IBM Software White Paper

ILOG Optimization

Optimization applications
in finance, securities,
banking and insurance
2 Optimization applications in finance, securities, banking and insurance
Table of contents
2 Important differentiators
2 Competitive advantage in finance
3 Better decisions faster
3 Portfolio optimization and financial planning
4 Asset liability management
4 Derivatives pricing
4 Loan configuration and lending
5 Conclusion
5 Customer case studies
Important differentiators
The recent crisis in the financial sector—lending, investment,
securities, banking and insurance—has focused executive
attention on near-term issues of survival and recovery, espe-
cially in the area of risk management, while diverting attention
from improving operational efficiency and building customer
relationships. Yet, the two latter factors remain important
competitive advantages for leading companies in this sector.
Optimization technologies—particularly IBM® ILOG®
products—have played an important role in enabling compa-
nies in the financial sector to make better decisions faster. As
this white paper shows, IBM ILOG CPLEX® Optimization
Studio and IBM ILOG ODM Enterprise enable rapid devel-
opment and deployment of applications that address the
financial sectors’ most important competitive differentiators.
Competitive advantage in finance
IBM ILOG Optimization products provide tools that deliver
significant competitive advantage for solving the most chal-
lenging problems encountered in finance. Three in particu-
larly are well suited for optimization:
● Risk management: Recent events have caused many com-
panies in the financial sector to revisit their risk manage-
ment policies and the underlying analytical models that
support them. Mathematical models remain at the heart of
risk management, balancing the expected returns and corre-
lations of market risk among securities. Current models
account for investor preferences, sectoral risks, transaction
costs and timing. Furthermore, as hedging with derivative
securities has become commonplace, optimization models
have played a key role in quantifying their value and
implementing trading strategies. As the economic basis of
risk management undergoes revision and evolution, reliable
and fast optimization engines continue to provide the basis
for effective risk management applications.
● Operational cost: Controlling transaction costs is critical
in implementing profitable portfolio trading strategies.
Optimization models can identify opportunities to group
trades across multiple portfolios to take advantage of dis-
counts or execute internal trades among portfolios within
the same organization, avoiding the cost of going to the
market. The ability to manage large numbers of trades auto-
matically through an optimization application provides the
basis for effective operational cost control applications.
● Product innovation: Firms in the finance sector have his-
torically avoided commoditization by innovating to create
new products and services. In the past, impressive growth
has been achieved in mature markets. However, today’s
growth opportunities in those geographies are declining,
and meaningful future expansion will come from new mar-
kets. The firms that will benefit in these emerging profit
pools will be the ones that specialize in the areas valued
by their clients while optimizing their global reach.
Optimization can provide the basis to do both in
unexpected ways.

Optimization tools do not remove inherent risks in financial
markets, but they do allow users to optimally leverage
resources while balancing profit considerations with risk. They
are an inherent part of strategies for making more effective
management decisions.
Better decisions faster
IBM ILOG Optimization products have been used effectively
by many financial institutions in model development, empiri-
cal validation, benchmarking and comparative studies, while
developed applications can easily interface with existing sys-
tems such as spreadsheets, databases, data visualization tools,
statistical analysis packages, and existing frameworks and user
interfaces.
Optimization models
● Portfolio optimization
● Financial planning
● Asset-liability management
● Derivatives pricing
● Loan configuration and lending
Optimization products
● IBM ILOG CPLEX Optimization Studio
● IBM ILOG ODM Enterprise
Portfolio optimization and financial
planning
Mathematical programming algorithms implemented with
CPLEX Optimization Studio are well suited for solving index
tracking, portfolio rebalancing models, and portfolio planning
models, including mean variance and factor models. Various
side constraints modeled with linear programming (LP) and
quadratic programming (QP) are often included in these clas-
sical portfolio optimization models.
IBM Software 3
IBM ILOG Optimization tools are also effective at solving
mixed integer programs (MIPs) induced by cardinality con-
straints, fixed costs, and all sorts of indivisible decisions that
can occur when issuing a security, as well as fixed transaction
costs and percentile risk measures (CVaR). IBM ILOG
CPLEX Optimizers provides algorithms that are, in turn,
ideal for processing discrete optimization (MILP, MIQP and
MIQCP) models, and deal with these constraints while han-
dling common risk measures.
Nonlinear terms, including nonlinear transaction costs that
have an impact on trading, benefit from the ability to model
piecewise linear functions and special ordered set (SOS) for-
mulations, which are both easily accessible with CPLEX
Optimization Studio.
