Solving Multi-period Financial Planning Problem Via Quantum-Behaved Particle Swarm Algorithm

Jun Sun, Wenbo Xu, and Wei Fang

Center of Intelligent and High Performance Computing, School of Information Technology, Southern Yangtze University, No. 1800, Lihudadao Road, Wuxi, 214122 Jiangsu, China {sunjun_wx, xwb_sytu, wxfangwei}@hotmail.com

Abstract. A multistage stochastic financial optimization manages portfolio in constantly changing financial markets by periodically rebalancing the asset portfolio to achieve return maximization and/or risk minimization. In this paper, we present a decision-making process that uses our proposed Quantum-behaved Particle Swarm Optimization (QPSO) Algorithm to solve multi-stage portfolio optimization problem. The objective function is classical return-variance function. The performance of our algorithm is demonstrated by optimizing the allocation of cash and various stocks in S&P 100 index. Experiments are conducted to compare performance of the portfolios optimized by different objective functions with Particle Swarm Optimization (PSO) algorithm and Genetic Algorithm (GA) in terms of efficient frontiers.

1 Introduction
Financial optimization involves asset allocation and risk management. A multi-stage stochastic financial optimization is a quantitative model that integrates asset allocation strategies and saving strategies in a comprehensive fashion. It manages portfolio in constantly changing financial markets by periodically rebalancing the asset portfolio to achieve return maximization and risk minimization. Stochastic optimization of portfolio is NP-hard and is non-linear with many local optima. A number of different algorithmic approaches have been proposed for solving stochastic optimization problems. To solve the asset allocation problem, one may employ linear programming solvers such as CPLEX and OSL by piecewise linearizing the nonlinear objective function [2]. The interior-point algorithms are another type of methods well suited to the scenario structure of multi-stage stochastic programs. Searching the global solution by these methods, however, is computationally expensive and ineffectively. Since time is a constraint for financial problems, a trade-off should be made between the performance and the computational time. Heuristic methods, such as Tabu Search [1] and GA [3] provide some appropriate ways to find optimal asset allocation. Particle Swarm Optimization (PSO) was originally proposed by J. Kennedy as a simulation of social behavior of bird flock, and was initially introduced as a heuristic optimization method in 1995 [7]. More recently, a new version of PSO, called
D.-S. Huang, K. Li, and G.W. Irwin (Eds.): ICIC 2006, LNAI 4114, pp. 1158 1169, 2006. Springer-Verlag Berlin Heidelberg 2006

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Quantum-behaved Particle Swarm Optimization (QPSO), has been proposed in order to improve the global search performance of the original PSO [12], [13], [14]. The QPSO is a global convergent and has fewer parameters to control, which makes it easier to implement. In this paper, we explore the practicability of QPSO in multi-stage financial optimization problem. To do so, we used S&P 100 Index and the prices of its component stocks as the training samples. The PSO and GA were also tested on the sample data for performance comparison. The rest of the paper is organized as follows. In next section, the multi-stage portfolio optimization model is described. In Section 3 and Section 4, we describe the PSO and QPSO in detail. Section 5 is the presentation of experiment results and the paper is concluded in Section 6.

2 Multi-stage Portfolio Optimization Model

Single period portfolio optimization model possesses several drawbacks. For examples, the risk is inconsistent over time. The multi-stage stochastic programming model proposed by Mulvey et al [8], [9] captures dynamic aspects of asset allocation problem. It manages portfolio in constantly changing financial markets by periodically rebalancing the asset portfolio to achieve return maximization and/or risk minimization, leading to optimal portfolio. To define the model, we divide the entire planning horizon T into two discrete intervals T1 and T 2 , where T1 = 0,1, L , and T 2 = + 1, L , T . The former corresponds to periods in which investment decisions are made. Period defines the date of planning horizon; we focus on the investors position at the beginning of period . Decisions occur at the beginning of each time stage. T 2 handles the horizon at time by calculating economic and other factors beyond period up to period T. The investor cannot render any active decisions after the end of period . Asset investment categories are defined by set A = 1, 2 , L , I , with category 1 representing cash. The remaining categories can include broad investment groupings such as stocks, bonds, and real estate. Ideally, the co-movements between pairs of asset returns would be relatively low so that diversification can be done across the asset categories. In the model, uncertainty is modeled through a large but finite number S of scenarios. Each scenario represents a possible realization of all uncertain parameters in the mode. To be specific, let t represent the vector of random parameters whose values are revealed in period t. Then the set of all scenarios is the set s of all realizations ( 1s , 2 , L , s ), s S := { ,2, L , S } , of ( 1 , 2 , L , ) . 1 Each scenario s has a probability

