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Optimization approaches in risk management and financial engineering

University of Florida Institutional Repository

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Ithankmysupervisors,Prof.StanislavUryasevandProf.R.TyrrellRockafellar,andthemembersofmyPh.D.committeefortheirhelpandguidance.Iamalsogratefultomyparentsfortheirconstantsupport. iii

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page ACKNOWLEDGMENTS ................................. iii LISTOFTABLES ..................................... vi LISTOFFIGURES .................................... vii ABSTRACT ........................................ x CHAPTER 1INTRODUCTION .................................. 1 2PORTFOLIOANALYSISWITHGENERALDEVIATIONMEASURES ... 4 2.1Introduction .................................. 4 2.2DeviationandRisk .............................. 8 2.3PortfolioFramework ............................. 14 2.4FundamentalOptimizationProblem .................... 18 2.5EcientSetsandFrontiers ......................... 24 2.6ThresholdDeterminationfortheRisk-FreeRate ............. 33 2.7CharacterizationofOptimalPortfolios ................... 41 2.8SpecializedCAPM-likeRelations ...................... 47 2.9MultiplierDerivationofThresholds ..................... 54 2.10Conclusions .................................. 56 3DRAWDOWNMEASUREINPORTFOLIOOPTIMIZATION ......... 57 3.1Introduction .................................. 57 3.1.1DrawdownRegulationsinRealTradingStrategies ......... 57 3.1.2DrawdownNotioninTheoreticalFramework ............ 58 3.2ModelDevelopment ............................. 60 3.2.1DynamicPerformanceFunctionals ................. 63 3.3AbsoluteDrawdownforaSingleSamplePath ............... 64 3.3.1Maximum,AverageandConditionalDrawdowns ......... 66 3.3.2ConditionalValue-at-RiskandConditionalDrawdownProperties 69 3.3.3MixedConditionalDrawdown .................... 73 3.4OptimizationTechniquesforConditionalDrawdownComputation ... 75 3.5Multi-scenarioConditionalValue-at-RiskandDrawdownMeasure .... 78 3.5.1Multi-scenarioConditionalValue-at-Risk .............. 79 3.5.2DrawdownMeasure .......................... 81 3.6PortfolioOptimizationwithDrawdownMeasure ............. 82 3.6.1ReductiontoLinearProgrammingProblem ............ 83 3.6.2EcientFrontier ........................... 85 iv

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.......... 86 3.7.1StaticAssetAllocation ........................ 86 3.7.2HistoricalDataandScenarioGeneration .............. 88 3.7.3NumericalResults ........................... 91 3.8Conclusions .................................. 92 4TRAJECTORYOPTIMIZATIONINATHREATENVIRONMENT ..... 106 4.1Introduction .................................. 106 4.2ModelDevelopment ............................. 110 4.3MinimizationofaFunctionalwithNonholonomicConstraintandMovableEndPoint .................................. 114 4.4CalculusofVariationsApproach ...................... 117 4.5NetworkFlowOptimizationApproach ................... 134 4.5.1NetworkStructure .......................... 134 4.5.2SmoothingProcedureandCurvatureConstraint .......... 136 4.5.3ApproximationScheme ........................ 138 4.5.4ReductiontotheConstrainedShortestPathProblem ....... 141 4.5.5TheLabelSettingsAlgorithmwithPreprocessingProcedure ... 142 4.6NumericalExperiments ........................... 145 4.6.12DNetworkOptimization ...................... 146 4.6.23DNetworkOptimizationintheCaseofaSingleRadar ..... 147 4.6.33DNetworkOptimizationinCaseswithTwoandThreeRadars 149 4.7AnalysisofComputationalResults ..................... 152 4.8Conclusions .................................. 159 5DISCUSSION ..................................... 162 REFERENCES ....................................... 165 BIOGRAPHICALSKETCH ............................... 169 v

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Table page 3{1AverageDrawdownoptimization:1samplepath ................ 96 3{2AverageDrawdownoptimization:100samplepaths .............. 97 3{3AverageDrawdownoptimization:300samplepaths .............. 98 3{40.8-ConditionalDrawdownoptimization:1samplepath ............ 99 3{50.8-ConditionalDrawdownoptimization:100samplepaths .......... 100 3{60.8-ConditionalDrawdownoptimization:300samplepaths .......... 101 3{7MaximumDrawdownoptimization:1samplepath ............... 102 3{8MaximumDrawdownoptimization:100samplepaths ............. 103 3{9MaximumDrawdownoptimization:300samplepaths ............. 104 4{1Optimalrisk,L,CandC'sestimate ...................... 133 4{2CoecientsfortheGaussianquadratureforJ=16 .............. 140 4{32Dnetworkpreprocessing:singleradar ..................... 147 4{42DnetworkoptimizationwithLSA:singleradar ................ 148 4{53Dnetworkpreprocessing:singleradar ..................... 150 4{63DnetworkoptimizationwithLSA:singleradar ................ 150 4{73DnetworkoptimizationwithLSA&smoothingcondition:singleradar .. 150 4{83Dnetworkoptimization:tworadars ...................... 153 4{93Dnetworkoptimization:threeradars ..................... 153 vi

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Figure page 2{1Classicalecientset:expectedgainversusstandarddeviation ........ 22 2{2Reducedoptimizationperspective ........................ 27 2{3Ecientsetsincoordinatesstandardforgraphsoffunctions ......... 29 2{4Ecientsetsincoordinatestraditionalfornance ............... 30 2{5Thresholdvaluesfortherisk-freerate ..................... 36 2{6Thresholdintervaltiedtocornerbehavior ................... 40 3{1Timeseriesofuncompoundedcumulativerateofreturnwandcorrespondingabsolutedrawdown. ............................. 65 3{2DrawdowntimeseriesandindicatorfunctionIfcsg 67 3{3Function(s) .................................. 68 3{4Inversefunction1() ............................. 68 3{5Drawdownsurfaceandthresholdplane ..................... 80 3{6Ecientfrontiers:AverageDrawdown ..................... 93 3{7Optimalrisk-adjustedreturns:AverageDrawdown .............. 93 3{8Ecientfrontiers:0.8-ConditionalDrawdown ................. 94 3{9Optimalrisk-adjustedreturns:0.8-ConditionalDrawdown .......... 94 3{10Ecientfrontiers:MaximumDrawdown .................... 95 3{11Optimalrisk-adjustedreturns:MaximumDrawdown ............. 95 4{1Ellipsoidshapeisdenedbyparameter=b=a 111 4{23Dmodelforoptimalpathplanninginathreatenvironment ........ 112 4{3Function()=sin1 33 126 4{4Optimaltrajectoriesforthecaseof\sphere"withdierentconstraintsonthelength,l,inthetrajectories'plane ...................... 127 4{5Optimaltrajectoriesforthecaseof\sphere"withdierentconstraintsonthelength,l,in3Dspace ............................. 128 vii

