Solution to Portfolio Optimization: Scenario Approach

The table below contains the closing stock prices for five firms from health industry
over the years 2007-2016.

1. Use the scenario approach to determine the minimum-risk portfolio of these stocks
that yields an expected return of at least 22%, without shorting.

The percent return on the portfolio is represented by the random variable R.

5
R   ri xi
i 1

In this model, xi is the proportion of the portfolio (i.e. a number between zero and one)
allocated to investment i.
Each investment i have a percent return under each scenario j, which we represent with
the symbol rij.
We calculate the percent return on each of the stocks in each year:

For example, ABT went from $ 25.97 to $ 25.13672 in 1984, so the return on ABT in 2007
was:

S1 j  S0 25.13672 - 25.97
r1 j    -0.03209
S0 25.97

The portfolio return under any scenario j is given by:

5
R j   rij x i
i 1

Let Pj represent the probability of scenario j occurring. The expected value of R is given
by:
10
 R   R j Pj
j 1

The standard deviation of the portfolio’s return is given by:

 R   R  Pj
10
R  j
2

j 1

In this model, each scenario is considered to have an equal probability of occurring, so

we can simplify the two expressions:
10

R
j 1
j

R 
10
  R  R 
10
2
j
j 1
R 
10

Formulation
Decision Variables
We need to determine the proportion of our portfolio to invest in each of the five stocks.
Objective
Minimize risk.
Constraints
All of the money must be invested. (1)
The expected return must be at least 22%. (2)
No shorting. (3)

Mathematical Formulation
Decision Variables
x1 , x2 , x3 , x4 , and x5 (corresponding to ABT,ABEO,ACAD,ACER,ACHN).

Objective

 R  R 
10
2
j
j 1
Minimize Z =  R 
10

Constraints
5

x
i 1
i  1.0 (1)
10

R
j 1
j

R   0.22 (2)
10
For all i, xi ≥ 0 (3)
The decision variables are in F2:J2.
The objective function is in C7.
Cell E2 keeps track of constraint (1).
Cells C6 and C9 keep track of constraint (2).
Constraint (3) can be handled by checking the “assume non-negative” box in the Solver
Options.

Conclusions
Invest 77.4% in ABT, 10.4% in ACAD, 2.1% in ACER, and 10.01% in ACHN. The
expected return will be 22%, and the standard deviation will be 31.1%.

2. Show how the optimal portfolio changes as the required return varies.
We use Solver Table, using C9 (the required return value) as the input cell. We include
the xi variables as output cells and create this Excel “area” chart, illustrating how the
portfolio changes as the constraint on expected return varies.

1.2

0.8
ABT
0.6
ABEO
0.4 ACAD
ACER
0.2
ACHAN
0
3. Draw the efficient frontier for portfolios composed of these five stocks.

Efficient Frontier
0.35

0.3

0.25

0.2

0.15
expected return
0.1

0.05

4. Repeat Part 2 with shorting allowed.

We remove the check in the “assume nonnegative” box, and get the same optimal
solution for a required expected return of 22%.
5. Interpret the results.

With shorting allowed the expected return can be increased beyond the limited value
which we were receiving in without shorting.

With shorting we have less standard deviation compared to without shorting.

-By Group 15

Meenakshi-MS17A070

Imran Kadolkar-MS17A022

Sanam Manisha Devi-MS17A049