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ffirs.frm Page iii Tuesday, April 10, 2007 10:54 AMRobust PortfolioOptimization andManagementFRANK J. FABOZZIPETTER N. KOLMDESSISLAVA A. PACHAMANOVASERGIO M. FOCARDIJohn Wiley & Sons, Inc.
ffirs.frm Page vi Tuesday, April 10, 2007 10:54 AM
ffirs.frm Page i Tuesday, April 10, 2007 10:54 AMRobust PortfolioOptimization andManagement
ffirs.frm Page vi Tuesday, April 10, 2007 10:54 AM
ffirs.frm Page iii Tuesday, April 10, 2007 10:54 AMRobust PortfolioOptimization andManagementFRANK J. FABOZZIPETTER N. KOLMDESSISLAVA A. PACHAMANOVASERGIO M. FOCARDIJohn Wiley & Sons, Inc.
ffirs.frm Page ii Tuesday, April 10, 2007 10:54 AMTHE FRANK J. FABOZZI SERIESFixed Income Securities, Second Edition by Frank J. FabozziFocus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant andJames A. AbateHandbook of Global Fixed Income Calculations by Dragomir KrginManaging a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. FabozziReal Options and Option-Embedded Securities by William T. MooreCapital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. FabozziThe Exchange-Traded Funds Manual by Gary L. GastineauProfessional Perspectives on Fixed Income Portfolio Management, Volume 3 edited byFrank J. FabozziInvesting in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia PilarinuHandbook of Alternative Assets by Mark J. P. AnsonThe Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad ChoudhryThe Handbook of Financial Instruments edited by Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman andFrank J. FabozziInterest Rate, Term Structure, and Valuation Modeling edited by Frank J. FabozziInvestment Performance Measurement by Bruce J. FeibelThe Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. FabozziThe Theory and Practice of Investment Management edited by Frank J. Fabozzi andHarry M. MarkowitzFoundations of Economic Value Added: Second Edition by James L. GrantFinancial Management and Analysis: Second Edition by Frank J. Fabozzi and Pamela P. PetersonMeasuring and Controlling Interest Rate and Credit Risk: Second Edition by Frank J. Fabozzi,Steven V. Mann, and Moorad ChoudhryProfessional Perspectives on Fixed Income Portfolio Management, Volume 4 edited byFrank J. FabozziThe Handbook of European Fixed Income Securities edited by Frank J. Fabozzi andMoorad ChoudhryThe Handbook of European Structured Financial Products edited by Frank J. Fabozzi andMoorad ChoudhryThe Mathematics of Financial Modeling and Investment Management by Sergio M. Focardiand Frank J. FabozziShort Selling: Strategies, Risks, and Rewards edited by Frank J. FabozziThe Real Estate Investment Handbook by G. Timothy Haight and Daniel SingerMarket Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. LevySecurities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozziand Steven V. MannFat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn,and Frank J. FabozziFinancial Modeling of the Equity Market: From CAPM to Cointegration by Frank J.Fabozzi, Sergio M. Focardi, and Petter N. KolmAdvanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited byFrank J. Fabozzi, Lionel Martellini, and Philippe PriauletAnalysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J.Lucas, Laurie S. Goodman, and Frank J. FabozziHandbook of Alternative Assets, Second Edition by Mark J. P. AnsonIntroduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad ChoudhryFinancial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi,Sergio M. Focardi, and Teo JasicDevelopments in Collateralized Debt Obligations: New Products and Insights by Douglas J.Lucas, Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning
ffirs.frm Page iv Tuesday, April 10, 2007 10:54 AMCopyright 2007 by John Wiley & Sons, Inc. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.Wiley Bicentennial Logo: Richard J. PacificoNo part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their bestefforts in preparing this book, they make no representations or warranties with respect to theaccuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professionalwhere appropriate. Neither the publisher nor author shall be liable for any loss of profit orany other commercial damages, including but not limited to special, incidental, consequential,or other damages.For general information on our other products and services or for technical support, pleasecontact our Customer Care Department within the United States at (800) 762-2974, outsidethe United States at (317) 572-3993, or fax (317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appears inprint may not be available in electronic books. For more information about Wiley products,visit our web site at www.wiley.com.ISBN: 978-0-471-92122-6Printed in the United States of America.10 9 8 7 6 5 4 3 2 1