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............................... 128 4{7Optimaltrajectoriesforsphere(=1:0)andelongatedellipsoids(=0:5,0.1)forn=4andl=3:2shownintrajectory'splane ........... 132 4{8Optimaltrajectoriesforsphere(=1:0)andcompressedellipsoids(=2:0,10)forn=4andl=3:2shownintrajectory'splane ........... 132 4{9Optimaltrajectoriesforsphere(=1:0),elongated(=0:1)andcom-pressed(=2:0)ellipsoidsforn=4andl=3:2in3Dspace ....... 133 4{10Structureofarcsineverynodeina2Dnetwork:\1"{axisarcs,\2"{diagonalarcs,\3"{longdiagonalarcs .................... 136 4{11Structureofarcsineverynodeina3Dnetwork ................ 137 4{12Networksmoothingandcurvatureconstraint ................. 137 4{133Dnetworkforsolvingtheriskminimizationproblem ............ 139 4{14Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforthecaseofsphere(=1:0),n=4anddierentlengthconstraints,l,intrajectories'plane ...................................... 148 4{15Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforelongated(=0:1)andcompressed(=2:0)ellipsoidsforn=4andthesameconstraintonthelengthl=3:2intrajectories'plane ........... 149 4{16Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforsphere(=1:0),n=4withdierentlengthconstraints,l,in3Dspace ..... 151 4{17Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforelongatedellipsoid=0:1andparametersn=4,l=3:2in3Dspace ........ 151 4{18Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforcom-pressedellipsoid=2:0andparametersn=4,l=3:2in3Dspace ... 152 4{19Optimaltrajectoriesinthecaseoftworadarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 ........................... 153 4{20Frontview:optimaltrajectoriesinthecaseoftworadarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 ..................... 154 4{21Viewfromabove:optimaltrajectoriesinthecaseoftworadarsforcom-pressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 ............. 154 4{22Optimaltrajectoriesinthecaseofthreeradarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 ........................... 155 viii

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..................... 155 4{24Sideview:optimaltrajectoriesinthecaseofthreeradarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 ..................... 156 4{25DependenceofLSArunningtimeontheshapeofellipsoid,(3Dnetwork,singleradar):curve\1"{nosmoothing,curve\2"{smoothingisused 157 4{26LSArunningtimeversusnumberoflabelstreated:3Dnetwork,singleradar 158 4{27Numberoflabelstreatedversusnumberofnodesleftafterpreprocessing(3Dnetwork,singleradar):curves\1"and"2"correspondtoLSAandLSAwithsmoothing,respectively ......................... 159 ix

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ThedissertationisdedicatedtodevelopmentandapplicationofanalyticalanddiscreteoptimizationapproachesinRiskManagementandFinancialEngineering.Throughtech-niquesofconvexanalysis,thedissertationrigorouslygeneralizestheaxiomaticpropertiesofstandarddeviationtoanewclassofdeviationmeasures.Theroleofdeviationmea-suresinoptimizationandFinancialEngineeringisanalyzed.Optimalityconditionsbasedonconceptsofconvexanalysis,butrelyingonthespecialfeaturesofdeviationmeasuresarederivedinsupportofavarietyofpotentialnancialapplications,suchasportfoliooptimizationandtheCapitalAssetPricingModel.Thedissertationintroducesanewone-parameterfamilyofriskmeasurescalledConditionalDrawdown(CDD).Thesemeasuresofriskarefunctionalsoftheportfoliodrawdown(underwater)curveconsideredinactiveportfoliomanagement.MathematicalpropertiesoftheCDDarestudied;andecientopti-mizationtechniquesforCDDcomputationandsolvingassetallocationproblemswithCDDmeasureareproposed.Areal-lifeasset-allocationproblemisanalyzedandsolvedusingtheproposedmeasures.Thedissertationdevelopsamodelandcorrespondinganalyticalanddiscreteoptimizationapproachesforroutinganaircraftinathreatenvironment.Thethreatisassociatedwiththeriskofaircraftdetectionbyradarorsensorinstallations.Themodelconsiderstheaircraftinthreedimensionalspacewithavariableradarcross-section x

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Thedissertationconsidersanddevelopsanalyticalanddiscreteoptimizationap-proachestovariousRiskManagementandFinancialEngineeringapplications.Chapter2considersgeneralizedmeasuresofdeviation,assubstitutesforstandarddeviation,inaframeworklikethatofclassicalportfoliotheoryforcopingwiththeuncertaintyinherentinachievingratesofreturnbeyondtherisk-freerate.Suchmeasures,associatedforexamplewithconditionalvalue-at-riskanditsvariants,canreectthedierentattitudesofdierentclassesofinvestors.Theyleadnonethelesstogeneralizedone-fundtheoremsaswellastocovariancerelationswhichresemblethosecommonlyusedincapitalassetpricingmodels(CAPM),buthavewiderinterpretations.Amorecustomizedversionofportfoliooptimiza-tionistheaim,ratherthantheideathatasingle\masterfund"mightarisefrommarketequilibriumandservetheinterestsofallinvestors. Theresultscoverdiscretedistributionsalongwithcontinuousdistributions;andthere-foreareapplicableinparticulartonancialmodelsinvolvingnitelymanyfuturestates,whetherintroduceddirectlyorforpurposesofnumericalapproximation.Throughtech-niquesofconvexanalysis,ourstudydealsrigorouslywithanumberoffeaturesthathavenotbeengivenmuchattentiontothissubject,suchassolutionnonuniqueness,ornonex-istence,andapotentiallackofdierentiabilityofthedeviationexpressionwithrespecttotheportfolioweights.Moreoverweaddressindetailthepreviouslyneglectedphenomenonthat,iftherisk-freerateliesaboveacertainthreshold,amasterfundoftheusualtypewillfailtoexistandneedtobereplacedbyoneofanalternativetype,representinga\netshortposition"insteadofa\netlongposition"intheriskyinstruments. Chapter2developstheCapitalAssetPricingModel(CAPM)basedongeneralizeddeviationmeasuresinthegeneralcaseofstockdistributions.TheCAPMisintendedforndinganecientportfolioofnancialinstrumentsavailableinthemarket;andpricingtheseinstrumentswithrespecttoanecientportfolio.Theriskandexpectedrateof 1

