This document discusses portfolio optimization through index tracking models. It begins by setting the market context, including return vectors for benchmarks and assets. It then discusses minimizing tracking error by finding the optimal portfolio weights that minimize variance between benchmark and portfolio returns. Finally, it formulates tracking error minimization as linear programming problems for different error metrics, such as mean absolute deviation, MinMax, mean absolute downside deviation, and downside MinMax. The linear programming formulations allow minimizing these error metrics by introducing variables for deviations between returns and constraints linking them to optimal portfolio weights.
This document discusses portfolio optimization through index tracking models. It begins by setting the market context, including return vectors for benchmarks and assets. It then discusses minimizing tracking error by finding the optimal portfolio weights that minimize variance between benchmark and portfolio returns. Finally, it formulates tracking error minimization as linear programming problems for different error metrics, such as mean absolute deviation, MinMax, mean absolute downside deviation, and downside MinMax. The linear programming formulations allow minimizing these error metrics by introducing variables for deviations between returns and constraints linking them to optimal portfolio weights.
This document discusses portfolio optimization through index tracking models. It begins by setting the market context, including return vectors for benchmarks and assets. It then discusses minimizing tracking error by finding the optimal portfolio weights that minimize variance between benchmark and portfolio returns. Finally, it formulates tracking error minimization as linear programming problems for different error metrics, such as mean absolute deviation, MinMax, mean absolute downside deviation, and downside MinMax. The linear programming formulations allow minimizing these error metrics by introducing variables for deviations between returns and constraints linking them to optimal portfolio weights.
This document discusses portfolio optimization through index tracking models. It begins by setting the market context, including return vectors for benchmarks and assets. It then discusses minimizing tracking error by finding the optimal portfolio weights that minimize variance between benchmark and portfolio returns. Finally, it formulates tracking error minimization as linear programming problems for different error metrics, such as mean absolute deviation, MinMax, mean absolute downside deviation, and downside MinMax. The linear programming formulations allow minimizing these error metrics by introducing variables for deviations between returns and constraints linking them to optimal portfolio weights.
Duan LI & Xiangyu Cui India Institute of Technology Kharagpur May 26 - 30, 2014
Market Setting
Outline
Market Setting Tracking Error Minimization Linear Programming Formulation
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Market Setting
Market Setting
Let T be the number of observations and n be the number of
assets.
Y is a vector of continuously compounded benchmark returns,
which is a T dimensional vector.
X is the matrix of continuously compounded returns on n
assets, which is a T n matrix.
is the portfolio weights to be determined, which is an n
dimensional vector.
2 / 10
Tracking Error Minimization
Outline
Market Setting Tracking Error Minimization Linear Programming Formulation
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Tracking Error Minimization
Minimization of Tracking Error Variance
The investor chooses the portfolio such that tacking error variance is minimized, min (Y X )0 (Y X ). The optimal portfolio is :
= (X 0 X )
X 0Y .
4 / 10
Tracking Error Minimization
Minimization of Various Tracking Error
Functions I
Mean absolute deviation (MAD):
min 10 (|X
MinMax:
min I
max |Xt t
Yt | .
Mean absolute downside deviation (MADD):
min 10 (min(X
Y |).
Downside MinMax (DMinMax):
min max (min(Xt
t
Y , 0)).
Yt , 0)) .
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Linear Programming Formulation
Outline
Market Setting Tracking Error Minimization Linear Programming Formulation
6 / 10
Linear Programming Formulation
MAD Let zt+ 0 be a positive deviation and zt 0 the absolute value of a negative deviation between the portfolio and benchmark returns. Then Yt > 0 , Xt
Xt
zt = Yt ,
Yt < 0 , Xt + zt+ = Yt ,
Xt which implies min
zt+ ,
zt ,
s.t.
T X
(zt+ + zt )
t=1
Xt + zt+ 0
zt+
zt = Yt , t = 1, . . . , T ,
= 1, 0, zt
0, t = 1, . . . , T . 7 / 10
Linear Programming Formulation
MinMax Let z
0 be an upper boundary of the absolute deviations:
Yt |, t = 1, . . . , T .
|Xt
z We have min z z,
s.t. Xt
z Yt , t = 1, . . . , T ,
Xt + z 0
= 1,
0.
Yt , t = 1, . . . , T ,
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Linear Programming Formulation
MADD If investors are concerned about negative deviations between the portfolio and the benchmark, the zt+ are dropped from the optimization MAD, which results in min
zt ,
T X
zt
t=1
s.t. Xt + zt 0
zt
Yt , t = 1, . . . , T ,
= 1, 0, t = 1, . . . , T .
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Linear Programming Formulation
DMinMax Only the restrictions Xt Yt are relevant. Thus, we only care about Xt + z Yt . min z z,
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