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Dynamic Portfolio Optimization

using Decomposition and Finite


Element Methods

John R. Birge
Quantstar and
The University of Chicago Graduate
School of Business
www.ChicagoGSB.edu/fac/john.birge
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Theme
• Models for Dynamic Portfolio Optimization are:
– big (exponential growth in time and state)
– general (can model many situations)
– structured (useful properties somewhere)
• Some hope for solution by:
– modeling the “right” way
– using structure wisely
– approximating (with some guarantees/bounds)

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Outline
• General Model – Observations
• Dynamic Model Construction and Motivation
• Overview of approaches
• Decomposition
• Lagrangian and ADP methods
• Finite-Element Approach
• Conclusions

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Why Model Dynamically?
• Three potential reasons:
– Market timing
– Reduce transaction costs (taxes) over time
– Maximize wealth-dependent objectives
• Example
– Suppose major goal is $100MM to pay pension liability in 2 years
– Start with $82MM; Invest in stock (annual vol=18.75%, annual
exp. Return=7.75%); bond (Treasury, annual vol=0; return=3%)
– Can we meet liability (without corporate contribution)?
– How likely is a surplus?

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Alternatives
• Markowitz (mean-variance) – Fixed Mix
– Pick a portfolio on the efficient frontier
– Maintain the ratio of stock to bonds to minimize
expected shortfall
• Buy-and-hold (Minimize expected loss)
– Invest in stock and bonds and hold for 2 years
• Dynamic (stochastic program)
– Allow trading before 2 years that might change the mix
of stock and bonds

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Efficient Frontier
• Some mix of risk-less
and risky asset
• For 2-year returns:

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Best Fixed Mix and Buy-and-Hold
• Fixed Mix: 27% in
stock
– Meet the liability 25%
of time (with binomial
model)
• Buy-and-Hold: 25% in
stock
– Meet the liability 25%
of time

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Best Dynamic Strategy
• Start with 57% in stock

• If stocks go up in 1 year,
shift to 0% in bond
• If stocks go down in 1 Stocks Up Stocks Down

year, shift to 91% in stock


• Meet the liability 75% of
time

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Advantages of Dynamic Mix
• Able to lock in gains
• Take on more risk when necessary to meet
targets
• Respond to individual utility that depends
on level of wealth

Shortfall Target

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Approaches for Dynamic Portfolios
• Static extensions
– Can re-solve (but hard to maintain consistent objective)
– Solutions can vary greatly
– Transaction costs difficult to include
• Dynamic programming policies
– Approximation
– Restricted policies (optimal – feasible?)
– Portfolio replication (duration match)
• General methods (stochastic programs)
– Can include wide variety
– Computational (and modeling) challenges

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Dynamic Programming Approach
• State: xt corresponding to positions in each asset (and possibly price,
economic, other factors)
• Value function: Vt (xt)
• Actions: ut
• Possible events st, probability pst
• Find:
Vt (xt) = max –ct ut + Σst pstVt+1 (xt+1(xt,ut,st))
Advantages: general, dynamic, can limit types of policies
Disadvantages: Dimensionality, approximation of V at some point
needed, limited policy set may be needed, accuracy hard to judge
Consistency questions: Policies optimal? Policies feasible? Consistent
future value?

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Other Restricted Policy
Approaches
• Kusy-Ziemba ALM model for Vancouver Credit
Union
• Idea: assume an expected liability mix with variation
around it; minimize penalty to meet the variation
• Formulation:
min Σi ci xi + Σst pst(qst+ yst+ + qst- yst-)
s.t. Σi fits xi + yst+ - yst- = lts all t and s; xi y >= 0, i = 1…n
Problems: Similar to liability matching.
Consistency questions: Possible to purchase insurance at cost of penalties?
Best possible policy?

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General Methods
• Basic Framework: Stochastic Programming
• Model Formulation:
max   p( U(W(  , T) )
s.t. (for all  ):  k x(k,1,  ) = W(o)
(initial)
 k r(k,t-1,  ) x(k,t-1,  ) -  k x(k,t,  ) = 0 , all t >1;
 k r(k,T-1,  ) x(k,T-1,  ) - W(  , T) = 0, (final);
x(k,t,  ) >= 0, all k,t;
Nonanticipativity:
x(k,t,  ’) - x(k,t,  ) = 0 if  ’,  Sti for all t, i,  ’, 
Advantages:
This says decision cannot depend on future.
General model, can handle transaction costs, include tax lots, etc.
Disadvantages: Size of model, insight
Consistency questions: Price dynamics appropriate?
objective appropriate? Solution method consistent?
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Model Consistency
• Price dynamics may have inherent arbitrage
– Example: model includes option in formulation that is not the
present value of future values in model (in risk-neutral prob.)
– Does not include all market securities available
• Policy inconsistency
– May not have inherent arbitrage but inclusion of market
instrument may create arbitrage opportunity
– Skews results to follow policy constraints
• Lack of extreme cases
– Limited set of policies may avoid extreme cases that drive
solutions