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returnaretwomaincharacteristicsassociatedwithaportfolio.Theecientportfolioisanoptimalsolutionforaproblemofportfolioriskminimizationwithconstraintontheportfolioexpectedrateofreturn.Usingapparatusofconvexanalysis,weextendedclassicalCAPMtotheclassofdeviationmeasuresundertheassumptionthattherisk-freeinstrumentisavailableinthemarket.Itturnedout,that,theoretically,thereisacriticalsetforthevaluesoftherateofreturnoftherisk-freeinstrument,forwhichanappropriateCAPMcannotbeconstructed.Atheoremestablishingthestructureofthecriticalsetisformulatedandproved.Thecriticalsetmustbeaclosedniteinterval.Oneofmainresultsisformulatedinthefollowingform:iftherateofreturnoftherisk-freeinstrumentdoesnotbelongtothecriticalinterval,thenthevectorcomposedbythestock'sexpectedratesofreturnmustbelongtothesetofgeneralizedgradientsofadeviationmeasurecalculatedfortheecientportfolio.ThisresultisillustratedbyseveralexamplesusingclassicalmeasuressuchasstandarddeviationandConditionalValueatRisk. Chapter3proposesanewone-parameterfamilyofriskmeasurescalledConditionalDrawdown(CDD).Thesemeasuresofriskarefunctionalsoftheportfoliodrawdown(un-derwater)curveconsideredinactiveportfoliomanagement.Forsomevalueofthetoleranceparameter,inthecaseofasinglesamplepath,drawdownfunctionalisdenedasthemeanoftheworst(1)100%drawdowns.TheCDDmeasuregeneralizesthenotionofthedrawdownfunctionaltoamulti-scenariocaseandcanbeconsideredasageneraliza-tionofadeviationmeasuretoadynamiccase.TheCDDmeasureincludestheMaximalDrawdownandAverageDrawdownasitslimitingcases.Chapter3studiesmathematicalpropertiesoftheCDDanddevelopsecientoptimizationtechniquesforCDDcomputationandsolvingasset-allocationproblemswithaCDDmeasure.Foraparticularexample,wendtheoptimalportfoliosforcasesofMaximalDrawdown,AverageDrawdown,andsev-eralintermediatecasesbetweenthesetwo.TheCDDfamilyofriskfunctionalsissimilartoConditionalValue-at-Risk(CVaR),whichisalsocalledMeanShortfall,MeanAccessloss,orTailValue-at-Risk.Somerecommendationsonhowtoselecttheoptimalriskfunc-tionalsforgettingpracticallystableportfoliosareprovided.Chapter3solvesareal-lifeasset-allocationproblemusingtheproposedmeasures.

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Chapter4dealswithRiskManagementinmilitaryapplications.Itdevelopsamodelandanalyticalanddiscreteoptimizationapproachesforroutinganaircraftinathreaten-vironment.Themodelconsidersanaircraft'strajectoryinthreedimensional(3D)space;andpresentstheaircraftbyasymmetricalellipsoidwiththeaxisofsymmetrydeterminingtrajectorydirection.Thethreatisassociatedwiththeriskofaircraftdetectionbyradars,sensorsorsurfaceairmissiles.Usingtheanalyticalanddiscreteoptimizationapproaches,thedeterministicproblemofndinganaircraft'soptimalrisktrajectorysubjecttoacon-straintonthetrajectorylengthhasecientlybeensolved.ThroughtechniquesofCalculusofVariations,theanalyticalapproachreducestheoriginalriskoptimizationproblemtoavectorialnonlineardierentialequation.Inthecaseofasingledetectinginstallation,thesolutiontothisequationisexpressedbyaquadrature.ThediscreteoptimizationapproachapproximatestheoriginalproblembytheConstrainedShortestPathProblem(CSPP)fora3Dnetworkwithaexiblestructure.TheCSPPhasbeensolvedforvariousellipsoidshapesanddierentlengthconstraintsinthecasesofseveralradars.Theimpactofellip-soidshapeonthegeometryofanoptimaltrajectoryaswellasimpactofvariableRCSonperformanceofthediscreteoptimizationapproachhavebeenanalyzedandillustratedwithseveralnumericalexamples.

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Forsoundmethodologyinnance,atheoryrelatingthesedierentapproachesandallowingtheireectstobecomparedisessential.AveryimportantsteptowardsuchacomprehensivetheorywasmadebyArtzneretal.[ 1 ],whointroducedthenotionofacoherentriskmeasure,demonstratingthatVaRdidnotprovidecoherency.AlthoughextensivemotivationwasgivenbyArtzneretal.[ 1 ],\coherency"hasnotfullytakenholdinthecommunityconcernedwithapplications.Oneobstaclehasbeentheiraxiom[ 1 ]thatdealswiththeeectofaddingaconstanttothereturnofanancialrandomvariable.Manyhavebalkedatthataxiom,despiteitsexplanation. Thereasonforthisdicultymaywellbeconfusionoverthemeaningof\loss".Artzneretal.[ 1 ]referredtolossasanegativeoutcome,whereasformanypractitionersitisassumedtorefertoashortfallrelativetoexpectation.Thisiscompoundedbythefactthat,inapplications,VaRandCVaRaretypicallyinvokedtomeasuresuchashortfall,insteadofmeasuringabsolutelossitself. 4

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Thereismoretothisthanmightappearonthesurface.OnaspaceofrandomvariablesX,itisonethingtoapplyariskmeasuretoXCforsomexedconstantC,andquiteanothertoapplyittoXEX.Abasicaimofthischapteristomakeclearthatriskmeasures,moreorlessinthesenseofArtzneretal.[ 1 ],whenappliedtoXEX,yieldaseparateclassfunctionalsthatcanaptlybecalleddeviationmeasures.Deviationmeasuressatisfydierentaxiomsandhavetheirownsignicance,withstandarddeviationjustbeingoneexamplethathappenstobesymmetric. Inclassicalportfoliotheory,investorsrespondtotheuncertaintyofprotsbyselectingportfoliosthatminimizevariance,orequivalentlystandarddeviation,subjecttoachievingaspeciedlevelinexpectedgain[ 2 3 ].Thewellknown\one-fundtheorem"[ 4 5 ]stipulatesthatthiscanbeaccomplishedintermsofasingle\masterfund"portfoliobymeansofaformulathatbalancestheamountinvestedinthatportfoliowiththeamountinvestedatthecurrentrisk-freerate.Theaccompanying\CAPM"theoremfurnishescovariancerelationswithrespecttothemasterfundportfoliowhichareinterpretedashavingapotentialforpredictingthemarketbehaviorofnancialinstruments[ 6 5 ].Anoverviewof\CAPM"resultswasprovidedbyGrauer[ 7 ].ExtensionsofthetheorytoaccountforhighermomentsthanvariancewereconsideredbySamuelson[ 8 ]. Nowadays,otherapproachestouncertaintyhavegainedinpopularity.Portfoliosarebeingselectedonthebasisofcharacteristicssuchasvalue-at-risk(VaR),conditionalvalue-at-risk(CVaR),orotherpropertiesproposedforuseinriskassessment.Thesemeasureshavenopretensionofbeinguniversal,however,VaRandCVaRdepend,forinstance,onthespecicationofacondencelevelparameter,whichcouldvaryamonginvestors.Instead,whatisapparentinthealternativeapproachescurrentlybeingtoutedisamovetowardakindofpartialcustomizationofresponsestorisk,whilestillavoiding(asimpractical)arelianceonspecifyingindividualutilityfunctions.Utilityfunctionsinnancehavebeenthethemeinnumerouspublications[ 9 10 ]. Aquestioninthisevolvingenvironmentiswhetheranyparallelstotheclassicaltheorypersistwhentheminimizationofstandarddeviationisreplacedbysomethingelse.Re-searchershavealreadylookedintothepossibilitiesinseveralspecialcases,undervariouslimitingassumptions(recognizedexplicitlyorimbeddedimplicitly).Ourgoal,incontrast,

