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**via Efficient Frontier with
**

the IMSL

®

Numerical Libraries

A White Paper by Visual Numerics, Inc.

March 2008

www.vni.com

Visual Numerics, Inc.

2500 Wilcrest Drive, Suite 200

Houston, TX 77042

USA

Portfolio Optimization via Efficient Frontier with the IMSL Numerical Libraries

by Visual Numerics, Inc.

Copyright © 2004 - 2008 by Visual Numerics, Inc. All rights reserved.

Printed in the United States of America.

Publishing History:

Updated March 2008

Originally published April 2004

Trademark Information

Visual Numerics, IMSL and PV-WAVE are registered trademarks of Visual Numerics, Inc. in the U.S. and other countries. JMSL, JWAVE, TS-

WAVE and Knowledge in Motion are trademarks of Visual Numerics, Inc. All other company, product or brand names are the property of their

respective owners.

The information contained in this document is subject to change without notice. Visual Numerics, Inc., makes no warranty of any kind with

regard to this material, included, but not limited to, the implied warranties of merchantability and fitness for a particular purpose. Visual

Numerics, Inc., shall not be liable for errors contained herein or for incidental, consequential, or other indirect damages in connection with

the furnishing, performance, or use of this material.

3

TABLE OF CONTENTS

Introduction 4

Inputs to the Problem 4

Constraints on the Solution 5

Computing the Efficient Frontier 6

Analysis of the Efficient Frontier Curve 8

Finding the Optimal Portfolio 9

For more Information 9

4

Introduction

The ultimate goal of portfolio optimization is to build a portfolio with the proper proportion of its

components that will balance minimum risk and maximum return. One textbook method to that end

involves the computation of the efficient frontier curve, which enumerates a set of portfolios that will

generate some given rate of return while minimizing risk to the investor. Once that curve is computed, an

optimal portfolio can be selected from the set through a graphical method that involves the risk-free rate

of return. This document will travel through the discovery of that ideal portfolio by reviewing the necessary

inputs, constraints on the solution, the computation and analysis of the efficient frontier, and how to select

the optimal solution from the set of possible solutions.

Several IMSL Library functions are referred to in the text. The function is named generically in the text,

and the actual function names are provided parenthetically for the IMSL Fortran Library, IMSL C Library,

IMSL C# Library and JMSL™ Library respectively. Some details of the use of some of the functions may

be included in the text; for complete usage information, please consult the appropriate IMSL Library

documentation.

The term “security” will be used in reference to the items that make up the portfolio throughout this

document; however, the contents of the portfolio may well be a combination of stocks, bonds, indices or

any investment. Further, the example in this paper is built on just five securities. The analysis technique

and algorithms scale to problems of much larger scale with hundreds or thousands of securities.

Inputs to the Problem

The required data for input to the main optimization routine is the variance-covariance matrix for the

securities involved, the individual expected fractional returns, and the risk-free interest rate. The first two

items may not be explicitly known. However, they can be computed from a time history of each security.

The variance-covariance matrix contains the variance for each security as well as the covariance between

each pair of securities. This information is important because the variance, Ȝ, is a measure of the risk

associated with a given security. Further, it is important to know how well the securities are correlated with

each other. This matrix is symmetric (Ȝ

12

= Ȝ

21

) so only the upper triangular part needs to be stored and

looks like:

Ȝ

11

Ȝ

12

Ȝ

13

Ȝ

14

Ȝ

15

Ȝ

22

Ȝ

23

Ȝ

24

Ȝ

25

Ȝ

33

Ȝ

34

Ȝ

35

Ȝ

44

Ȝ

45

Ȝ

55

5

Occasionally, one will have this information already, but the IMSL Library Covariance function (CORVC,

covariances, com.imsl.stat.Covariances, Imsl.Stat.Covariances) can compute the matrix from the input

time series.

Next, the expected returns must be provided. These values are often based on knowledge of the security or

its market, but if such knowledge is lacking then they can be computed using any of several methods such

as a linear regression or a geometric mean of the historical returns.

The final required input is the risk-free interest rate. This is the rate of return an investor could realize

assuming zero risk, like the Fed Funds rate or the Treasury Bill rate. The computed efficient frontier is a

set of optimized portfolios, each of which minimizes risk (volatility) for a given rate of return. The risk-free

rate of return is used to select a single optimal portfolio from this set of optimized portfolios that has the

greatest return for a low amount of risk.

