# Optimal Portfolios Exam

Pour l’examen du cours de Gestion d’Actifs (optimal portfolios) un cas pratique avec des vraies données, disponibles sur

```loc="http://freakonometrics.free.fr/base_portefeuille.csv" base=read.csv2(loc,sep=";") base[,1]=as.Date(as.character(base[,1]),"%Y-%m-%d") for(i in 2:10) base[,i]=as.numeric(as.character(base[,i]))```

Pour le rendu, je demande un markdown dont la trame est en ligne ici,  exam_portfolio.Rmd, et la sortie est exam_portfolio.html. Il faut télécharger le fichier Rmd, l’ouvrir avec RStudio, puis me renvoyer le fichier rempli (ainsi que le fichier html compilé) pour midi, à arthur.charpentier@univ-rennes1.fr.

# Optimal Portfolios, or sort of…

Last week, we got our first class on portfolio optimization. We’ve seen Markowitz’s theory where expected returns and the covariance matrix are given,

```> download.file(url="http://freakonometrics.free.fr/portfolio.r",destfile = "portfolio.r") > source("portfolio.r") > library(zoo) > library(FRAPO) > library(IntroCompFinR) > library(rrcov) > data( StockIndex ) > pzoo = zoo ( StockIndex , order.by = rownames ( StockIndex ) ) > rzoo = ( pzoo / lag ( pzoo , k = -1) - 1 ) * 100 > Moments <- function ( x , method = c ( "CovClassic" , "CovMcd" , "CovMest" , "CovMMest" , "CovMve" , "CovOgk" , "CovSde" , "CovSest" ) , ... ) { method <- match.arg ( method ) ans <- do.call ( method , list ( x = x , ... ) ) + return ( getCov ( ans ) )} > covmat=Moments(as.matrix(rzoo),"CovClassic") > (covmat=round(covmat,1)) SP500 N225 FTSE100 CAC40 GDAX HSI SP500   17.8 12.7 13.8 17.8 19.5 18.9 N225    12.7 36.6 10.8 15.0 16.2 16.7 FTSE100 13.8 10.8 17.3 18.8 19.4 19.1 CAC40   17.8 15.0 18.8 30.9 29.9 22.8 GDAX    19.5 16.2 19.4 29.9 38.0 26.1 HSI     18.9 16.7 19.1 22.8 26.1 58.1 > er=apply(as.matrix(rzoo),2,mean) > (er=round(er,1)) SP500 N225 FTSE100 CAC40 GDAX HSI 0.6 -0.2 0.4 0.5 0.8 1.0 > ef <- efficient.frontier(er, covmat, alpha.min=-2.5, alpha.max=2.5, nport=50)```

We can now visualize the efficient frontier (and admissible portfolios) below

```> u=c(12,ef\$sd,12,12) > v=c(5,ef\$er,-1,5) > plot(ef\$sd,ef\$er,type="l",xlab="Standard Deviation",ylab="Expected Return", xlim=c(3.5,11),ylim=c(0,2.5),col="red",lwd=1.5) > points(sqrt(diag(covmat)),er,pch=19,col="blue") > text(sqrt(diag(covmat)),er,names(er),pos=4, col="blue",cex=.6) > polygon(u,v,border=NA,col=rgb(0,0,1,.3))``` That was the starting point of our class. We did also mention that something important was actually hard to visualize on that graph : the correlation between returns. It is not in the points (which are univariate, with expected return and standard deviation), but in the efficient frontier. For instance, here is our correlation matrix

```> (cormat=covmat/(sqrt(diag(covmat) %*% t(diag(covmat))))) SP500 N225 FTSE100 CAC40 GDAX HSI SP500   1.00 0.50 0.79 0.76 0.75 0.59 N225    0.50 1.00 0.43 0.45 0.43 0.36 FTSE100 0.79 0.43 1.00 0.81 0.76 0.60 CAC40   0.76 0.45 0.81 1.00 0.87 0.54 GDAX    0.75 0.43 0.76 0.87 1.00 0.56 HSI     0.59 0.36 0.60 0.54 0.56 1.00```

We can actually change the correlation between FT500 and FTSE100 (which is here .786)

```courbe=function(r=.786){ R=cormat R[1,3]=R[3,1]=r covmat2=(sqrt(diag(covmat) %*% t(diag(covmat))))*R ef <- efficient.frontier(er, covmat2, alpha.min=-2.5, alpha.max=2.5, nport=50) plot(ef\$sd,ef\$er,type="l",xlab="Standard Deviation",ylab="Expected Return", xlim=c(3.5,11),ylim=c(0,2.5),col="red",lwd=1.5) points(sqrt(diag(covmat)),er,pch=19,col=c("blue","red")[c(2,1,2,1,1,1)]) text(sqrt(diag(covmat)),er,names(er),pos=4,col=c("blue","red")[c(2,1,2,1,1,1)],cex=.6) polygon(u,v,border=NA,col=rgb(0,0,1,.3)) }```

for instance, with a correlation of 0.6, we get the following efficient frontier

`> courbe(.6)` and with a stronger correlation

`> courbe(.9)` So clearly, correlation does matter. A lot. But more important, one should keep in mind that expected returns and covariances are not given, but estimated. Previously, we did use the standard estimator for the variance matrix. But another (more robust) estimator can be considered