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istodemonstratethatimportantparallelswithclassicaltheoryexistmuchbroaderandmore,despitetechnicalhurdles.Byshowingthis,wehopetobringoutfeaturesthathavenotcompletelybeenanalyzed,orevenperceived,inthepast. WefocusonthegeneraldeviationmeasuresthatweredevelopedaxiomaticallybyRockafellaretal.[ 11 ].Thesewereshowntobecloselyrelatedto,yetdistinctfrom,riskmeasuresinthesenseofArtzner,Delbaen,EberandHeath[ 1 ];andtoenjoyanumberofattractivecharacterizations.Ourideaistosubstitutesuchadeviationmeasureforstandarddeviationinthesettingofclassicaltheoryandinvestigatetheconsequencesrigorouslyindetail.Furthermore,weaimatdoingso,forthersttime,incaseswheretheratesofreturnmayhavediscretedistributionsaswellascaseswheretheyhavecontinuousdistributions. Ourcentralresultsaysthatabasicone-fundtheoremholdsregardlessoftheparticularchoiceofthedeviationmeasure,butwithcertainmodications.Theoptimalriskyportfolioneednotbeunique(althoughitoftenmightbe).Moresignicantly,thefullstudyofoptimalityinthecontextofanavailablerisk-freeinstrumentrequiresanunderstandingnotonlyofanecientfrontierforriskyportfoliosatcost1,butalsoofsuchafrontierforriskyportfoliosatcost1.Weestablishthatthesecondfrontiercomesintoplaywhentherisk-freerateofreturnexceedsacertainthreshold.Moreover,weshowhowthatthresholdcanbecalculatedbysolvinganauxiliaryoptimizationproblem. Theneedforanecientfrontierreferringto\netshortpositions,"alongwiththeusualonefor\netlongpositions,"isnotsurprising,inviewofthediversityofmeasuresthatinvestorsmaybeusing.Inlinewiththeirdierentopinionsaboutrisk,someinvestorsmayndtherisk-freeratehighenoughtowarrantborrowingfromthemarketandinvestingthatmoneyrisk-free,whileotherswillpreferafundinwhichthe\longs"outweighthe\shorts."Sharpe[ 6 ,p.507]discussedaninterestinganalogyintermsofastockindexfuturescontractwhichmightevenconsistentirelyofshortpositions. Theemergenceofavarietyofdierentmasterfunds,optimalfordierentdeviationmeasures,isaninescapableoutcomeofanytheorywhich,likeours,attemptstocopewiththecurrenttendencytowardcustomizationinportfoliooptimization.WhatdoesitmeanforCAPM,though?Amasterfundidentiedwithrespecttothewishesofoneclassofinvestorscannolongerbeproposedasobviouslyfurnishinginputforfactoranalysisofthe

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marketasawhole,becausethenancialmarketsreacttothewishesofallinvestors.Amasterfund,inourgeneralsense,cannolongerbeinterpretedasassociatedwithasortofuniversalequilibrium. Whethersomesuchmasterfunds,individuallyorcollectively,mightnonethelessturnouttobevaluableinfactoranalysis,isanissueoutsidethescopeofthischapter.Wedo,however,proveatheoremthatresemblestheclassicaloneinprovidingCAPM-likecovariancerelations,whichservetocharacterizethemasterfunds.Weplacethegeneralizedcoecientsintheserelationsinaframeworkfromwhichtheresultsinthiscategorythatotherresearchershaveobtainedearlier,inspecialcontexts,canreadilybederived. Includedinthatwayareresults,subjecttorestrictions,forthedeviationmeasuresassociatedwithmean-lowerpartialmoments[ 12 13 ],conditionalvalue-at-risk[ 14 15 16 ],andwithmeanabsolutedeviation[ 17 ].OurCAPM-likeresultshavefarfewerrestrictions.Theydonotrelyontheexistenceofdensityfunctionsforthedistributionsthatarise,orevenontheabsenceofprobabilityatoms(correspondingtojumpsinthedistributionfunctions),whichwouldprecludeapplicationstodiscreterandomvariables.Furthermore,theydonotrequirethedierentiabilityofthedeviationwithrespecttotheparametersspecifyingtherelativeweightsoftheinstrumentsintheportfolio.Thisbroadadvancehasbeenmadepossiblebyourutilizationoftechniquesofconvexanalysis[ 18 ]beyondstandardcalculus,alongwithstrictadherencetothefundamentalprinciplesofoptimizationtheory. Lackoffamiliaritywiththemathematicsofoptimizationhasbeenahandicapinsomeofthenanceliteratureinthisarea,goingallthewaybacktoMarkowitz.Forexample,Markowitz[ 3 ]excludedshortpositionsbyconstrainingtheportfolioweightstobenon-negative.Heneglected,however,totakeintoaccountthatLagrangemultipliersforthoseinequalityconstraintscouldcomeintoplay,inwhichcaseaclosed-formsolutiontotheoptimalityconditionsforamasterfundwouldbeimpossible.Supposingthatthemulti-plierscanbetakentobezeroisequivalent(becauseofconvexity)tosupposingthat,ifshortingwereallowed,therewouldanywaybenoshortpositionsatoptimality.Thereisnosupportforthatconviction,however,andindeed,numericalcalculationsareknowntoproducequitedierentanswerswhenshortingisallowedandwhenitisnot.Similarloose-nessaboutwhethersolutionstooptimizationproblemsevenexistmustbethereasonwhy

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themagnitudeoftherisk-freeratewasnotperceivedtohaveaneect,andtheneedformasterfundsrepresentingnetshortpositionswentundetected.TheneedforallowingatleastsomeshortpositionsinamasterfundwasemphasizedbySharpe[ 6 ,pp.500,505]. EventhoughthegeneralizedCAPM-likecoecientswestudylackthe\universal"connotationsascribedtotheclassical's,theycapturecharacteristicswhichmaybevalu-ableinassessingtheriskinessofnancialinstruments.Ineverycase,theofaninstrumentistheratioofacovarianceexpressiontothegeneralizeddeviationoftherandomvariablegivingtherateofreturnofaparticularmasterfund.Insteadofthecovariancebetweentherateofreturnoftheinstrumentandtherateofreturnofthemasterfund,however,theisbasedonthecovariancebetweentherateofreturnoftheinstrumentandaspecialrandomvariableextractedfromtherateofreturnofthemasterfund,asdictatedbytheparticulardeviationmeasure.Forinstance Suchexamples,workedoutneartheendofthechapter,revealthat,despitedeparturesfromclassicalportfoliotheoryininterpretation,thepassagetogeneraldeviationmeasuresiscapableofuncoveringinformationthatcouldbeofconsiderableinterestinnancialapplications. Weconsideraspace,theelements!ofwhichcanrepresentfuturestatesorindividualscenarios(perhapsjustnitelymany),andsupposeittobesuppliedwithaprobabilitymeasurePandtheothertechnicalitiesthatmakeitalegitimateprobabilityspace.We