Monte Carlo simulations have become the common method
used by financial institutions to test the robustness of their risk
models. Testing them against a large set of scenarios helps val-
idate the underlying assumptions, building trust that they will
fully and effectively capture risks. These simulations can then
be solved with optimization, allowing the handling of hun-
dreds of instruments and scenarios. ODM Enterprise is partic-
ularly well suited to these uses, with its scenario management
and database capabilities.
The flexibility of the IBM ILOG Optimization products
allows resolutions to be embedded within iterative strategies
and to interact with other systems to solve a series of scenar-
ios, which can be provided by alternative scenario generation
procedures, to test several modeling possibilities, optimize
portfolio rebalancing at multiple points in time, analyze the
consequences of portfolio composition in subsequent trading
periods and other comparative operations.
4 Optimization applications in finance, securities, banking and insurance
Asset liability management
A typical problem in asset-liability management is determining
which assets an investor should hold, and in what quantities,
in each period in order to maximize expected wealth at the
end of the planning horizon. The investor may be a financial
institution such as a bank or insurance company, but many
institutions also provide this service for their customers.
Therefore, effective tools for asset-liability management pro-
vide a basis for competitive advantage.
Problems in asset-liability management can be very hard to
solve when they incorporate complex probability distribution
functions that model the various uncertainties facing an
investor, such as the expected returns from the assets and the
expected liabilities. Typically, the more accurately a probability
distribution function models the real world, the more complex
and harder it is to solve.
Mathematical problems that deal with uncertainty are referred
to as stochastic programs and require very powerful mixed
integer programming (MIP) optimization engines to be
solved, as well as advanced modeling and solution strategies
(for example, Bender’s decomposition).
Derivative pricing
Derivative pricing has become a very important problem in
finance, and many analytical methods (for example, Black-
Scholes and Stochastic Volatility) have been developed to
assist investors with their decision-making process. Lately,
researchers have started using mathematical programming
techniques to answer basic, as well as advanced, questions in
derivative pricing. Mathematical programming provides more
generality and flexibility than many of the specialized algo-
rithms developed in the past to price individual types of deriv-
atives, thus enabling innovation and reducing time to market
for new derivative products.
Mathematical programs solved with CPLEX Optimization
Studio allow decisions to be incorporated over an extended
planning horizon taking into account market volatility based
on stochastic scenario trees, and can easily incorporate taxes,
transaction costs, trade restrictions and other portfolio con-
straints, which are typically not straightforward with closed
formula solutions.
Loan configuration and lending
Optimization tools can prove valuable in maximizing overall
profit and customer acceptance in loan configuration and
lending applications. Some of the key criteria for loan qualifi-
cation include credit score, amount for the loan, payment
terms and interest rates. Often the factors that lead a customer
to accept a loan are perceived to be at odds with the factors
that make the loan attractive to a lender. But in today’s com-
petitive market, where customers have many choices for
financing, a rapid, yet flexible, response from a lender can be
instrumental to winning business. Lenders also want to man-
age their loan portfolios to achieve specific targets for risk and
return while satisfying regulatory and prudency requirements.
There are potentially many other considerations that a loan
company might want to consider in developing its loan
portfolio, such as:
● Cardinality rules that specify the maximum number of loans
in a portfolio
● Business rules that specify combinations of loans that can or
cannot be included in the same portfolio
The loan portfolio problem can be modeled as a LP, or in
cases of more complicated constraints, as a MIP. Both of these
problem types can be modeled and solved efficiently with
CPLEX Optimization Studio.

IBM ILOG Optimization products can then be used to
develop solutions based on a selection of constraints and
parameters. The optimization tools will, for instance, take into
account user-defined limits to allow the best solution to be
offered—for the customer and the financial institution. Credit
configuration is then optimized and the needed time to ana-
lyze a customer demand before taking a decision is shortened.
Conclusion
Recent advances in computer processing power and
IBM ILOG Optimization technology, allied with larger com-
puter memory and data management systems, allow problems
to be solved today that were intractable only a few years ago.
As a consequence, the finance, securities, banking and insur-
ance industries, with their rich heritage of developing quanti-
tative and probabilistic models with large sets of data, can
build practical optimization applications to optimally leverage
resources while balancing profit considerations with risk.
Customer case studies
● Bank asset management
IBM WebSphere® ILOG JRules is used to ensure that
incoming market information from various sources is com-
pliant with data quality standards and regulations. JRules
provides additional agility with real-time use to monitor
merger and acquisition data, changes in stock values and
other critical information, enabling real-time updates to this
bank’s asset management reference data systems.