s ,

where

> 0 and

S s =1

s = 1 . Since in a

dynamic model information on actual value of the uncertain parameters is revealed in stages, a suitable representation of scenarios is given by a scenarios tree, such as in Figure 1. In this case =3 and S=8. Each path form t=0 to t= represents one scenario. Any node of the tree, corresponding to time t, symbolizes a possible state of the world at time t, represented by the observed values of 1 , 2 , L , t . The branches directly

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to the right of it symbolize the various values of t +1 (and their corresponding conditional probabilities) given the realization of 1 , 2 , L , t . Obviously, all scenarios passing this node have the same history in periods 1, 2 , L , t . The status of decision variables is related to the scenario tree, too. Basically, a decision at time t may depend on the observed part of the scenario at that time, but not on unknown values of future periods. That is, for each possible history (i.e. for each node at time t in the scenario tree) there is precisely one vector of decision variables representing the decisions at hand.

t=0

t=1

t=2

t=3

Fig. 1. A scenario tree with two scenarios and three time periods

We assume that the portfolio is rebalanced at the beginning of each period. Alternatively, we could simply make no transaction except reinvest any dividend and interest a buy and hold strategy. For convenience, we also assume that the cash flows are reinvested in the generating asset category and all the borrowing is done on a single period basis. For each i A , t T1 , and s S , we define the following parameters and decision variables. Parameters s s ri st = 1 + i,t , where i,t is the return percentage of asset i, time period t under sce, nario s (projected by the stochastic scenario generator, for example, see [10]). s Probability that scenario s occurs, thus S s = 1 .
s

w0 Wealth in the beginning of time period 0. s,t Transaction costs incurred in rebalancing asset i at the beginning of time period t

(symmetric transaction costs are assumed, i.e., cost of selling equals cost of buying) ts Borrowing rate in period t under scenario s.
Decision variables xis,t Amount of money for asset category i, in time period t, under scenario s, after

rebalancing.

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vis,t

Amount of money in asset category i, in the beginning of time period t, under

scenario s, before rebalancing.

wts Wealth at the beginning of time period t, under scenario s.

pis,t Amount of asset i purchased for rebalancing at time t under scenario s.
dis,t Amount of asset i sold for rebalancing in time period t, under scenario s.

bts Amount of money borrowed in period t, under scenario s.

Given these definitions, we outline the general stochastic programming model in financial optimization.
Model SP

Max
s.t.

Z = s f ( ws )
s =1

(1)

x is, 0 = w 0

s S ,

(2) (3) (4)

i 1

x
i

s i ,t

= w ts

s S ,

t = 1, 2 , L ,

v is,t = ri ,st 1 x istt 1 ,

x is, t = v is, t + p is, t (1
i ,t

s S , t = 1, 2 L , , i A,
s S, t = 1, 2 , L , ,

) d is, t
i ,t

(5)

x 1s, t = v 1s, t + s S ,

d
i 1

s i ,t

(1

i 1

p is, t b ts1 (1 + ts1 ) + b ts

t = 1, 2 , L , ,

(6)

x is,t = x is,t' for all scenarios s and s with identical past up to time t

(7)