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treatasrandomvariables(r.v.'s)the(measurable)functionsXonforwhichE[X2]<1;thespaceofsuchfunctionswillbedenoted,forshort,byL2().ForXinL2(),themean(X)andvariance2(X)arewelldened,inparticular: Toassistinworkingwithconstantr.v.'s,X(!)C,theletterCwillalwaysdenoteaconstantintherealnumbersIR. ByadeviationmeasurewillbemeantafunctionalDthatassignstoeachrandomvariableX(understoodtobeinL()always)avalueD(X)inaccordancewiththefollowingaxioms:(D1)D(X+C)=D(X);equivalently,D(X)=D(XEX)forallX,(D2)D(0)=0,andD(X)=D(X)forallXand0,(D3)D(X+X0)D(X)+D(X0)forallXandX0,(D4)D(X)>0fornonconstantX,whereasD(X)=0forconstantX.Theseaxiomscomefromourpaper[ 11 ],wherethenotionofageneraldeviationmeasurewasrstformulatedatthislevel. Theexampleofstandarddeviation,D(X)=(X),dominatesclassicalportfoliotheoryandissymmetricinthesensethatD(X)=D(X).SimilarnonsymmetricexamplesofdeviationmeasuressatisfyingtheaxiomsincludethestandardsemideviationsD(X)=+(X)andD(X)=(X),where 13 ]describedaclassofmeasuresaxiomaticallyintermsofD1,D2(eectively),andtheversionofD4requiringonlyweakinequality,butnoD3.Suchmeasureslackconvexityandotherproperties.

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TherstoftheseemphasizesthedownsideofX,whilethesecondemphasizestheupside.Averydierentpairofexamples,likewiseorientedtodownsideorupside,isfurnishedbythelowerrangeandtheupperrange, whereinfXandsupXdenotethe\essential"inmumandsupremumofX(!)over!2(obtainedbydisregardingsubsetsofhavingprobability0).Foreitherofthese,itispossibleforsomer.v.'sXthatD(X)=1,whichisallowedbytheaxioms.Ofcourse,botharesuretobeniteinthecaseofanite,discreteprobabilityspace. Anotherclassofdeviationmeasures,ofincreasinginterestnowinapplications,arisesfromconditionalvalue-at-risk,CVaR,asanalternativetovalue-at-risk,VaR.Abriefdiscus-sionofriskmeasures,incontrasttodeviationmeasures,willlaytheplatformforintroducingthisclassproperly. Byanexpectation-boundedriskmeasurewillbemeantafunctionalRthatassignsvaluesR(X)torandomvariablesXinsuchawaythat(R1)R(X+C)=R(X)CforallXandconstantsC,(R2)R(0)=0,andR(X)=R(X)forallXandall>0,(R3)R(X+X0)R(X)+R(X0)forallXandX0,(R4)R(X)>E[X]forallnonconstantX,whereasR(X)=E[X]forconstantX.AxiomR4isthepropertyweexplicitlymeanby\expectation-boundedness".(TheequationpartofR4isalreadyaconsequenceofR1,sothestrictinequalityfornonconstantXisthechiefassertion.) Artzner,Delbaen,EberandHeathintheirlandmarkcontributiontorisktheorywerethersttoconsiderriskmeasuresfromabroadperspective,buttheyconcentratedinsteadonfunctionalsRsatisfyingR1,R2,R3and,insteadofR4,themonotonicityaxiom:(R5)R(X)R(X0)whenXX0.Theycalledthesecoherentriskmeasures.(Actually,theyposedR5inaseeminglyweakerform,namelyR(X)0whenX0,whichisequivalenttothepresentR5undertheotheraxioms.Also,theyhadsomewhatdierentversionR1,tailoredtotheuseofaninvestment

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instrument,buttheversionusedherewassubsequentlyadoptedbyDelbaen[ 19 ].)PropertyR5isnaturalandevencrucialformanypurposes,andwewillbeconcernedwithitaswell.However,weforgoitinthebasicdenitionofanexpectation-boundedriskmeasureinordertocaptureafundamentalpairingbetweenriskmeasuresanddeviationmeasures.Therisk-boundednessaxiomR4,rstspelledoutinourownearlierwork,isneededforthefollowingresult,whereitemergesasthecounterparttodeviationaxiomD4. 11 ]).Deviationmeasurescorrespondone-to-onewithexpectation-boundedriskmeasuresundertherelations(a)D(X)=R(XEX),(b)R(X)=E[X]+D(X).Specically,ifRisanexpectation-boundedriskmeasureandDisdenedby(a),thenDisadeviationmeasurethatyieldsbackRthrough(b).Ontheotherhand,ifDisanydeviationmeasureandRisdenedby(b),thenRisariskmeasurethatyieldsbackDthrough(a).Inthiscorrespondence,RhasthefurtherpropertyR5,yieldingcoherency,ifandonlyifDhasthefurtherpropertythat(D5)D(X)EXinfXforallX. ThedeviationmeasureD(X)=(X)forany2(0;1)ispaired,forinstance,withR(X)=(X)(X),whereasthelower-rangedeviationmeasureD(X)=EXinfXispairedwiththemaximumlossriskmeasureR(X)=sup[X].Coherencyislackingintherstexamplebutpresentinthesecondexample. Recallnextthatforany2(0;1)thevalue-at-riskofXatlevelisdenedby VaR(X)=inffzjPfXzg>g; andthenthecorrespondingconditionalvalue-at-riskis CVaR(X)=[expectationofXinitslower-taildistribution]. (2.5)

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TheexpectationinquestionisthesameastheconditionalexpectationofXsubjecttoXVaR(X)whenPfXjX=VaR(X)g=0,butrefersmoregenerallytotheexpectationofther.v.whosecumulativedistributionfunctionFisobtainedfromthecumulativedistributionfunctionFforXbytakingF(z)=F(z)=whenz
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theelement12Qasitsdensity).ForadensityfunctionQ,theprobabilityofasubset0isR0Q(!)dP(!),whereastheexpectationofarandomvariableXisEQ[X]=RX(!)Q(!)dP(!). ToexplaintheconnectionbetweenriskenvelopesQanddeviationmeasuresD,weneedtoimposeonDtheminortechnicalpropertyoflowersemicontinuity,whichmeansthatthesetsfXjD(X)gareclosedinL2()forall>0.ThisholdsforalloftheexamplesofdeviationmeasuresDmentionedabove;cf.[ 11 ,Proposition2]. 11 ]).ThelowersemicontinuousdeviationmeasuresDsatisfyingD1,D2,D3andD4correspondone-to-onewithrisken-velopesQsatisfyingQ1,Q2andQ3undertherelations(a)D(X)=supQ2QE[Q(EXX)],(b)Q=fQjEQ=1;E[Q(EXX)]D(X)forallXg,whereequivalentlyE[Q(EXX)]=E[Q(X)]E[X]=covar(X;Q):Moreover,DhastheadditionalpropertyD5(forcoherency)ifandonlyifQhaspropertyQ4.