```covmat=Moments(as.matrix(rzoo),"CovSde") er=apply(as.matrix(rzoo),2,mean) ef <- efficient.frontier(er, covmat, alpha.min=-2.5, alpha.max=2.5, nport=50) plot(ef\$sd,ef\$er,type="l",xlab="Standard Deviation",ylab="Expected Return",xlim=c(3.5,11),ylim=c(0,2.5),col="red",lwd=1.5) points(sqrt(diag(covmat)),er,pch=19,col="blue") text(sqrt(diag(covmat)),er,names(er),pos=4,col="blue",cex=.6) polygon(u,v,border=NA,col=rgb(0,0,1,.3))``` It did influence (horizontal) position of points, since variances are now different, as well as the efficient frontier, with clearly much lower variances that can be reached.

And to illustrate a last point, to illustrate the fact that we do have estimators based on observed returns, what if we had observed different ones? A way to get an idea of what might happened is to use bootstrap, e.g. of daily returns.

```> covmat=Moments(as.matrix(rzoo),"CovClassic") > er=apply(as.matrix(rzoo),2,mean) > ef <- efficient.frontier(er, covmat, alpha.min=-2.5, alpha.max=2.5, nport=50) > a=sqrt(diag(covmat)) > b=er > k=1 > plot(ef\$sd,ef\$er,type="l",xlab="Standard Deviation",ylab="Expected Return", xlim=c(3.5,11),ylim=c(0,2.5),col="white",lwd=1.5) > polygon(u,v,border=NA,col=rgb(0,0,1,.3)) > for(i in 1:100){ + id=sample(nrow(rzoo),replace=TRUE) + covmat=Moments(as.matrix(rzoo)[id,],"CovClassic") + er=apply(as.matrix(rzoo)[id,],2,mean) + points(sqrt(diag(covmat))[k],er[k],cex=.5) + }``` or for another asset Here is what we got on the (estimated) efficient frontier

```> covmat=Moments(as.matrix(rzoo),"CovClassic") > er=apply(as.matrix(rzoo),2,mean) > ef <- efficient.frontier(er, covmat, alpha.min=-2.5, alpha.max=2.5, nport=50) > plot(ef\$sd,ef\$er,type="l",xlab="Standard Deviation",ylab="Expected Return", xlim=c(3.5,11),ylim=c(0,2.5),col="white",lwd=1.5) > points(sqrt(diag(covmat)),er,pch=19,col="blue") > text(sqrt(diag(covmat)),er,names(er),pos=4, col="blue",cex=.6) > polygon(u,v,border=NA,col=rgb(0,0,1,.3)) > for(i in 1:100){ + id=sample(nrow(rzoo),replace=TRUE) + covmat=Moments(as.matrix(rzoo)[id,],"CovClassic") + er=apply(as.matrix(rzoo)[id,],2,mean) + ef <- efficient.frontier(er, covmat, alpha.min=-2.5, alpha.max=2.5, nport=50) + lines(ef\$sd,ef\$er,col="red") + }``` Thus, it is somehow rather difficult to assess wheter a portfolio is optimal, or not… At least from a statistical perspective….

# Optimal Portfolios #1

This afternoon, I will start a crash course on financial portfolio optimization, with application in R. This week, we start with simple things, with the theoretical setup, without and with a risk free asset. We will discuss then the problem of estimating parameters, in a robust way. Then we introduce the idea of consider a more general criteria to quantify risk than the variance (but it means more general distributions… this point will be discussed further next time). The slides are available here, and R codes from there (in a Markdown)

# Allocations for Value-at-Risk portfolio optimization

Parution de l’article Estimating allocations for Value-at-Risk portfolio optimization dans Mathematical Methods of Operations Research.

Value-at-Risk, despite being adopted as the standard risk measure in finance, suffers severe objections from a practical point of view, due to a lack of convexity, and since it does not reward diversification (which is an essential feature in portfolio optimization). Furthermore, it is also known as having poor behavior in risk estimation (which has been justified to impose the use of parametric models, but which induces then model errors). The aim of this paper is to chose in favor or against the use of VaR but to add some more information to this discussion, especially from the estimation point of view. Here we propose a simple method not only to estimate the optimal allocation based on a Value-at-Risk minimization constraint, but also to derive— empirical—confidence intervals based on the fact that the underlying distribution is unknown, and can be estimated based on past observations.