As with the single-period models, the nonlinear objective function (1) can take several different forms. If the classical return-risk function is employed, then (1) becomes Max Z = Mean(w ) (1 ) Var(w ) , where Mean(w ) is the average total wealth and Var( w ) is the variance of the total wealth across the scenarios at the end of period . Parameter indicates the relative importance of variance as compared with the expected value. This objective leads to an efficient frontier of wealth at period . Constraint (2) guarantees that the total initial investment equals the initial wealth. Constraint (3) states the wealth accumulated at the end of t-th period under scenario s before rebalancing in asset i. This constraint can be modified to include assets,

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liabilities, and investment goals. Constraint (4) depicts the wealth

v is,t accumulated at

the beginning of period t before rebalancing in asset i. The flow balance constraint for all assets except cash for all periods is given by constraint (5). This constraint guarantees that the amount invested in period t equals the net wealth for asset. Constraint (6) represents flow balancing constraint for cash. Non-anticipativity constraint is represented by (7). These constraints ensure that the scenarios with the same past will have identical decisions up to that period.

3 Particle Swarm Optimization

In a Particle Swarm Optimization (PSO) system, individuals representing the candidate solutions to the problem at hand fly through a multidimensional search space to find out the optima or sub-optima. In PSO with M individuals, each individual is treated as a volume-less particle in the D-dimensional space, with the position vector and velocity vector of particle i at kth iteration represented as Xi (k) = (Xi1 (k), Xi2 (k),L, XiD (k)) and Vi (t ) = (Vi1 (k ),Vi 2 (k ),L,ViD (k )) . The particles move according to the following equations:

Vij (k + 1) = w Vij (k ) + c1 r1 ( Pij (k ) X ij (k )) + c2 r2 ( Pgj (k ) X ij (k ))

X ij ( k + 1) = X ij ( k ) + V ij ( k + 1)

(8) (9)

for i = 1,2, L M ; j = 1,2 L , D . Parameters c1 and c 2 are called acceleration coefficient. Vector Pi = ( Pi1 , Pi 2 , L , PiD ) is the best previous position (the position giving the best fitness value) of particle i called personal best position, and vector P = (P 1, P 2,L, P ) is the position of the best particle among all the particles in the g g g gD population and called global best position. The parameters r1 and r2 are random numbers distributed uniformly in (0,1). Generally, the value of Vid is restricted in the interval [ V max , V max ] . The inertia weight w in equation (8) was introduced by Shi and Eberhart [13]. The addition of the inertia weight results in faster convergence.

4 Quantum-Behaved Particle Swarm Optimization

Trajectory analyses in [5] demonstrated the fact that convergence of the PSO algorithm may be achieved if each particle converges to its local attractor. Let the local attractor p i = ( p i1 , p i 2 ,L p iD ) of particle i be defined at the coordinates
p ij ( k ) = Pij ( k ) + (1 ) Pgj ( k ), where

= c1 r1 ( c1r1 + c 2 r2 )

(10)

with regard to the random numbers r1 and r2 in equation (8). It can be seen that the local attractor is a stochastic attractor of particle i that lies in a hyper-rectangle with Pi and P g being two ends of its diagonal and moves following Pi and Pg .

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Assume that there is one-dimensional Delta potential well on each dimension at its local attractor p and each particle has quantum behavior. For simplicity, we consider a particle in one-dimensional space, with point p the center of potential. Solving the Schrdinger equation, we can get the normalized the following probability density function Q and distribution function D

Q ( x) =

1 2 e L

px L

and D ( x ) = e

2 p x

(11)

where L determines search scope of each particle like standard deviation in Gaussian distribution. Using Monte Carlo method, we can obtain the position of the particle
x= P L ln( 1 u ) 2 u = rand ( 0 ,1)

(12)

where u is a random number uniformly distributed in (0, 1). A global point called Mainstream Thought or Mean Best Position of the population is introduced into PSO for the evaluation of L. The global point, denoted as C, is defined as the mean of the personal best positions among all particles. That is
1 C ( k ) = (C1 ( k ), C 2 ( k ),L , C D ( k )) = M