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FocussingonaparticularchoiceofthedeviationmeasureDinsomeapplicationcor-respondsinthisframeworktodecidingonaparticularattitudetowardrisk,inthesenseofthetrustworthinessofthereferenceprobabilitydistributionP.Rockafellaretal.[ 11 ]discussedseveralissuesinconnectionwithconceptsof\acceptablerisk." DescriptionsoftheriskenvelopesQcorrespondingtoanumberofspecicdeviationmeasuresDhavebeenworkedoutbyRockafellaretal.[ 11 23 ].SomewillberecalledtowardtheendofthischapterinconnectionwithoptimalityrulesandCAPM-likeequations. Anadditionalexample,whichwehavenotaddressedelsewherebutdeservesmentionbecauseofitsrichmodelingimplications,istheoneinwhichisjustanitesetoffuturestatesandQistakentobetheconvexhullofanitecollectionoffunctionsQ1;:::;Qmonwhichgiveprobabilitydensities,i.e.,satisfyQj(!)0;X!2Qj(!)=1; isthereforecoherent. Inthissetting,eachQjcanbeviewedasa\mixedscenario"representinganalternativeprobabilitydistributionamongthe\purescenarios"(theelements!of)thatisdierentfromthereferencedistribution.Aninvestormayhavespeciedthesemixedscenariosastestsforwhatmightreasonablybeacauseforconcerninappraisingthefuture.ThedeviationD(X)( 2.8 )identiestheworstdiscrepancythatcouldoccurbetweentheexpectedlossesunderthespeciedalternativesandtheexpectedlossE[X].

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constant.Theotherinstruments,fori=1;:::;m,arerisky;theirratesofreturnriarer.v.'sinL2().Adollarinvestedininstrumentibringsback1+ri,foragain(orprot)ofridollarsattheendofthetimeperiodunderconsideration. Wewillbeconcernedwithportfoliosthatcanbeputtogetherbyinvestinganamountxiineachinstrumenti.Theseamounts(indollars)canbepositive,zeroornegative.(Anegativeinvestmentcorrespondstoashortposition.)Suchaportfoliohasthepresentcostx0+x1++xnandtheuncertainfuturevaluex0(1+r0)+x1(1+r1)++xn(1+rn).Theassociatedgainisthusther.v.XinL2()describedby Hereweareusing\gain"inthesensethatalossisanegativegain.Costs,too,mightbenegativeaswellaspositive,orzero. Tofacilitateourworkwiththeser.v.'sXwhiletakingintoaccountthespecialroleoftherisk-freeinstrumentandkeepingnotationsimple,weintroducer=(r1;:::;rn)(vectorr.v.),r=(r1;:::;rn)forri=Eri; 2.9 );itsexpectedgainEXisx0r0+x>r,anditscostisx0+x>e.Wespeakofx=(x1;:::;xn)itselfasgivingthex-portfolioforwhichthegainisther.v.x>rinL2(),theexpectedgainisx>r,andthecostisx>e. Thefollowingassumptionsoninstrumentsi=1;:::;ninthemodelwillhenceforthbeineect.Therestofthissectionwillbedevotedtoelucidatingtheirimmediateconse-quences.Basicassumptionsare(A1)Nox-portfoliowithx6=0isrisk-free.(A2)Theexpectedratesofreturnr1;:::;rnarenotallthesame.(A3)D(ri)<1andD(ri)<1foralli. AssumptionA1isharmlessandmerelyunderscoresouraimoflettingthei=0instru-mentdoalltherisk-freeservice.Anotionofredundancywillhelpinunderstandingwhy

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thisistrue.Letussaythataninstrumentsiisredundantinthemodeliftheassociatedr.v.ri,whichgivesthegainfrominvestingonedollarininstrumenti,canexactlybereplicatedbythegainr.v.ofaportfolioputtogetherfromtheotherinstruments.Notethatsuchreplication,ifpossibleatall,wouldhavetobeachievedatcost1,oranarbitrageopportu-nitywouldexist,therebyunderminingourintentofstartingfromamarketinwhichpricesareinequilibrium. Fortheconverse,supposesomeinstrumentiisredundant.Ifthatholdsfori=0,thenbythedenitionofredundancytheremustbeanonzerox-portfoliothatisrisk-free.Otherwise,wecansupposeforsimplicityofnotationthati=1isredundant.Thisreferstotheexistenceofcoecientsx0;x2;:::;xnsuchthatr1=x0r0+x2r2++xnrn.Thenr1+x2r2++xnrn=x0r0,sothex-portfolioforx=(1;x2;:::;xn)wouldberisk-free. Redundantinstrumentsoernothingnew,sowecouldalwayseliminatethemfromthemodelonebyoneuntilnothingredundantwasleft.ThenA1wouldhold. AnotherinsightintoA1canbeobtainedthroughconsiderationofdistributionfunc-tions.

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AssumptionA2isneededtosidestepspecialcircumstanceswhichhavelittleinterestforushere.Ifitdidnothold,therewouldbeavaluesuchthatri=fori=1;:::;n;thentheexpectedgainx>rofanx-portfoliowouldalwaysbetimesitscostx>e. BothA1andA2seemtobetakenforgrantedbymanyinnance,eventhoughtheyareessentialtothevalidityofcommonlymadeassertions. AssumptionA3iscertainlysatisedwhenDisadeviationmeasurethatisniteonallofL2(),andmanymeasureswiththatpropertyhavealreadybeenindicatedbeyondD(X)=(X),forinstanceD(X)=CVaR(XEX).ButA3mayalsobesatisedforsomedeviationmeasuresthatarenotniteonallofL2().AnexampleisD(X)=EXinfXwhentheratesofreturnriarebounded.NotethatweareobligedtorequirethenitenessofD(ri)andD(ri)separately,becauseDneednotbesymmetric. 24 ,p.159],then+2linearequationsinn+2unknownsthatdescribetheweightsforanecientriskyportfoliointheMarkowitzmodelaresaidtohaveauniquesolution,butreallythatisonlytruewhenthecoecientmatrixisnonsingular.ThematrixinquestionfailstobenonsingularifA1andA2donothold.

