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Financial Application: Portfolio Selection

The document describes a linear programming problem faced by Winslow Savings. It wants to maximize interest earned over 4 months by investing in government bonds and construction loans, while having $10 million available in month 5. It formulates the problem as maximizing the interest earned in each investment subject to budget and maximum investment constraints. Decision variables, objective function, and 13 constraints are defined. The computer solution provides the optimal investment amounts each month satisfying all constraints.

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Teree Zu
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73 views

Financial Application: Portfolio Selection

The document describes a linear programming problem faced by Winslow Savings. It wants to maximize interest earned over 4 months by investing in government bonds and construction loans, while having $10 million available in month 5. It formulates the problem as maximizing the interest earned in each investment subject to budget and maximum investment constraints. Decision variables, objective function, and 13 constraints are defined. The computer solution provides the optimal investment amounts each month satisfying all constraints.

Uploaded by

Teree Zu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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FINANCIAL APPLICATION

PORTFOLIO SELECTION
FINANCIAL APPLICATIONS

LP can be used in financial decision-making that involves capital


budgeting, make-or-buy, asset allocation, portfolio selection,
financial planning, and more.
Portfolio selection problems involve choosing specific investments
– for example, stocks and bonds – from a variety of investment
alternatives.
This type of problem is faced by managers of banks, mutual funds,
and insurance companies.
The objective function usually is maximization of expected return or
minimization of risk.
PORTFOLIO SELECTION

Winslow Savings has $20 million available for


investment. It wishes to invest over the next four
months in such a way that it will maximize the total
interest earned over the four month period as well as have at
least $10 million available at the start of the fifth month for a
high rise building venture in which it will be participating.
PORTFOLIO SELECTION

For the time being, Winslow wishes to invest


only in 2-month government bonds (earning 2% over
the 2-month period) and 3-month construction loans
(earning 6% over the 3-month period). Each of these
is available each month for investment. Funds not
invested in these two investments are liquid and earn
3/4 of 1% per month when invested locally.
PORTFOLIO SELECTION

Formulate a linear program that will help Winslow


Savings determine how to invest over the next four months if
at no time does it wish to have
more than $8 million in either government bonds or
construction loans.
PORTFOLIO SELECTION

Define the Decision Variables

Gi = amount of new investment in government


bonds in month i (for i = 1, 2, 3, 4)
Ci = amount of new investment in construction
loans in month i (for i = 1, 2, 3, 4)
Li = amount invested locally in month i,
(for i = 1, 2, 3, 4)
PORTFOLIO SELECTION

Define the Decision Variables

Maximize total interest earned in the 4-month period:

Max (interest rate on investment) X (amount invested)

Max .02G1 + .02G2 + .02G3 + .02G4


+ .06C1 + .06C2 + .06C3 + .06C4
+ .0075L1 + .0075L2 + .0075L3 + .0075L4
PORTFOLIO SELECTION

Define the Constraints

Month 1's total investment limited to $20 million:


(1) G1 + C1 + L1 = 20,000,000

Month 2's total investment limited to principle and interest


invested locally in Month 1:
(2) G2 + C2 + L2 = 1.0075L1
or G2 + C2 - 1.0075L1 + L2 = 0
PORTFOLIO SELECTION

Define the Constraints (continued)

Month 3's total investment amount limited to principle and


interest invested in government bonds in Month 1 and
locally invested in Month 2:

(3) G3 + C3 + L3 = 1.02G1 + 1.0075L2


or - 1.02G1 + G3 + C3 - 1.0075L2 + L3 = 0
PORTFOLIO SELECTION

Define the Constraints (continued)

Month 4's total investment limited to principle and interest


invested in construction loans in Month 1, goverment
bonds in Month 2, and locally invested in Month 3:
(4) G4 + C4 + L4 = 1.06C1 + 1.02G2 + 1.0075L3
or - 1.02G2 + G4 - 1.06C1 + C4 - 1.0075L3 + L4 = 0

$10 million must be available at start of Month 5:


(5) 1.06C2 + 1.02G3 + 1.0075L4 > 10,000,000
PORTFOLIO SELECTION

Define the Constraints (continued)

No more than $8 million in government bonds at any time:


(6) G1 < 8,000,000
(7) G1 + G2 < 8,000,000
(8) G2 + G3 < 8,000,000
(9) G3 + G4 < 8,000,000
PORTFOLIO SELECTION

Define the Constraints (continued)

No more than $8 million in construction loans at any time:


(10) C1 < 8,000,000
(11) C1 + C2 < 8,000,000
(12) C1 + C2 + C3 < 8,000,000
(13) C2 + C3 + C4 < 8,000,000

Non-negativity:
Gi, Ci, Li > 0 for i = 1, 2, 3, 4
PORTFOLIO SELECTION
Computer Solution
Objective Function Value = 1429213.7987
.02(8000000) + .02(0) + .02(5108613.9228) + .02(2891386.0772) + .06(8000000) + .
06C2(0) + .06(0) + .06(8000000) + .0075(4000000) + .0075(4030000) + .
0075(7111611.0772) + .0075(4753562.0831)
Variable Value Reduced Costs
G1 8000000.0000 0.0000
G2 0.0000 0.0000
G3 5108613.9228 0.0000
G4 2891386.0772 0.0000
C1 8000000.0000 0.0000
C2 0.0000 0.0453
C3 0.0000 0.0076
C4 8000000.0000 0.0000
L1 4000000.0000 0.0000
L2 4030000.0000 0.0000
L3 7111611.0772 0.0000
L4 4753562.0831 0.0000
PORTFOLIO SELECTION

Constraints
• (1) G1 + C1 + L1 = 20,000,000
8,000,000 + 8,000,000 + 4,000,000 = 20,000,000
• (2) G2 + C2 - 1.0075L1 + L2 = 0
0 + 0 - 1.0075(4,000,000) + 4,030,000 = 0
• (3) - 1.02G1 + G3 + C3 - 1.0075L2 + L3 = 0
-1.02 (8,000,000) + 5,108,613.9228 + 0 - 1.0075(4,030,000) + 7,111,611.0772
=0
• (4) - 1.02G2 + G4 - 1.06C1 + C4 - 1.0075L3 + L4 = 0
- 1.02(0) + 2,891,386.0772 - 1.06(8,000,000)+ 8,000,000 -
1.0075(7111611.0772) + 4753562.0831 = 0
PORTFOLIO SELECTION

Constraints
• (5) 1.06C2 + 1.02G3 + 1.0075L4 > 10,000,000
1.06(0) + 1.02(5108613.9228) + 1.0075 4,753,562.0831 > 10,000,000
• (6) G1 < 8,000,000
8,000,000 < 8,000,000
• (7) G1 + G2 < 8,000,000
8,000,000 + 0 < 8,000,000
• (8) G2 + G3 < 8,000,000
0 + 5,108,613.9228 < 8,000,000
• (9) G3 + G4 < 8,000,000
5,108,613.9228 + 2,891,386.0772 < 8,000,000
PORTFOLIO SELECTION

Constraints
• (10) C1 < 8,000,000
8,000,000 < 8,000,000
• (11) C1 + C2 < 8,000,000
8,000,000 + 0 < 8,000,000
• (12) C1 + C2 + C3 < 8,000,000
8,000,000 + 0 + 0 < 8,000,000
• (13) C2 + C3 + C4 < 8,000,000
0 + 0 + 8,000,000 < 8,000,000

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