ffirs.frm Page v Tuesday, April 10, 2007 10:54 AMFJFTo my wife Donna and my children,Francesco, Patricia, and KarlyPNKTo Åke and Gunilla, my parents, and to John and Carmen,my wife’s parents, for their unending love and supportDAPTo my husband, Christian Hicks,and in memory of my grandfather, Georgyi MilyankovSMFTo the memory of Bertrand Russell to whom I owethe foundation of my intellectual development
ftoc.frm Page vii Tuesday, April 10, 2007 10:56 AMContentsPrefaceAbout the AuthorsxixvCHAPTER 1IntroductionQuantitative Techniques in the Investment Management IndustryCentral Themes of This BookOverview of This Book11912PART ONEPortfolio Allocation: Classical Theory and ExtensionsCHAPTER 2Mean-Variance Analysis and Modern Portfolio TheoryThe Benefits of DiversificationMean-Variance Analysis: OverviewClassical Framework for Mean-Variance OptimizationThe Capital Market LineSelection of the Optimal Portfolio When There Is a Risk-Free AssetMore on Utility Functions: A General Framework for Portfolio ChoiceSummaryCHAPTER 3Advances in the Theory of Portfolio Risk MeasuresDispersion and Downside MeasuresPortfolio Selection with Higher Moments through Expansions of UtilityPolynomial Goal Programming for PortfolioOptimization with Higher MomentsSome Remarks on the Estimation of Higher MomentsThe Approach of Malevergne and SornetteSummary15171821243541455053547078808186vii
ftoc.frm Page viii Tuesday, April 10, 2007 10:56 AMviiiCONTENTSCHAPTER 4Portfolio Selection in PracticePortfolio Constraints Commonly Used in PracticeIncorporating Transaction Costs in Asset-Allocation ModelsMultiaccount OptimizationSummary8788101106111PART TWORobust Parameter Estimation113CHAPTER 5Classical Asset PricingDefinitionsTheoretical and Econometric ModelsRandom Walk ModelsGeneral Equilibrium TheoriesCapital Asset Pricing Model (CAPM)Arbitrage Pricing Theory (APT)Summary115115117118131132136137CHAPTER 6Forecasting Expected Return and RiskDividend Discount and Residual Income Valuation ModelsThe Sample Mean and Covariance EstimatorsRandom MatricesArbitrage Pricing Theory and Factor ModelsFactor Models in PracticeOther Approaches to Volatility EstimationApplication to Investment Strategies and Proprietary TradingSummary139140146157160168172176177CHAPTER 7Robust EstimationThe Intuition behind Robust StatisticsRobust StatisticsRobust Estimators of RegressionsConfidence IntervalsSummary179179181192200206
ftoc.frm Page ix Tuesday, April 10, 2007 10:56 AMContentsCHAPTER 8Robust Frameworks for Estimation: Shrinkage,Bayesian Approaches, and the Black-Litterman ModelPractical Problems Encountered in Mean-Variance OptimizationShrinkage EstimationBayesian ApproachesSummaryix207208215229253PART THREEOptimization Techniques255CHAPTER 9Mathematical and Numerical OptimizationMathematical ProgrammingNecessary Conditions for Optimality for ContinuousOptimization ProblemsOptimization Duality TheoryHow Do Optimization Algorithms Work?Summary267269272288CHAPTER 10Optimization under UncertaintyStochastic ProgrammingDynamic ProgrammingRobust OptimizationSummary291293308312332CHAPTER 11Implementing and Solving Optimization Problems in PracticeOptimization SoftwarePractical Considerations When Using Optimization SoftwareImplementation ExamplesSpecialized Software for Optimization Under UncertaintySummary333333340346358360257258