Constraints on the Solution

The above inputs are the raw data necessary to compute a solution. To solve the optimization problem, a

set of constraints is also required. The default constraints on the contents of the portfolio would be that

each security can make up from 0 to 100% of the portfolio and that the sum of all the security

contributions must be 100%.

An investor may have other ideas that constrain the weights of some or all of the securities in the portfolio.

For example, in the interest of diversification, one may require that no security make up more than 25% of

the portfolio. Alternatively, there may be a favorite security among the group that deserves a minimum

weight of 12%. There may also be a security that is not in favor that should be limited to a maximum

weight of 8%. And there remains the transparent constraint on the solution that the total of the weights

must be 100% to build a complete portfolio. For an example case of five securities with the above

constraints, the bounds on the weights may look like the following matrix:

The left side holds the lower bounds; the right, the upper. The second security is the favorite, and the

fourth is the one to limit. The final row is for the constraint that the total of all the weights must be 100%.

0.00 0.25

0.12 0.25

0.00 0.25

0.00 0.08

0.00 0.25

1.00 1.00

6

The coefficient matrix for the constraints goes along with the bounds discussed above. For the general

example with five securities, this coefficient matrix looks like:

As before, each of the first five rows is for each security in the portfolio and the final row is for the additional

constraint that all the weights must sum to 100%. One can make this more complex if there are constraints

like “the sum of the first three securities must be less than 15%” where there would be an additional row in

the coefficient matrix (1,1,1,0,0) and an additional row in the constraints on the weights of (0,0.15).

It may be easier to understand these constraints if they are written out algebraically. For the above example

for five securities, the weights are w

1

through w

5

in the following set of equations:

Computing the Efficient Frontier

With the above required inputs and the bounds on the solution set, the efficient frontier can now be

computed. This step is made up of several smaller steps. First, minimum and maximum possible returns

must be computed. Then for all the returns between the extremes, the portfolio that minimizes the risk is

computed. The efficient frontier is this set of portfolios for given values of risk and return.

The minimum and maximum possible returns are computed using the IMSL Library Linear Programming

function (DENSE_LP, linear_programming, com.imsl.math.DenseLP, Imsl.Math.DenseLP). The inputs into this

function are the constraints discussed above and the expected returns for each investment. Note that the

constraints here are both upper and lower bounds. As such, they must be input into the function as separate

one-dimensional arrays, with the lower bound as a parameter and the upper as an optional argument. The

optimal value returned from the linear programming function is the minimum possible return that can be

realized given this set of securities and the bounds on their weights in the portfolio. To find the maximum

possible return, the same function and input matrices are used except that the negative of the expected

returns is used. Literally, the negative return will be minimized now, yielding the maximum possible return.

1 0 0 0 0

0 1 0 0 0

0 0 1 0 0

0 0 0 1 0

0 0 0 0 1

1 1 1 1 1

0.05 ǉ w

1

ǉ 1.00

0.12 ǉ w

2

ǉ 1.00

0.05 ǉ w

3

ǉ 1.00

0.05 ǉ w

4

ǉ 0.08

0.05 ǉ w

5

ǉ 1.00

1.00 ǉ w

1

+ w

2

+ w

3

+ w

4

+ w

5

ǉ 1.00

7

With the minimum and maximum possible returns known, the extents of possible values on the risk-return

plot have been limited vertically. The next step is to find the portfolio that minimizes risk for each one of a

hundred or so return values evenly distributed between the minimum and maximum possible returns. Each

portfolio is computed using the IMSL Library Quadratic Programming function (QPROG, quadratic_prg,

com.imsl.math.Quadradic.Programming, Imsl.Math.QuadraticProgramming). The solution to this function is

a vector of weights for the securities that build the portfolio with the minimum amount of risk for the given

expected return. Also of interest is the overall value of risk for the portfolio, which is related to the optimal

object function found. Note that this is an output keyword for the IMSL C Library function, but not for the

IMSL Fortran, IMSL C#, or JMSL Library routines. It can be computed easily, however, since it is just:

Here x is the solution (the vector of weights), Q is the variance-covariance matrix.

At this point, for each possible return, the combination of securities that minimizes risk is known.

Graphically, one plots the risk and return values with risk on the x axis and return on the y axis. For

graphical purists, this will appear to be the reverse of what would normally be plotted since the resulting

curve appears as a double-valued function. That is, for some value of risk (on the x axis), two values of

return (on the y axis) may be observed. Figure 1 shows a typical efficient frontier graph.