P ( k ),
i =1 i1

1 M

P
i =1

i2

( k ), L ,

1 M

P
i =1

iD

( k ) ,

(13)

where M is the population size and Pi is the personal best position of particle i. Thus the value of L and the position are evaluated as L = 2 C j ( k ) X j ( k )
X ij ( k + 1) = p ij C ij ( k ) X ij ( k ) ln(1 / u )

(14)

where is Expansion-Constraction Coefficient (CE), which can be tuned to control the convergence speed of the algorithm. The PSO with equation (14) is called Quantum-behaved Particle Swarm Optimization (QPSO) described as follows.
QPSO Algorithm Initialize particles with random position Xi=X[i][:] and velocities Vi=V[i][:]; Let personal best position Pi=Xi; while termination criterion is not met do Compute the mean best position C[:] by equation (13); for i=1 to swarm size M if f(Xi)<f(Pi) then Pi=Xi; endif Find the Pg=P[g][:]across the swarm; for j=1 to D fi=rand(0,1); u=rand(0,1); p=fi*P[i][j]+(1-fi)*P[g][j]; if (rand(0,1)>0.5 X[i][j]=p+*abs(C[j]-X[i][j])*ln(1/u); else X[i][j]=p-*abs(C[j]-X[i][j])*ln(1/u); endif endfor

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endif endfor endwhile

Generally, the value of no more than 1.0 can lead to a good performance if it is fixed over the running of QPSO. But in most cases, decrease linearly from 0 to

1 .
5 Numerical Experiments
In order to evaluate the performance of QPSO on multistage financial optimization, experiments were carried out. Weekly closing prices of S&P 100 Index and its component stocks from 1 January 2000 to 31 December 2004 were collected. Cash and stocks of ten corporations that belong to different industries were selected to be optimized. The planning horizon interval T 1 was divided into three periods. In our approach, the economic parameter that determines scenarios is the mark index and therefore each scenario represents a possible realization of market index. We set the market index two possible realization:(1) the market index has been raised and (2) the market index has been dropped. Denoting rise with 1 and drop with 0, we can obtain the scenario tree as Figure 1 with 8 scenarios: (0,0,0), (0,0,1), (0,1,0), (0,1,1), (1,0,0), (1,0,1), (1,1,0) and (1,1,1). Each edge in the scenario tree corresponds to a realization of market indexs raise and drop as well as a set of percentage returns of all assets in time period t under a certain scenario. We worked out s of each scenario and is, t of each stock according to closing price of the index and stocks. For the percentage return of cash, we set a fixed annual interest rate 6%, and therefore the weekly percentage return is 0.12% across the whole period of planning. s Using s and i,t as parameters, we tested three optimizers: QPSO, PSO and GA, to search the optimal xis,t to maximize the objective function (1). To implement the algorithms, we adopted ais,t , allocation proportion of the selected assets after rebalancing under different scenarios over the planning horizon as our decision variables. Therefore, xis,t is determined by xis,t = ais,t wts . There are 15 nodes in the scenario tree with each node containing the allocation proportions of 11 assets under the corresponding scenario. For each scenario s at time t, the total asset allocation proportion must be equal to 100%. Hence, each of asset allocation proportion

ais,t under scenario is normalized by a is, t , = a is, t ,

A i =1

a is, t ,

after the optimization algorithm has run for an iteration, where ais,t , is the normalized asset allocation proportion. Moreover, in our numerical experiment, we dont take borrowing and transaction costs into account. The values of s,t , ts and b ts in constraint (5), (6) are zeros consequently.

