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Heuristic Optimisation in Financial Modelling

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  • Manfred Gilli
  • Enrico Schumann

Abstract

There is a large number of optimisation problems in theoretical and applied finance that are difficult to solve as they exhibit multiple local optima or are not ‘well- behaved’ in other ways (eg, discontinuities in the objective function). One way to deal with such problems is to adjust and to simplify them, for instance by dropping constraints, until they can be solved with standard numerical methods. This paper argues that an alternative approach is the application of optimisation heuristics like Simulated Annealing or Genetic Algorithms. These methods have been shown to be capable to handle non-convex optimisation problems with all kinds of constraints. To motivate the use of such techniques in finance, the paper presents several actual problems where classical methods fail. Next, several well-known heuristic techniques that may be deployed in such cases are described. Since such presentations are quite general, the paper describes in some detail how a particular problem, portfolio selection, can be tackled by a particular heuristic method, Threshold Accepting. Finally, the stochastics of the solutions obtained from heuristics are discussed. It is shown, again for the example from portfolio selection, how this random character of the solutions can be exploited to inform the distribution of computations.

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Bibliographic Info

Paper provided by COMISEF in its series Working Papers with number 007.

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Length: 29 pages
Date of creation: 09 Feb 2009
Date of revision:
Handle: RePEc:com:wpaper:007

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Related research

Keywords: Optimisation heuristics; Financial Optimisation; Portfolio Optimisation;

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References

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  1. D. B. Madan, 2001. "On the modelling of option prices," Quantitative Finance, Taylor & Francis Journals, vol. 1(5), pages 481-481.
  2. Ozgur S. Ince & R. Burt Porter, 2006. "INDIVIDUAL EQUITY RETURN DATA FROM THOMSON DATASTREAM: HANDLE WITH CARE!," Journal of Financial Research, Southern Finance Association & Southwestern Finance Association, vol. 29(4), pages 463-479.
  3. Manfred Gilli & Peter Winker & Vahidin Jeleskovic, 2006. "An Objective Function for Simulation Based Inference on Exchange Rate Data," Computing in Economics and Finance 2006 147, Society for Computational Economics.
  4. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
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  12. Winker, Peter & Gilli, Manfred, 2004. "Applications of optimization heuristics to estimation and modelling problems," Computational Statistics & Data Analysis, Elsevier, vol. 47(2), pages 211-223, September.
  13. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  14. Manfred Gilli & Peter Winker, 2008. "Review of Heuristic Optimization Methods in Econometrics," Working Papers 001, COMISEF.
  15. Manfred Gilli & Enrico Schumann, . "Distributed Optimisation of a Portfolio's Omega," Swiss Finance Institute Research Paper Series 08-17, Swiss Finance Institute.
  16. R. Cont, 2001. "Empirical properties of asset returns: stylized facts and statistical issues," Quantitative Finance, Taylor & Francis Journals, vol. 1(2), pages 223-236.
  17. Gilli, M. & Winker, P., 2003. "A global optimization heuristic for estimating agent based models," Computational Statistics & Data Analysis, Elsevier, vol. 42(3), pages 299-312, March.
  18. Maringer, Dietmar G., 2004. "Finding the relevant risk factors for asset pricing," Computational Statistics & Data Analysis, Elsevier, vol. 47(2), pages 339-352, September.
  19. Eugene F. Fama & Kenneth R. French, 2004. "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 25-46, Summer.
  20. Alan P. Kirman, 1992. "Whom or What Does the Representative Individual Represent?," Journal of Economic Perspectives, American Economic Association, vol. 6(2), pages 117-136, Spring.
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Citations

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Cited by:
  1. Jevtić, Petar & Luciano, Elisa & Vigna, Elena, 2013. "Mortality surface by means of continuous time cohort models," Insurance: Mathematics and Economics, Elsevier, vol. 53(1), pages 122-133.
  2. Monica Billio & Massimiliano Caporin & Michele Costola, 2012. "Backward/forward optimal combination of performance measures for equity screening," Working Papers 2012_13, Department of Economics, University of Venice "Ca' Foscari".
  3. Ardia, David & Boudt, Kris & Carl, Peter & Mullen, Katharine M. & Peterson, Brian, 2010. "Differential Evolution (DEoptim) for Non-Convex Portfolio Optimization," MPRA Paper 22135, University Library of Munich, Germany.

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