Chapter 8

Nonlinear Optimization Models

Case Problem: Portfolio Optimization with Transaction Costs

1. If $41,268.51are spent purchasing the Intermediate-Term Bond fund, and the transaction cost is 1
percent (i.e. one cent on the dollar), then the transaction fee is

.01 ($41, 268.51) = $412.6851

2. The total dollar amount spent on transaction costs is $1090.311.

3. After rebalancing, Ms. Delgado has $100,000 - $1090.311 = $98,909.689

4. To calculate the expected amount in the Intermediate-Term bond fund at year end, figure out the
year-end amount in each scenario and then weight each scenario by a factor of 1/5 = .2. Since Ms.
Delgado started with $51,268.51 after rebalancing, this gives

$51,268.51 + (.2)(.1764)( $51,268.51) + (.2)(.0325)( $51,268.51)

+ (.2)(.0751)( $51,268.51) - (.2)(.0133)( $51,268.51) +(.2)(.0736)( $51,268.51)

= $51,268.51 + $3530.35 = $54,798.86

5. From the LINGO solution we see that Ms. Delgado can expect an average return of $10,000 on her
investment. After rebalancing (see question 3) Ms. Delgado has $98,909.689 in her portfolio to start
the year, so she is getting a return of greater than 10 percent on the amount of money she starts
with after rebalancing! However, this is not what she wants or expects. Since she starts the year with
$98,909.689 after rebalancing and earns (in expectation) $10,000 she can expect $98,909.689 +
$10,000 = $108,909.689 in her portfolio. However, this does not give a return of 10 percent on her
original portfolio of $100,000 which is what she expected. In order to end up with a return of at least
10 percent on her original portfolio she must have at least $110,000.00 in her portfolio at the end of
the year.

6. Here is the formulation that provides an expected value at least $110,000 at year end.

MIN = (1/5)*((R1 - RBAR)^2 + (R2 - RBAR)^2 + (R3 - RBAR)^2 + (R4 -

RBAR)^2 + (R5 - RBAR)^2);
! THE SCENARIO RETURNS;
1.1006*FS + 1.1764*IB + 1.3241*LG + 1.3236*LV + 1.3344*SG + 1.2456*SV =
R1;
1.1312*FS + 1.0325*IB + 1.1871*LG + 1.2061*LV + 1.1940*SG + 1.2532*SV =
R2;
1.1347*FS + 1.0751*IB + 1.3328*LG + 1.1293*LV + 1.0385*SG +
(1- .0670)*SV = R3;
1.4542*FS + (1 - .0133)*IB + 1.4146*LG + 1.0706*LV + 1.5868*SG +
1.0543*SV = R4;
(1-.2193)*FS + 1.0736*IB + (1- .2326)*LG + (1- .0537)*LV +
(1- .0902)*SG + 1.1731*SV = R5;
! PORTFOLIO AVERAGE RETURN;
(1/5)*(R1 + R2 + R3+ R4 + R5) = RBAR;
! UNITY CONSTRAINT;

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Chapter 6

FS + IB + LG + LV + SG + SV + TRANS_COST = 100000;
RBAR > RMIN;
RMIN = 10000 + 100000;
! DEFINE BUY AND SELL QUANTITIES;
FS = FS_START + FS_BUY - FS_SELL;
IB = IB_START + IB_BUY - IB_SELL;
LG = LG_START + LG_BUY - LG_SELL;
LV = LV_START + LV_BUY - LV_SELL;
SG = SG_START + SG_BUY - SG_SELL;
SV = SV_START + SV_BUY - SV_SELL;
! DEFINE TOTAL TRANSACTION COSTS;
TRANS_COST = TRANS_FEE*(FS_BUY + FS_SELL + IB_BUY + IB_SELL +
LG_BUY + LG_SELL + LV_BUY + LV_SELL + SG_BUY + SG_SELL + SV_BUY +
SV_SELL);
FS_START = 10000;
IB_START = 10000;
LG_START = 10000;
LV_START = 40000;
SG_START = 10000;
SV_START = 20000;
TRANS_FEE = 0.01;
@FREE(R1);
@FREE(R2);
@FREE(R3);
@FREE(R4);
@FREE(R5);

CP - 52
 Solutions to Case Problems

7. Here is the solution for the formulation in Question 7 using LINGO.

Local optimal solution found.