Once the data has been qualified by JRules, IBM ILOG
CPLEX Optimization Studio determines the optimum port-
folio configuration based on predefined investment guide-
lines, or benchmarks, creating tax-efficient portfolios while
meeting customers’ investment goals and risk profiles.
CPLEX Optimization Studio also reduces the tracking error
between benchmarks and a tailored portfolio.
IBM Software 5
Account managers can then comply automatically with spe-
cific client requests, such as asset allocation, as well as regu-
lations, further personalizing the bank’s asset management
offerings.
● Investment manager
Optimization creates competitive advantage as part of
innovative services that have saved customers hundreds of
millions of dollars.
Optimizing portfolio management helps one of the world’s
largest investment managers create competitive advantage
and provide substantial savings to its clients.
Three of the company’s applications use CPLEX
Optimization Studio:
Trade crossing
Several hundred million dollars in transaction cost savings
have been achieved through an innovative approach to
“trade crossing” in which the company uses ILOG
Optimization software to match thousands of assets in buy
orders against similar assets in sell orders, where the orders
come from thousands of different funds under management.
Leveraging a leading position as a top global manager of
institutional assets, the trade-crossing application avoids
market trades and related transaction costs (for both buy-
and sell-side trades).
Because of the volume of trades and the complex set of busi-
ness policies and regulatory guidelines, trade crossing could
not be performed effectively or efficiently without using
advanced optimization software.
6 Optimization applications in finance, securities, banking and insurance
Portfolio in-kinding
A large number of clients opted to transition their assets to
hundreds of the company’s funds. However, transitioning to
new strategies normally has potential for significant transac-
tion costs. In this second application, “portfolio in-kinding,”
the company used ILOG Optimization to transfer a large
majority of portfolio values directly (“in-kind”) into their
targeted funds, saving clients hundreds of millions in
transaction costs.
Fund rebalancing
In addition to taking full advantage of both trade crossing
and in-kinding to minimize the related transaction costs, the
company uses ILOG Optimization in “fund rebalancing,” a
huge task because the company manages hundreds of bil-
lions of dollars distributed into thousands of funds tracking
over hundreds of indexes. The goal is to create optimal
holdings of fund assets through appropriate trades, allowing
fund managers to perform accurate index tracking while
minimizing transaction costs. The high complexity of recon-
ciling risk and return objectives, fund policies, and regula-
tory guidelines makes this process a differentiating factor in
the investment industry.
The application has saved hundreds of millions in transac-
tion costs. Trade crossing and in-kinding are a major source
of competitive advantage, as they allow managing the high
complexity of reconciling risk and return objectives, fund
policies and regulatory guidelines, and makes the fund
rebalancing process a differentiating factor in the
investment industry.
● Portfolio manager
This company provides portfolio management solutions to
institutions and wealthy individuals. It is widely recognized
for its pioneering research in the field of tax-efficient invest-
ing. It uses an application that automates the process of
determining the best mix of tax-efficient investments in a
consistent and timely manner.
CPLEX Optimization Studio enables the company to evalu-
ate portfolios daily. The evaluation incorporates cash level,
capital gains and losses, risk, investor needs, risk tolerance
and time since last optimization. CPLEX Optimization
Studio and the included Optimization Programming
Language (OPL), simplifies the modeling process by quickly
modeling a problem and converting it into code used by the
IBM ILOG CPLEX Optimizers.
With billions in assets under management, the firm special-
izes in combining index-based stock selection with active tax
management within a privately managed account.
The company is one of the few firms that report after-tax
returns, and as a recognized leader, it works with the invest-
ment industry to create new standards in this area. As many
of its competitors do not factor taxes when rebalancing port-
folios, this affords the company a sizable advantage. The
optimizer also improves the stability, quality and speed
of analysis.
Compared with passive management, the company estimates
that its portfolio optimizer increases after-tax returns by up to
1.5 percent per year. It also accommodates a broader range of
portfolios, achieves twofold growth and enlarges its customer
base. It also allows faster responses to requests and better
delivery of services to customers.
Notes
For more information
To learn more about the Optimization Applications in
Finance, Securities, Banking and Insurance, please
contact your IBM representative or IBM Business
Partner or visit the following website:
ibm.com/software/websphere/industries/financial/
Additionally, financing solutions from IBM Global Financing
can enable effective cash management, protection from tech-
nology obsolescence, improved total cost of ownership and
return on investment. Also, our Global Asset Recovery
Services help address environmental concerns with new, more
energy-efficient solutions. For more information on
IBM Global Financing, visit: ibm.com/financing
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