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We employed the classical return-risk function as the objective function. Therefore the purpose of our experiment was to generate an efficient frontier of wealth at period . In order to generate the entire efficient frontier, we adopt a series of different values of in interval [0,1]. Some of these values of are listed in the first column of Table 4. Each objective function corresponding to a particular was maximized to generate a couple of Expected Return and Variance at period . Thus, a series Expected Return-Variance can be obtained to yield a curve of the efficient frontier. Three groups of experiments were implemented with each group running an optimization algorithm. The configurations of the three algorithms are as follows. For the QPSO, the CE Coefficient was varying linearly from 1.0 to 0.5 over 500 iterations for a running of the algorithm. The objective function corresponding to each vale of was maximized for 10 runs by the QPSO. For the experiment performed by the PSO, the acceleration coefficients c1 and c2 in are set to be 2 keeping constant and the inertia weight w was decreasing from 0.9 to 0.4 over 500 iterations for a running as adopted in most existing literatures. Also each objective function was optimized for 10 runs. Sixty particles were used in both the QPSO and PSO. For the GA, 100 individuals were employed. Each objective function was also maximized for 10 runs with each run executed for 500 iterations too. The experiments of GA were performed using real-valued encoding, binary tournament selection. Probability of mutating a genome is p m = 0 .2 , and probability of crossover is p c = 0 .9 . The algorithm use a arithmetic crossover with one weight for each variable. All weights exept one are randomly assigned to either to 0 or 1. The other ones are set to a random number between 0 and 1. This crossover operator is hybrid between uniform and arithmetic crossover and showed a better performance than traditional uniform and arithmetic crossover [15]. The mutation operator used here is standard Gaussian mutation with zero mean and variance 2 = 1 k + 1 , where k is iteration number.The search scope for every decision variable is [0,1] for all experiments. At an iteration during executing the algorithm, if the allocation proportions of all assets at time t under scenario s were all be zeros, the allcotion proportion of cash would be set to 1 to satisfy the normalization ceriterion. We depicted the efficent frontiers generated by the three algorithms and presented in Figure 2. The curves in (a) are the efficient frontiers traced out by the Expected Return-Variance values with the best optimized objective function value (or say best fitness value) out of the results of 10 runs. It is shown that the efficient frontier generated by the QPSO is the best, because all points on the curve are left to those on the curves by PSO and GA. The efficient frontier generated by GA is the worst in this case. In (b), the three curve is depicted by the Expected Return-Variance values corresponding to the worst optimized objective function value out of the resutls of 10 runs. The efficient frontier by the QPSO is also the best, while the curve by the PSO is the worst now. The efficient frontiers in (c) is tranced out by the average Expected Return-Variance values of 10 results corresponding to 10 runs for each objective function. The QPSO also generated the best curve. Concludingly, the QPSO can search out the optimal solution and generate the optimal efficient frontier more frequently than other two optimizers, while the PSO always trapped in local optimal algough it can

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J. Sun, W. Xu, and W. Fang

0.027 0.026

0.03

0.02

0.025
0.01

Profit

Profit

0.024 0.023

-0.01

0.022 QPSO 0.021 GA PSO

-0.03 -0.02 QPSO GA PSO

0.02

10

10

Variance

Variance

(a)
0.03

(b)

0.025

0.02

Profit

0.015

0.01 QPSO 0.005 PSO GA 0

10

Variance

(c)
Fig. 2. (a) Efficient frontiers generated by the best solutions out of 10 runs. (b). Efficient frontiers generated by the worst solutions out of 10 runs. (c) Those generated by mean of solutions. Table 1. Numerical results with some different values of
QPSO Max.
1.0037 20.1199 40.3817 60.8801 81.6346 102.664

0.01 0.2 0.4 0.6 0.8 1.0

Mean
1.0037 20.1198 40.3817 60.88 81.6346 102.664

GA St. Dev. Max.

0.00007 0.00003 0.00006 0.00016 0.00000 0.00000 0.9839 20.0635 40.3237 60.8199 81.5505 102.552

Mean
0.9803 20.0332 40.298 60.7798 81.4797 102.479

St.Dev
0.0018 0.024 0.0172 0.0317 0.0427 0.0372

PSO Max.
1.0036 20.11 40.3538 60.7852 81.6346 102.664

Mean
0.8864 19.9772 40.1117 60.5629 81.3659 102.299

St.Dev.
0.1336 0.1366 0.2095 0.1985 0.2004 0.3996

find out the global opima occasionally. The fact that the performance of the GA is inferior to that of the QPSO is due to its slow convergence rate, which can be seen in the following part of the paper.