ftoc.frm Page x Tuesday, April 10, 2007 10:56 AMxCONTENTSPART FOURRobust Portfolio Optimization361CHAPTER 12Robust Modeling of Uncertain Parameters in ClassicalMean-Variance Portfolio OptimizationPortfolio Resampling TechniquesRobust Portfolio AllocationSome Practical Remarks on Robust Portfolio Allocation ModelsSummary363364367392393CHAPTER 13The Practice of Robust Portfolio Management: Recent Trends andNew DirectionsSome Issues in Robust Asset AllocationPortfolio RebalancingUnderstanding and Modeling Transaction CostsRebalancing Using an OptimizerSummary395396410413422435CHAPTER 14Quantitative Investment Management Today and TomorrowUsing Derivatives in Portfolio ManagementCurrency ManagementBenchmarksQuantitative Return-Forecasting Techniques and Model-BasedTrading StrategiesTrade Execution and Algorithmic TradingSummary447456460APPENDIX AData Description: The MSCI World Index463INDEX473439440442445
fpref.frm Page xi Tuesday, April 10, 2007 10:59 AMPrefacen the past few years, there has been a notable increase in the use offinancial modeling and optimization tools in equity portfolio management. In addition to the pressure on asset management firms to reducecosts and maintain a more stable and predictable performance in theaftermath of the downturn in the U.S. equity markets in 2002, three othergeneral trends have contributed to this increase. First, there has been arevived interest in predictive models for asset returns. Predictive modelsassume that it is possible to make conditional forecasts of futurereturns—an objective that was previously considered not achievable byclassical financial theory. Second, the wide availability of sophisticatedand specialized software packages has enabled generating and exploitingthese forecasts in portfolio management, often in combination with optimization and simulation techniques. Third, the continuous increase incomputer speed and the simultaneous decrease in hardware costs havemade the necessary computing power affordable even to small firms.As the use of modeling techniques has become widespread amongportfolio managers, however, the issue of how much confidence practitioners can have in theoretical models and data has grown in importance. Consequently, there is an increased level of interest in the subjectof robust estimation and optimization in modern portfolio management. For years, robustness has been a crucial ingredient in the engineering, statistics, and operations research fields. Today, these fieldsprovide a rich source of ideas to finance professionals. While robustportfolio management undoubtedly demands much more than therobust application of quantitative techniques, there is now a widespreadrecognition for the need of a disciplined approach to the analysis andmanagement of investments.In this book we bring together concepts from finance, economic theory, robust statistics, econometrics, and robust optimization, and illustratethat they are part of the same theoretical and practical environment—in away that even a nonspecialized audience can understand and appreciate.At the same time, we emphasize a practical treatment of the subject, andtranslate complex concepts into real-world applications for robust returnIxi
fpref.frm Page xii Tuesday, April 10, 2007 10:59 AMxiiPREFACEforecasting and asset allocation optimization. Thereby, we address a number of issues in portfolio allocation and rebalancing. In particular, we discuss how to make portfolio management robust with respect to model risk,long-term views of the market, and market frictions such as trading costs.The book is divided into four parts. Part I covers classical portfoliotheory and its modern extensions. We provide an up-to-date treatment ofmethods for advanced risk management, nonnormal distributions forasset returns, transaction costs, and multiaccount portfolio management.Part II introduces traditional and modern frameworks for robust estimation of returns. We address a number of topics that include dimensionality reduction, robust covariance matrix estimation, shrinkage estimators,and the Black-Litterman framework for incorporating investors’ views inan equilibrium framework. Part III provides readers with the necessarybackground for handling the optimization part of portfolio man
Frank J. Fabozzi. Investing in Emerging Fixed Income Markets . edited by Frank J. Fabozzi and Efstathia Pilarinu. Handbook of Alternative Assets. by Mark J. P. Anson. The Global Money Markets . by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry. The Handbook of Financial Instruments. edited by Frank J. Fabozzi. Collateralized Debt Obligations: Structures and Analysis. by Laurie S .