Objective value: 0.3380209E+08
Total solver iterations: 46

Variable Value Reduced Cost

R1 119713.7 0.000000
RBAR 110000.0 0.000000
R2 112235.3 0.000000
R3 105190.3 0.000000
R4 109673.8 0.000000
R5 103186.9 0.000000
FS 10000.00 0.000000
IB 44769.45 0.000000
LG 10870.66 0.000000
LV 0.000000 327.7706
SG 719.8605 0.000000
SV 32664.18 0.000000
TRANS_COST 975.8443 0.000000
RMIN 110000.0 0.000000
FS_START 10000.00 0.000000
FS_BUY 0.000000 41.03809
FS_SELL 0.000000 106.0720
IB_START 10000.00 0.000000
IB_BUY 34769.45 0.000000
IB_SELL 0.000000 147.1100
LG_START 10000.00 0.000000
LG_BUY 870.6613 0.000000
LG_SELL 0.000000 147.1100
LV_START 40000.00 0.000000
LV_BUY 0.000000 147.1100
LV_SELL 40000.00 0.000000
SG_START 10000.00 0.000000
SG_BUY 0.000000 147.1100
SG_SELL 9280.140 0.000000
SV_START 20000.00 0.000000
SV_BUY 12664.18 0.000000
SV_SELL 0.000000 147.1100
TRANS_FEE 0.1000000E-01 0.000000

CP - 53
Chapter 6

Case Problem 2 CAFÉ COMPLIANCE IN THE AUTO INDUSTRY

Note that the solution to this case uses LINGO output.

1. The model is

! PASSENGR CAR MILES PER GALLON;

PASSMPG = 30;
! LIGHT TRUCK MILES PER GALLON;
LTRUCKMPG = 20;
! PP - PASSENGER CAR PRICE;
! TP - LIGHT TRUCK PRICE;
! PD - PASSENGER CAR DEMAND
! TD - LIGHT TRUCK DEMAND;

PD = 750 - 20*PP;
TD = 830 - 17*TP;

PCOST = 15;
TCOST = 17;

MAX = PD*(PP - PCOST) + TD*(TP - TCOST);

The objective function

PD*(PP - PCOST) + TD*(TP - TCOST)

is the desired contribution margin.

2. The LINGO solution to the above model is

Local optimal solution found.

Objective value: 6835.382
Extended solver steps: 5
Total solver iterations: 37

Variable Value Reduced Cost

PASSMPG 30.00000 0.000000
LTRUCKMPG 20.00000 0.000000
PD 225.0000 0.000000
PP 26.25000 0.000000
TD 270.5000 0.000000
TP 32.91176 0.000000
PCOST 15.00000 0.000000
TCOST 17.00000 0.000000

Row Slack or Surplus Dual Price

1 0.000000 0.000000
2 0.000000 0.000000
3 0.000000 11.25000
4 0.000000 15.91176
5 0.000000 -225.0000

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 Solutions to Case Problems

6 0.000000 -270.5000
7 6835.382 1.000000

3. As seen from the LINGO solution in question 2, 225 passenger cars are sold and 270.5 light trucks
are sold.

4. See Figure 8.17.

5. The Café average is

CAFEAVG = (PD + TD)/((PD/PASSMPG)+(TD/LTRUCKMPG));

which for the solution in 2 is 23.56718.

6. Adding

CAFEAVG = (PD + TD)/((PD/PASSMPG)+(TD/LTRUCKMPG));

and

CAFEAVG > 25;

to the LINGO model gives

Local optimal solution found.

Objective value: 6274.514
Extended solver steps: 5
Total solver iterations: 39

CP - 55