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(e)fD(x)=maxQ2QPni=1xi(riE[Qri])=maxQ2QPni=1xicovar(Q;ri),where,inthenalformula,QistheriskenvelopeassociatedwiththedeviationmeasureD. ForthefactthatniteconvexfunctionsIRnarecontinuous[ 18 ,Theorem10.1].Ontheprincipleof[ 18 ,Corollary8.7.1]andfDbeingconvexandcontinuous,ifanysetofformfxjfD(x)gisbounded,thenallsetsofthatformmustbebounded.By(a),thesetfxjfD(x)0gisthesingletonf0g,so(d)iscorrect. Finally,themaxformulain(e)comesimmediatelyfromapplyingthemaxformulainTheorem2(a)toX=x>r=Pni=1xiri. 2.9 )isP()minimizeD(x0r0+x>r)subjecttox0+x>e=1andx0r0+x>rr0+;

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whereD(x0r0+x>r)isactuallyjustthefD(x)inProposition3,ofcourse.Thecostconstraintx0+x>e=1signiesthatexactlyonedollaristobeinvestedintheportfolio.Thegainconstraintx0r0+x>rr0+requiresthatthisunitinvestmentshouldresultinanexpectedfuturevalueofatleast1+r0+.Theparametergivestheriskpremium|theextraamountbeingdemandedoverthegainassociatedwithinvestingattherisk-freerater0.Thegainconstrainthasbeenwrittenasaninequalityinsteadofanequationbecausethereshouldnotbeanyobjectionifsomeportfolio,withoutworseningthedeviationorcostingmore,mighthaveanexpectedgainthatismorethanr0+.Itwillcomeoutbelow,however,thatanyportfoliosolvingproblemP()mustsatisfythisconstraintwithequality,when>0. TheunitcostconstraintinP()canbeusedtoeliminatex0byassigningitthevaluex0=1x>e.Theproblemstatementcomesdownthento:P0()minimizefD(x)subjecttox>[rr0e]:

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(2.12) arenonemptybythedenitionofd0()aswellascompactbecauseofthecontinuityoffDandtheboundednessinProposition3(d).Anynestofnonemptycompactsetshasanonemptyintersection.Inthiscase,moreover,thesetsareconvexbyvirtueoftheconvexityoffD,sotheintersectionislikewiseaconvexset.ThisconrmsthatS0()isnonempty,convexandcompact. ThespecialassertionsaboutP0()inthecaseof0areevidentfromProposition3(a).Theyrelyalsoontheconstrainthavingbeenstatedasaninequalityratherthananequation.Inthecasewhere>0,therelationshipsinvolvingd0(1)andS0(1)areimmediatefromthepositivehomogeneityoffDinProposition3(b). TheconstraintinP0()hastobeactivewhen>0,becauseifxhasx>[rr0e]>,thereisafactor2(0;1)suchthatthevectorx0=xsatisesthesameinequalityandyetyieldsadeviationamountthatissmallerthantheoneforxbythesamefactor.Thisisincompatiblewithxbeingoptimal.NotethathereweareinvokingProposition3(a)oncemore,sincethisargumentwouldfallthroughifthedeviationinquestionwere0. 2.11 )ofProposition5,byhavingx2S0()wearesuretohave(=)x2S0().WehaveformulatedproblemP0()insuchamannerthatasolutiontoP()isconstructedbyacquiringanx2S0(),atcostx>e,andtheninvestingtheamountx0=1x>eintherisk-freeinstrument.Herewehavex>e=(=)(x>e),sotheconclusionisathand. Theorem3is\unscaled"becauseitimposesnorestrictiononthecostx>eoftheriskyportfoliothatisbeingutilizedinconstructingasolutiontoproblemP()foreach>0.

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Inprinciple,thecostofthex-portfolioshouldnotreallymatter,sinceinpassingfromxtox=(=)xtherelativeproportionsinvestedintheinstrumentsi=1;:::;nremainthesame.Themagnitudesoftheseamountsgoupordown,buttheydosobythecommonfactor=.Theunscaledresultneverthelessleadsrightawaytothefollowing\scaled"conclusions. Theanswerliesinthefactthatnothinginourassumptions,sofar,aboutr0andther.v.'sr1;:::;rnensuresthatinsolvingproblemP(),orequivalently,solvingproblemP0(),foraspecied>0,theriskyx-portfoliowegetinoptimalitywillhavepositivecost.Thepossibilitythatthecostisnegative,orzero,cannotbeunderstoodwithoutadeeperinvestigation.Indeed,wewillseethatitdependsontheinterplaybetweenthechosendeviationmeasureDandthesizeoftherisk-freerater0,relativetotheuncertainratesr1;:::;rn.

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Intheclassicaltheory,basedonD=,onlymasterfundsofthe\positivetype"inthisdenitionarecontemplated,andtheyareimmediatelytiedintothenotionof\ecientset."ThefamiliarpictureinFigure 2{1 isusedtoindicatethat,for>0,theoptimalvalued0()canbeobtainedbyinterpolatingalongatangentlinetotheecientsetthatpassesthroughthepoint(0;r0).Thepointoftangencycorrespondstoanx-portfolioofcost1havingexpectedgain=r0+forsome>0.ThisportfoliothensolvesproblemP0()andfurnishesamasterfundwhichisabletoperformtheroleinTheorem30(a). Inoursituationofnonstandarddeviation,thereisaneedtolookmuchmorecloselyatthispictureandrecognizecertainshortcomingsaswellasmajorchallenges.Intherstplace,the\ecientset"correspondinganalogouslytoageneraldeviationmeasureD6=maynolongerbeaquadraticcurveliketheoneinFigure 2{1 (whichisactuallyahyperbola).Forthatreason,theone-fundtheoremmustcontendwithseriouscomplications. Classicalecientset:expectedgainversusstandarddeviation 4 ],whichassertstheexistenceoftwoportfoliosfromwhichallecientportfolioscanbeconstructedaslinearcombinations.Thatresultisintrinsically\quadratic"initsmathematicalunderpinnings.

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Althoughtheregionmarkedoutbytheecientsetwillcontinuetobeconvexinourgeneralizedsetting,itsboundarymayincorporatecornersorstraightsegments.Forthecaseofacorner,theverymeaningoftangencyhastobepinneddowncarefully.Inthepresenceofstraightsegments,thetangentlinecouldhaveawholeintervalincommonwiththeecientset,andthismightinfactbeaninniteinterval. Anothercomplication,whichcanalsocomeupintheclassicalmodel,isthepossibilitythat,becauseoftheasymptoticbehavioroftheecientset,theecientsethasno\tangent"lineatallthatpassesthrough(0;r0).Indeed,apartfromanytroubleswithasymptoticbehavior,thereisanunspokendicultyintheclassicalpictureoverthefactthatittakesforgrantedtheexistenceofamasterfundofpositivetype.Clearlythisexistence,perceivedinrelationto\tangency,"dependsinparticularontherater0.Itmightfailifr0weretoohigh. InthetraditionalsettingwithD=,suchasituationhasbeenregardedasimplausibleandanyway\incompatiblewithmarketequilibrium."ThisviewappearstooriginateinCAPMconsiderationsandthesuppositionthatallinvestorsareeectivelyengagedinminimizingstandarddeviation.Amasterfundcouldnotbeofnegativetype,forthereasonthatifallinvestorswantedtotakeanetshortpositionasrepresentedbyacertainportfolio,soastoobtainmoneytoinvestattherisk-freerate,somethingmustbewrongwiththerisk-freerate|animplicitmarketinstabilitywhichfailstoaccountforthelimitedsupplyofmoney. Noneofthatreallyappliestooursetting,however,becauseweareonlyexploringportfoliooptimizationforasubclassofinvestors,thosewhochoosetheparticulardeviationmeasureDwearefocussingon.Otherinvestors,withdierentmeasuresD,canbeexpectedtocometodierentconclusionsabouttheirportfoliochoices.Somemayendupwithnetshortpositions,whileothersmaynot.Fromthatangle,thereisnohintofconictwithmarketequilibriuminthinkingaboutamasterfundofnegativetypepossiblyemergingfromaparticularchoiceofDatsomelevelofr0. Wearecompelled,therefore,inourframeworkofadiversityofdeviationmeasuresD,tofaceuptoallcostpossibilitiesforx-portfoliosaspotentialsolutionstoproblemP0().Thiswillleadustostudyhowsuchsolutionsmaydependonr0asaparameter.

