
r
32
r
n2
r
13
r
23
r
33
r
n3
_
_
_

_
x
1
x
2
.
.
.
x
n
_

_
.
If we denote y = (y
1
, y
2
, y
3
)
T
, x = (x
1
, x
2
, . . . , x
n
)
T
, and
S =
_
_
r
11
r
21
r
31
r
n1
r
12
r
22
r
32
r
n2
r
13
r
23
r
33
r
n3
_
_
,
then we have y = Sx. Therefore, it follows from Theorem 2 that
Sp[

n
i=1
x
i

i
] =
1
48
y
T
By =
1
48
x
T
S
T
BSx.
On the other hand, by the independence of the fuzzy variables, we have
E
_
n

i=1
x
i

i
_
=
n

i=1
x
i
E[
i
] = b
T
x, (7)
where b = (E[
1
], E[
2
], . . . , E[
n
])
T
.
A Class of Fuzzy Portfolio Optimization Problems: E-S Models 47
As a consequence, the E-S model (6) can be turned into the following equiv-
alent parametric programming problem
_

_
min
1
48
x
T
S
T
BSx b
T
x
s.t.

n
i=1
x
i
= 1
x
i
0, i = 1, 2, . . . , n.
(8)
Furthermore, in problem (8), if we denote c = b, H = S
T
BS/24, e =
(1, 1, . . . , 1)
T
, and
A =
_

_
1 0 0
0 1 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 1
_

_
,
then problem (8) can be rewritten as the following equivalent parametric pro-
gramming model
_

_
min c
T
x +
1
2
x
T
Hx
s.t. e
T
x = 1
Ax 0.
(9)
In problem (9), H is a parametric matrix with respect to (r
i1
, r
i2
, r
i3
)
T
, i =
1, . . . , n. Given the parameters, H is a deterministic matrix. Thus, in the case
when H is a positive semidenite for some parameters, then problem (9) is a
quadratic convex programming. In this case, the Kuhn-Tucker point x of problem
(9) is just a global optimal solution to the problem. Therefore, to solve prob-
lem (9), it suces to nd the K-T points, which satisfy the following conditions
_
_
_
Hx e + v = c
v
i
x
i
= 0, i = 1, 2, . . . , n
v
i
0, i = 1, 2, . . . , n,
(10)
with being a positive real number and v = (v
1
, v
2
, . . . , v
n
)
T

n
+
.
If we denote
M =
_
0 e
T
e H
_
, q =
_
1
c
_
, w =
_
0
v
_
, and z =
_

x
_
,
then the Kuhn-Tucker conditions (10) could be rewritten as the following linear
complementary problem
w Mz = q, w
T
z = 0, w, z 0,
which can be solved by Lemkes complementary pivoting algorithm (see [20]).
In the next section, we provide two numerical examples to demonstrate the
modeling idea developed in this section.
48 Y. Liu and X. Wu
4 Numerical Examples
In this section, we illustrate the developed modeling idea in this paper by two
numerical examples. The rst one is stated as follows:
Example 1. Suppose an investor intends to invest his fund in two securities. Let
x
i
denote the investment proportion in security i, and
i
the fuzzy return of
security i, i = 1, 2. Assume that
i
, i = 1, 2 are mutually independent triangu-
lar fuzzy variables, and their expected values and spreads are calculated and
collected in Table 1.
Table 1. The Values of E[
i
] and Sp[
i
]
Security Return E[
i
] Sp[
i
]
1 (0, 1, 1.5) 0.875 0.1927
2 (0, 1, 2) 1 0.3333
In this example, the Kuhn-Tucker conditions (10) become
_
_
_
Hx e + v = c
v
i
x
i
= 0, i = 1, 2
v
i
0, i = 1, 2,
(11)
where is a positive real number and v = (v
1
, v
2
)
T

2
+
. In the case when
= 1, the Kuhn-Tucker conditions (11) are reduced to nd a solution of the
following linear complementary system
w Mz = q, w
T
z = 0, w, z 0,
where c = (0.875, 1)
T
,
M =
_
_
0 1 1
1
37
96
1
2
1
1
2
2
3
_
_
, q =
_
_
1
0.875
1
_
_
, w =
_
_
0
v
1
v
2
_
_
, and z =
_
_

x
1
x
2
_
_
.
By using Lemkes complementary pivoting algorithm [20], we can obtain the
following solution (w
1
, w
2
, w
3
, z
1
, z
2
, z
3
) = (0, 0, 0, 7/15, 4/5, 1/5), which implies
the Kuhn-Tucker point is (x
1
, x
2
) = (z
2
, z
3
) = (4/5, 1/5). That is, the investor
should allocate four fths of his fund for the rst security and one fth for the
second security in order to the maximum benet.
Example 2. Suppose an investor intends to invest his fund to ve securities.
Let x
i
denote the investment proportion in security i, and
i
the fuzzy return of
security i, i = 1, . . . , 5. In addition, the fuzzy returns
i
, i = 1, . . . , 5 are supposed
to be mutually independent triangular fuzzy variables, and their expected values
and spreads are computed and provided in Table 2.
A Class of Fuzzy Portfolio Optimization Problems: E-S Models 49
Table 2. The Values of E[
i
] and Sp[
i
]
Security Return E[
i
] Sp[
i
]
1 (11.30, 12.61, 16.09) 13.1525 2.01011
2 (11.63, 13.21, 17.12) 13.7925 2.62478
3 (10.65, 14.55, 16.25) 14.0000 2.71417
4 (10.32, 15.10, 16.00) 14.1300 3.00217
5 (10.09, 14.21, 17.50) 14.2050 3.63001
To solve the portfolio selection problem, we rst turn the into its equivalent
quadratic parametric programming one. Given the parameter , we employ Lingo
software to solve the corresponding quadratic convex programming problem.
To illustrate parameters inuence to eciency, we also compare solutions with
dierent values of parameter , and the computational results are reported in
Table 3.
Table 3. Comparison of Solutions with Dierent Values of
x
1
x
2
x
3
x
4
x
5
0.00 1.00000 0.00000 0.00000 0.00000 0.00000
0.99 0.16160 0.36715 0.00000 0.47125 0.00000
1.00 0.08354 0.44219 0.00000 0.47427 0.00000
1.50 0.00000 0.42010 0.00000 0.57990 0.00000
20.00 0.00000 0.00000 0.00000 0.00000 1.00000
5 Concluding Remarks
For illustrating the use of spread as a new risk measure in practice, we pre-
sented the E-S model for portfolio optimization problem, which extends the
Markowitss mean-variance framework. Our main results are as follows. First,
we gave the parametric representations for spreads of frequently used trian-
gular and trapezoidal fuzzy variables. Second, we developed a new E-S model
for portfolio optimization problems, and discussed its equivalent parametric pro-
gramming problem. Under mild assumptions, the convexity about the equivalent
parametric programming problem was also analyzed. Third, two numerical ex-
amples were provided to demonstrate the developed modeling idea, one example
is solved by Lemkes complementary pivoting algorithm, another is solved by
Lingo software.
Acknowledgments. This work was supported by the National Nature Science
Foundation of China (NSFC) under Grant No. 60974134.
50 Y. Liu and X. Wu
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