Solving Multi-period Financial Planning Problem

10.5 10 9.5

1167

40.5 40 39.5 Mean Fitness 39 38.5 38

QPSO PSO GA

Mean Fitness

9 8.5 8 7.5 7 6.5

QPSO PSO GA

37.5 37

100

200 300 Iteration

400

500

100

200 300 Iteration

400

500

(a)
71.5 71 70.5

(b)
92.5 92 91.5 91 Mean Fitness
QPSO PSO GA

Mean Fitness

70 69.5 69 68.5 68 67.5

90.5 90 89.5 89 88.5 QPSO PSO GA 0 100 200 300 Iteration 400 500

100

200 300 Iteration

400

500

88

(c)

(d)

Fig. 3. Convergence process of three algorithms, when (a) =0.1, (b) =0.4, (c) =0.7, (d) =1.0

We also list in Table the Table 1 the mean, maximum and minimum of the best objective values of 10 runs for the objective functions with =0.01, 0.2, 0.4 0.6 0.8 1.0. It can be seen that at each particular , the QPSO yielded the best objective function values with lowest standard deviation. For example, when =0.01, the mean of the 10 objective function values (best fitness values) yielded by the QPSO is 1.0037, while those yielded by the GA and PSO is 0.9803 and 0.8864 respectively. But the standard deviation of the QPSO is only 0.00007, which means that the QPSO is a robust and stable algorithm. That does explain why the QPSO always generates better efficient frontier than either of the GA and PSO. To visualize and compare convergence rates of the three algorithms on the asset allocation problem, we depict the searching process of the algorithms averaged over 10 runs for each . We present those of cases when =0.1,0.4, 0.7, 0.9 in Figure 4. It is shown that the PSO converge most rapidly in early stage of the running, but may encounter premature convergence and therefore only find out sub-optima. The GA has the slowest convergence rate than the QPSO and PSO, but it encounters premature convergence less frequently than the PSO. The GAs slow convergence rate may cause the population to not converge to a point in the search space when the running

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J. Sun, W. Xu, and W. Fang

is over. Comparing with the other two algorithms, the QPSO can converge rapidly and search out the global optima most frequently. Although the PSO is invented to solve GO problems, it is not a global convergence guaranteed algorithm. If the particles in the PSO trap into sub-optima, they have less possibility to skip out, particularly in the late stage of the running. The GA is global convergent, but its convergence rate are so slow that its local search ability in late stage of running is weakened. The QPSO not only possess, rapid convergence rate, the strongpoint of the PSO, but it is guaranteed to be global convergent, which makes it outperform the PSO and GA in our tested portfolio optimization problem. In fact, not only the portfolio optimization problem is the QPSO excellent in, but it superior to the PSO and GA in other function optimization problems also [14].

6 Conclusions
In this paper, QPSO algorithm is used to optimize a multi-stage portfolio. The objective function used is classical expected return-variance function with S&P 100 index, cash and 10 selected component stock been optimized. Comparing with PSO and GA, QPSO generate better efficient frontiers with better objective function value and robustness. Furthermore, the convergence rates of the algorithms was studied and the results show that QPSO could converge to the optima rapidly, while PSO may encounter premature convergence and GA may not reach the optima due to its slow convergence rate. By these tests, it is suggested that QPSO is a promising solver for multistage stochastic financial optimization problems. The problem test in our experiment has 3 stages and eight scenarios. Many real problems may have more large scale. QPSO may obtain the solutions efficiently. However, computation of objective functions is time consuming. Since saving computational time is very important in financial planning, a resolvent for this issue is parallelization.

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