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Objective Consistency
• Examples with non-coherent objectives
– Value-at-Risk
– Probability of beating benchmark
• Coherent measures of risk
– Can lead to piecewise linear utility function
forms
– Expected shortfall, downside risk, or conditional
value-at-risk (Uryasiev and Rockafellar)

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Model and Method Difficulties
• Model Difficulties
– Arbitrage in tree
– Loss of extreme cases
– Inconsistent utilities
• Method Difficulties
– Deterministic incapable on large problems
– Stochastic methods have bias difficulties
• Particularly for decomposition methods
• Discrete time approximations
– Stopping rules and time hard to judge

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Resolving Inconsistencies
• Objective: Coherent measures (& good estimation)
• Model resolutions
– Construction of no-arbitrage trees (e.g., Klaassen)
– Extreme cases (Generalized moment problems and
fitting with existing price observations)
• Method resolutions
– Use structure for consistent bound estimates
– Decompose for efficient solution

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General Form in Discrete Time
• Find x=(x1,x2,…,xT) and p (allows for “robust
formulation”) to
minimize Ep [  t=1Tft(xt,xt+1,p) ]
s.t. xt 2 Xt, xt nonanticipative, p2 P (distribution class)
P[ ht (xt,xt+1,pt,) <= 0 ] >= a (chance constraint)
General Approaches:
Simplify distribution (e.g., sample) and form a mathematical
program:
• Solve step-by-step (dynamic program)
• Solve as single large-scale optimization problem
Use iterative procedure of sampling and optimization steps

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What about Continuous Time?
• Sometimes very useful to develop overall structure
of value function
• May help to identify a policy that can be explored
in discrete time (e.g., portfolio no-trade region)
• Analysis can become complex for multiple state
variables
• Possible bounding results for discrete
approximations (e.g., FEM approach)

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Simplified Finite Sample Model
• Assume p is fixed and random variables
represented by sample it for t=1,2,..,T, i=1,…,Nt
with probabilities pit ,a(i) an ancestor of i, then
model becomes (no chance constraints):
minimize  t=1T  i=1Nt pit ft(xa(i)t,xit+1,  it)
s.t. xit  Xit
Observations?
• Problems for different i are similar – solving one may help to solve others
• Problems may decompose across i and across t yielding
•smaller problems (that may scale linearly in size)
•opportunities for parallel computation.

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Outline
• General Model – Observations
• Dynamic Model Construction and Motivation
• Overview of approaches
• Decomposition
• Lagrangian and ADP methods
• Finite Element Methods
• Conclusions
.

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Solving As Large-scale
Mathematical Program
• Principles:
– Discretization leads to mathematical program but large-scale
– Use standard methods but exploit structure
• Direct methods
– Take advantage of sparsity structure
• Some efficiencies
– Use similar subproblem structure
• Greater efficiency
• Size
– Unlimited (infinite numbers of variables)
– Still solvable (caution on claims)

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Standard Approaches
• Sparsity structure advantage
– Partitioning
– Basis factorization
– Interior point factorization
• Similar/small problem advantage
– DP approaches
• Decomposition:
– Benders, l-shaped (Van Slyke – Wets)
– Dantzig-Wolfe (primal version)
– Regularized (Ruszczynski)
• Various sampling schemes (Higle/Sen stochastic decomposition, abridged nested
decomposition)
• Approximate DP (Bertsekas, Tsitsiklis, Van Roy..)
– Lagrangian methods

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Outline
• General Model – Observations
• Overview
• Decomposition
• Lagrangian and ADP methods
• Finite Element Methods
• Conclusions

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Similar/Small Problem Structure:
Dynamic Programming View
• Stages: t=1,...,T
• States: xt -> Btxt (or other transformation)
• Value function:
Vt(xt) = E[Vt(xt,t)] where
t is the random element and
Vt(xt,t) = min ft(xt,xt+1,t) +Vt+1(xt+1)
s.t. xt+1  Xt+1t(,t) xt given
• Solve : iterate from T to 1

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Linear Model Structure
Stage 1 Stage 2 Stage 3 max c1 x1 + V2  x1 
s.t. W1 x1 = h1
x1 � 0


Vt xt -1,a k  =  � prob    V  x
t ,k �Xt
t ,k t ,k t -1, a  k 
, t , k 
 
Vt ,k xt -1,a k  , t ,k = max ct  t ,k  xt ,k + Vt +1  xt ,k 
s.t. Wt xt ,k = ht  t ,k  - Tt -1  t ,k  xt -1,a k
 
xt ,k �0
• VN+1(xN) = 0, for all xN,
x1 2 x2 3 x3 • -Vt,k(xt-1,a(k)) is a piecewise linear,
convex function of xt-1,a(k)
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Decomposition Methods
• Benders idea
– Form an outer linearization of -Vt
– Add cuts on function :

Feasible region

-Vt (feasibility cuts)


new cut
(optimality cut)

min at k : < -Vt


LINEARIZATION AT ITERATION k

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Nested Decomposition
• In each subproblem, replace expected recourse function -Vt,k(xt-1,a(k)) with
unrestricted variable t,k
– Forward Pass:
• Starting at the root node and proceeding forward through the scenario tree, solve each node
subproblem

