An Exact Solution Approach for Portfolio Optimization Problems under Stochastic and Integer Constraints

Abstract

In this paper, we study extensions of the classical Markowitz’ mean-variance portfolio optimization model. First, we consider that the expected asset returns are stochastic by introducing aprobabilistic constraint imposing that the expected return of the constructed portfolio must exceeda prescribed return level with a high confidence level. We study the deterministic equivalents ofthese models. In particular, we define under which types of probability distributions the deterministic equivalents are second-order cone programs, and give exact or approximate closed-form formulations. Second, we account for real-world trading constraints, such as the need to diversify theinvestments in a number of industrial sectors, the non-profitability of holding small positions and theconstraint of buying stocks by lots, modeled with integer variables. To solve the resulting problems,we propose an exact solution approach in which the uncertainty in the estimate of the expected returns and the integer trading restrictions are simultaneously considered. The proposed algorithmicapproach rests on a non-linear branch-and-bound algorithm which features two new branching rules.The first one is a static rule, called idiosyncratic risk branching, while the second one is dynamic andcalled portfolio risk branching. The proposed branching rules are implemented and tested using theopen-source framework of the solver Bonmin. The comparison of the computational results obtainedwith standard MINLP solvers and with the proposed approach shows the effectiveness of this latterwhich permits to solve to optimality problems with up to 200 assets in a reasonable amount of time.