FIGURE 1. An Efficient Frontier.

kx

T

Qx

8

Analysis of the Efficient Frontier Curve

This curve forms the basis of portfolio optimization and should be well understood. Minimum and

maximum possible returns were the first two points solved for. Determined by the linear programming

function calls, these points indicate the extents of realizable return for the portfolio contents and weight

constraints. It is impossible to achieve a higher or lower return rate than this; that is, there is no portfolio

that can give returns outside these bounds. See Figure 2.

On the other axis, the quadratic programming function has found the minimum risk for values of return

between the extremes. There are many portfolios that can result in a larger amount of risk for a given

return, and these portfolios would be points to the right of the efficient frontier curve. However, it is

impossible to find a portfolio that exposes less risk for any given value of return than those portfolios that

lie on this line. Thus the achievable risk-return space is the area of the graph between the vertical extents

of the curve and to the right. It is not possible, again given the content selection and constraints on the

proportions, to build a portfolio that returns risk and return values outside of this region.

FIGURE 2. The Achievable Risk-Return Space.

9

Finding the Optimal Portfolio

Examination of the portfolios that make up the efficient frontier curve will help in understanding the

concept of an “optimal portfolio” out of this set of portfolios that minimizes risk. This examination starts

with the bottom most point on the curve, where the portfolio represents the minimum return achievable,

and it has some value of risk associated with it. As one moves along the curve, the rate of return increases

and the rate of risk decreases, indicating better portfolio combinations with regards to higher return for less

risk. Eventually, the point of minimum risk is reached for some given return. If one were interested in only

minimizing risk, then this is the ideal portfolio combination. However, notice that there are points on the

curve indicating portfolios that yield a higher return. Moving along the curve further upward, the level of

risk increases along with the rate of return. At some point, the portfolios, while achieving higher rates of

return, are entering into a region of unacceptably high amounts of risk for those returns. The question

becomes where along this portion of the curve is the ideal spot?

The capital market line is a line defined such that the intercept is the risk-free rate of return and the slope

is the Sharpe ratio. In terms of the Capital Asset Pricing Model, the slope is the beta of the portfolio, ȋ.

The optimal portfolio, balancing the maximum return for the lowest amount of risk, can be found by

maximizing the slope of the line. To find this optimal portfolio, the risk-free rate of return is plotted on the

same graph as the efficient frontier. Since this point is “risk-free” by definition, it will appear where risk

equals zero, or somewhere on the y axis. The maximum slope occurs where the line is tangent to the

efficient frontier. Continuing the march along the curve moving from the point of minimum risk, the

amount of risk slowly increases as the rate of return increases. After the optimal portfolio is reached,

notice that the curvature of the efficient frontier is such that assuming additional risk does not achieve

a proportional return.

Figure 3 shows the efficient frontier (solid line) along with the risk-free rate of return (square) and the

capital market line (dashed line). The intersection of the efficient frontier curve with the tangent line is

the location in risk-return space of the optimal portfolio. One would then return to the solution provided by

the quadratic programming function to find what the associated weights are for this value of return. This

weight vector is the answer to the overall optimization problem: the ratio of each security in the portfolio.

The last extreme point on the curve is the portfolio that gives the maximum return. If the interest was just

in maximizing the possible return, this is the portfolio of choice. However, an investor would assume a

larger amount of risk to achieve this return. The combination of maximizing return and minimizing risk

yields the optimal portfolio at the tangent point found above.

10

FIGURE 3. The Optimal Portfolio.

For more Information

The ultimate goal of portfolio optimization is to build a portfolio with the proper proportion of its

components that will balance minimum risk and maximum return. The efficient frontier curve, which

enumerates a set of portfolios, will generate some given rate of return while minimizing risk to the

investor. This white paper outlined the necessary inputs, constraints on the solution, the computation

and analysis of the efficient frontier, and how to select the optimal solution from the set of possible

solutions.

Several IMSL Library functions were referred to in the text. The IMSL Numerical Libraries have been

the cornerstone of predictive analytics and high-performance computing applications in science,

technical and business environments for more than three decades. Regarded as the most

sophisticated and reliable technology available, the IMSL Libraries provide users with the software

and technical expertise needed to develop and execute scalable numerical analysis applications.

To view a brief online demonstration of the JMSL Numerical Library being used to solve a portfolio

optimization problem similar to the one described in this white paper, visit the Demos area at

http://www.vni.com/products/imsl/jmsl/jmsl.php

For general information on the IMSL Numerical Libraries for Fortran, C/C++, .NET or Java, visit

http://www.vni.com/products/imsl/

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