Optimal Portfolio Execution Strategies: Uncertainty and Robustness
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Date
2011-10-28T17:54:58Z
Authors
Moazeni, Somayeh
Journal Title
Journal ISSN
Volume Title
Publisher
University of Waterloo
Abstract
Optimal investment decisions often rely on assumptions about the models and their associated
parameter values. Therefore, it is essential to assess suitability of these assumptions
and to understand sensitivity of outcomes when they are altered. More importantly, appropriate
approaches should be developed to achieve a robust decision. In this thesis, we carry
out a sensitivity analysis on parameter values as well as model speci cation of an important
problem in portfolio management, namely the optimal portfolio execution problem. We then
propose more robust solution techniques and models to achieve greater reliability on the
performance of an optimal execution strategy.
The optimal portfolio execution problem yields an execution strategy to liquidate large
blocks of assets over a given execution horizon to minimize the mean of the execution cost
and risk in execution. For large-volume trades, a major component of the execution cost
comes from price impact. The optimal execution strategy then depends on the market price
dynamics, the execution price model, the price impact model, as well as the choice of the
risk measure.
In this study, rst, sensitivity of the optimal execution strategy to estimation errors in
the price impact parameters is analyzed, when a deterministic strategy is sought to minimize
the mean and variance of the execution cost. An upper bound on the size of change in the
solution is provided, which indicates the contributing factors to sensitivity of an optimal
execution strategy. Our results show that the optimal execution strategy and the e cient
frontier may be quite sensitive to perturbations in the price impact parameters.
Motivated by our sensitivity results, a regularized robust optimization approach is devised
when the price impact parameters belong to some uncertainty set. We rst illustrate that
the classical robust optimization might be unstable to variation in the uncertainty set. To
achieve greater stability, the proposed approach imposes a regularization constraint on the
uncertainty set before being used in the minimax optimization formulation. Improvement in
the stability of the robust solution is discussed and some implications of the regularization
on the robust solution are studied.
Sensitivity of the optimal execution strategy to market price dynamics is then investigated.
We provide arguments that jump di usion models using compound poisson processes
naturally model uncertain price impact of other large trades. Using stochastic dynamic programming,
we derive analytical solutions for minimizing the expected execution cost under
jump di usion models and compare them with the optimal execution strategies obtained
from a di usion process.
A jump di usion model for the market price dynamics suggests the use of Conditional
Value-at-Risk (CVaR) as the risk measure. Using Monte Carlo simulations, a smoothing
technique, and a parametric representation of a stochastic strategy, we investigate an approach
to minimize the mean and CVaR of the execution cost. The devised approach can
further handle constraints using a smoothed exact penalty function.
Description
Keywords
Computational Finance, Robust Optimization, Sensitivity Analysis, Portfolio Management