ˆ
-Vt , k ~ Q  
t , k xt -1, a  k  ,  t , k =
min ct  t ,k  xt ,k + t , k
s.t. Wt xt ,k = ht  t ,k  - Tt -1  t ,k  xt -1,a  k 
Et ,k xt ,k + t ,k � et ,k  optimality cuts 
• Add feasibility cuts as infeasibilitiesDarise
t , k xt , k � dt ,k  feasibility cuts 
– Backward Pass xt ,k � 0
• Starting in top node of Stage t = N-1, use optimal dual values in descendant Stage t+1 nodes to
construct new optimality cut. Repeat for all nodes in Stage t, resolve all Stage t nodes, then t
t-1.
– Convergence achieved when

1 = -V2  x1 
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Sample Results
Example performance
LOG (CPUS)
4 Standard LP
NESTED DECOMP.
3

1
3 4 5 67
LOG (NO. OF VARIABLES)
PARALLEL: 60-80% EFFICIENCY IN SPEEDUP

Other problems: similar results

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Decomposition Enhancements
• Optimal basis repetition
– Take advantage of having solved one problem to solve others
– Use bunching to solve multiple problems from root basis
– Share bases across levels of the scenario tree
– Use solution of single scenario as hot start
• Multicuts
– Create cuts for each descendant scenario
• Regularization
– Add quadratic term to keep close to previous solution
• Sampling
– Stochastic decomposition (Higle/Sen)
– Importance sampling (Infanger/Dantzig/Glynn)
– Multistage (Pereira/Pinto, Abridged ND)
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Abridged Nested Decomposition
Donohue/JRB 2006

• Incorporates sampling into the general


framework of Nested Decomposition
• Assumes relatively complete recourse and
serial independence
• Samples both the sub-problems to solve and
the solutions to continue from in the
forward pass through sample-path tree

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Outline
• General Model – Observations
• Overview of approaches
• Decomposition
• Lagrangian and ADP methods
• Finite Element Methods
• Conclusions

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Lagrangian-based Approaches
• General idea:
– Relax nonanticipativity (or perhaps other constraints)
– Place in objective
– Separable problems
MIN E [  t=1T ft(xt,xt+1) ]
MIN E[ T
ft(xt,xt+1) ]
t=1
xt  Xt
s.t. x t  Xt
+ E[w,x] + r/2||x-x||2
xt nonanticipative
Update: wt; Project: x into N - nonanticipative space as x

Convergence: Convex problems - Progressive Hedging Alg.


(Rockafellar and Wets)
Advantage: Maintain problem structure (e.g., network)

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Approximate Dynamic
Programming: Infinite Horizon
• Use LP solution of dynamic (Bellman)
equation:
max (d,V) s.t. TV ¸ V for distribution d on x
• Approximate V with finite set of basis
functions j, weights j
• LP for finite set becomes: Find  to
max (d,) s.t. T¸ 
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Solving ADP Form
• Bounds available (Van Roy, De Farias)
• Discretizations:
– Discrete state space x
– Use structure to reduce constraint set
• Use Duality:
– Dual Form:
min max (d,) + (,T-)
Can combine with outer approximation
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Outline
• General Model – Observations
• Overview of approaches
• Decomposition
• Lagrangian and ADP methods
• Finite element methods
• Conclusions

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Continuous-Time Setup
• Suppose Vt(xt)=maxx2 X E[stT fu(xu|xt) du]
• Questions:
– Can the form of Vt provide insight into the
effects of time discretization?
– When does Vt have useful structural properties?
– Can different methods of discretization provide
better results than others?

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Portfolio in Continuous Time
• Setup:
– Value function, u
– PDE with no trade, ut + Gu – ru =0, u(T,x)
given
– Define Mu(t,x)=supx’|x’2 Y(t,x) u(t,x’)
where Y(t,x) is the set of attainable portfolios
from x at t

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Variational Inequality Form
• General variational inequality form
ut+Gu-ru· 0, u-Mu¸ 0, (ut+Gu-ru)(u-Mu)=0
• Computational approach:
– Apply high-order FEM methods for the
continuous regime
– Use a sequential optimization process to
determine the free boundary (which then
effectively determines the no-trade region)
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FEM Approach
• Local Discontinuous Galerkin Method
– Decomposes by time
– Parallel implementation
– Can achieve high order of accuracy
• Use Legendre polynomials as basis functions that
then approximate the value function
• General result (Liu/JRB): ||u – uh||· C hk+1/2
for kth order polynomials

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Extensions
• Increase the complexity of portfolio
examples in higher dimensions
• Extend approach to other models governed
by smooth dynamics plus non-smooth
impulse-type controls
• Provide generalizations for other forms of
stochastic programs

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Conclusions
• Use of structure in solving large-scale dynamic
portfolio problems:
– Repeated problems
– Nonzero pattern for sparsity
– Use of decomposition and sampling ideas
– Potential for high-accuracy methods with FEM
• Computational results
– Structure accelerates solution (and allows additional
complexity: asset types/transaction costs/etc)
– Speedups possible in orders of magnitude over standard
software implementations

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