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and Simulation
C o m p u t e r L a b M o d u l e 4
P o r t f o l i o O p t i m i z a t i o n
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Problem Description
Description:
An investment fund has 1 million euros that it wishes to invest
(during a year) in three assets:
A share index, gold or bonds
The historical returns associated to these three assets are:
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Index
Gold
Bonds
0,11 -0,09 0,04 0,14 0,19 -0,15 -0,27 0,37 0,24 -0,07 0,07 0,19 0,33 -0,05 0,22 0,23 0,06 0,32 0,19 0,05 0,09 -0,35 0,25 -0,1
0,11 0,08 -0,14 0,14 0,44 0,66 0,64 0 -0,22 0,18 0,31 0,59 0,99 -0,25 0,04 -0,11 -0,15 -0,12 0,16 0,22 -0,02 -0,12 0,22 0,13
0,05 0,07 0,07 0,04 0,04 0,07 0,08 0,06 0,05 0,05 0,07 0,1 0,11 0,15 0,11 0,09 0,1 0,08 0,06 0,05 0,06 0,04 0,03 0,04
Prepare a recommendation for the fund indicating the
Percentage of available funds to invest in each asset
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Problem Description
The model:
Decision variables
x
1
= proportion to invest in shares
x
2
= proportion to invest in gold
x
3
= proportion to invest in bonds
Data treatment
From the data we compute the yearly returns of each asset:
where p
t
denotes the prices of the assets at the end of each year
From these values we obtain the average returns, r, and the
covariance matrix, S
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Problem Description
The model:
Markowitz formulation:
where ! is the risk-aversion coefcient
Formulate and solve in Excel
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Problem Solution
Solution:
If the fund manager is risk-neutral (! = 0), then
He/she should invest all their money in gold, the asset with the
largest expected return
The expected return for this asset is 16% (per year), while its
expected volatility is 31%
If the investor is very risk-averse (! very large), then
Most of the available funds should be invested in bonds (! 97%)
The remaining funds should be allocated to the share index (!
1%) and to gold (! 2%)
The expected return for this investment is 7.1%, while the
expected volatility is 2.8%
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Problem Solution
Solution:
An intermediate investor (! = 5) should invest
! 10% in shares, ! 19% in gold, and ! 71% in bonds
The expected return for this investment is 8.8%, while the
expected volatility is 6.5%
Sensitivity:
When the estimates for the expected returns change slightly,
the composition of the portfolio is signicantly affected
Something similar, although on a smaller scale, can be observed
for the estimates of the volatility components
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