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Optimization Methods in Finance

Optimization Methods in Finance

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Optimization Methods in Finance
Gerard CornuejolsReha T¨ut¨unc¨u
Carnegie Mellon University, Pittsburgh, PA 15213 USA
January 2006
 
2
Foreword
Optimization models play an increasingly important role in financial de-cisions. Many computational finance problems ranging from asset allocationto risk management, from option pricing to model calibration can be solvedefficiently using modern optimization techniques. This course discusses sev-eral classes of optimization problems (including linear, quadratic, integer,dynamic, stochastic, conic, and robust programming) encountered in finan-cial models. For each problem class, after introducing the relevant theory(optimality conditions, duality, etc.) and efficient solution methods, we dis-cuss several problems of mathematical finance that can be modeled withinthis problem class. In addition to classical and well-known models suchas Markowitz’ mean-variance optimization model we present some neweroptimization models for a variety of financial problems.
Acknowledgements
This book has its origins in courses taught at Carnegie Mellon Universityin the Masters program in Computational Finance and in the MBA programat the Tepper School of Business (G´erard Cornu´ejols), and at the Tokyo In-stitute of Technology, Japan, and the University of Coimbra, Portugal (Rehaut¨unc¨u). We thank the attendants of these courses for their feedback and for many stimulating discussions. We would also like to thank the colleagueswho provided the initial impetus for this project, especially Michael Trick,John Hooker, Sanjay Srivastava, Rick Green, Yanjun Li, Lu´ıs Vicente andMasakazu Kojima. Various drafts of this book were experimented with inclass by Javier Pe˜na, Fran¸cois Margot, Miroslav Karamanov and KathieCameron, and we thank them for their comments.
 
Contents
1 Introduction 9
1.1 Optimization Problems . . . . . . . . . . . . . . . . . . . . . . 91.1.1 Linear and Nonlinear Programming . . . . . . . . . . 101.1.2 Quadratic Programming . . . . . . . . . . . . . . . . . 111.1.3 Conic Optimization . . . . . . . . . . . . . . . . . . . 121.1.4 Integer Programming . . . . . . . . . . . . . . . . . . 121.1.5 Dynamic Programming . . . . . . . . . . . . . . . . . 131.2 Optimization with Data Uncertainty . . . . . . . . . . . . . . 131.2.1 Stochastic Programming . . . . . . . . . . . . . . . . . 131.2.2 Robust Optimization . . . . . . . . . . . . . . . . . . . 141.3 Financial Mathematics . . . . . . . . . . . . . . . . . . . . . . 161.3.1 Portfolio Selection and Asset Allocation . . . . . . . . 161.3.2 Pricing and Hedging of Options . . . . . . . . . . . . . 181.3.3 Risk Management . . . . . . . . . . . . . . . . . . . . 191.3.4 Asset/Liability Management . . . . . . . . . . . . . . 20
2 Linear Programming: Theory and Algorithms 23
2.1 The Linear Programming Problem . . . . . . . . . . . . . . . 232.2 Duality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252.3 Optimality Conditions . . . . . . . . . . . . . . . . . . . . . . 282.4 The Simplex Method . . . . . . . . . . . . . . . . . . . . . . . 312.4.1 Basic Solutions . . . . . . . . . . . . . . . . . . . . . . 322.4.2 Simplex Iterations . . . . . . . . . . . . . . . . . . . . 352.4.3 The Tableau Form of the Simplex Method . . . . . . . 392.4.4 Graphical Interpretation . . . . . . . . . . . . . . . . . 422.4.5 The Dual Simplex Method . . . . . . . . . . . . . . . 432.4.6 Alternatives to the Simplex Method . . . . . . . . . . 45
3 LP Models: Asset/Liability Cash Flow Matching 47
3.1 Short Term Financing . . . . . . . . . . . . . . . . . . . . . . 473.1.1 Modeling . . . . . . . . . . . . . . . . . . . . . . . . . 483.1.2 Solving the Model with SOLVER . . . . . . . . . . . . 503.1.3 Interpreting the output of SOLVER . . . . . . . . . . 533.1.4 Modeling Languages . . . . . . . . . . . . . . . . . . . 543.1.5 Features of Linear Programs . . . . . . . . . . . . . . 553.2 Dedication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563.3 Sensitivity Analysis for Linear Programming . . . . . . . . . 583

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