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Beforegettingintothatparametricanalysis,wecanrecordakeyfactaboutdualityinP0().Thisproblemis,afterall,aconvexprogrammingproblem,inwhichtheconvexfunctionfDisminimizedsubjecttoasinglelinearconstraint.TheLagrangianfunctionis andtheproblemdualtoP0()consiststhereforeofmaximizingthefunctiongD()=infxL(x;)subjectto0(cf.thegeneraltheoryisdevelopedbyRockafellar[ 18 25 ]).BecauseofthepositivehomogeneityinProposition3(b),however,wehavegD()=whenfD(x)x>[rr0e]0forallx2IRn,butgD()=otherwise.TheproblemdualtoP0()thereforetakestheform: maximizewithrespecttosatisfyingfD(x)x>[rr0e]forallx2IRn: Ofcourse,wereallyonlyneedtounderstandthecaseof=1,sinceeverythingelsecanbeobtainedfromthatthroughrescaling.Byapplyingknowndualityresultsabouttherelationshipbetweenaconvexprogrammingproblemanditsdual,wegetthefollowingconclusionaboutthatcase. 25 ]. 2{1 mighthavetobemodiedandexpanded,wecannotlimitourattentiontox-portfolioswithcostx>e>0,

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forreasonsalreadyexplained.Itisessentialtolookatcostsx>e0aswell.Moreover,wehavetoadjusttothefactthatthedeviationmeasureDunderscrutinymightnotbesymmetric.Ifwehaveanx-portfoliorepresentinga\netlongposition,"inthesensethatx>e>0,andwewishtopasstotheassociated~x-portfoliowith~x=x,representinga\netshortposition"because~x>e=x>e<0,wecannotcountonhavingD(~x>r)=D(x>r).Switchesbetween\long"and\short"couldhavesignicanteectsonriskperception. Outoftheseconsiderations,weareobligedtoinvestigateanauxiliaryoptimizationproblemwithrespecttotheinstrumentsi=1;:::;n.Inthisproblem,andareparam-etersdenotingtargetedcostandexpectedgain,andweseektosolve:P(;)minimizefD(x)=D(x>r)subjecttox>e=andx>r=: ThegainconstraintinP(;)hasbeenwrittenasanequationthistimebecauseofthechieytechnicalrolethattheanalysiswillplayandthesimplergeometryaordedbyhavinganequationinsteadofaninequality.Welet

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TherelevanceofproblemP(;)forourgoalofanalyzingthecostofasolutiontoproblemP0()comesfromthefollowingobservation. AccordingtoProposition8,thepairs(x>e;x>r)givingthecostandexpectedgainassociatedwiththesolutionsx(orsolution,ifunique)toproblemP0()arethepairs(;)thatfurnishtheminimumofthefunctiondalongthelineinIR2describedbytheequation=r0+.Duetopositivehomogeneityin( 2.11 )ofProposition5,ofcourse,wecanconcentrateonthecasewhere=1.Inthatcase,depictedinFigure 2{2 ,thelineinquestionistheonewithsloper0thatpassesthroughthepoint(0;1). The\curves"showninFigure 2{2 aregivenbytheequationsd(;)=forvarious>0andreectthepropertiesinProposition7.Theyaretheboundariesofcertaincompact,

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convexsetswhicharemerelyrescaledversionsofeachother,generatedbyexpandingorcontractingtheonefor=d(0;1).Intheclassicalcaseofstandarddeviation,thecurveswouldbeellipses,butingeneraltheymayhavecornersandstraightsegments. Figure2{2: Reducedoptimizationperspective Theissueofwhetherthex-portfoliosforx2S0(1)havecostx>e>0,x>e=0orx>e<0,comesdowntowhether,inminimizingdalongthelineinFigure 2{2 ,thepoints(;)thatareobtainedattheminimumhave>0,=0or<0.(Wehavetospeakingeneralof\x-portfolios"and\points(;)"becauseuniquenessofoptimalsolutionsisnotassuredhere,ingeneral.)Itisimmediatelyclearthatthismustdependlargelyonthesizeoftherisk-freerater0andcannotberesolvedmerelyonthebasisofanyoftheassumptionsthathavebeenmade,sofar,ontheratesofreturnoftheinstrumentsi=1;:::;ninourmodel. Forther0thatisillustrated,theslantedlineinFigure 2{2 cutsintothesetf(;)jd(;)0atoptimality.Butforhigherandhigherlevelsofr0,astagewilleventuallybereachedwherethelinehenceforthcutsintothissetinsteadtowardtheleft,inwhichcase<0atoptimality.

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Aformalanalysisofthesecircumstances,aimedatcharacterizingthethresholdvalue,orvalues,ofr0wherethelinedoesnotcutintothesetatall,willhavetobeundertaken. ObservethatinthecaseshowninFigure 2{2 thereisnotjustoner0forwhichlinedoesnotcutintothesetinquestion,butindeedawholeintervalofsuchvalues.Geometrically,thiscorrespondstotheboundaryofthesethavinga\cornerpoint"at(0;1).Althoughthatcanberegardedasanexceptionalsituation,itcannotberuledout.Ourresultonthresholdbehavior(Theorem5inthenextsection)musttherefore,ingeneral,allowforanintervalofr0valuesforwhichonehas=0atoptimality. Fornow,theessentialthingtorecognizeistheneedtostudytwoecientsets,ifcostbehaviorintheone-fundtheoremistobeunderstoodoverthewholerangeofpossibler0values.Therehastobeanecientsetcorrespondingtox-portfoliosfurnishing\unitlongpositions"(cost=1),butalsooneforx-portfoliosfurnishing\unitshortpositions"(cost=1).BecausethedeviationmeasureDmightnotbesymmetric,neitheroftheseecientsetscanbeexpectedtobederivableinasimplewayfromtheother. Dictatesofsimplicityindealingwiththegeometryofeciencyanditsrelationshiptotheone-fundtheoremandpropertiesofthefunctiondcauseustoadoptaconventiondierentfromtheoneinFigure 2{1 ,wheredeviationisonthehorizontalaxisandexpectedgainontheverticalaxis.Instead,wewillhavedeviationontheverticalaxisandexpectedgainonthehorizontalaxis.Ofcourse,aipacrossthe45linebetweenthetwoaxescanbeusedtoconvertourconventiontotheclassicalone,whendesired.

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Figure2{3: Ecientsetsincoordinatesstandardforgraphsoffunctions Thevirtueofpassingto(;)inthedenitionofFwillemergeintheresultsbelowasawayofgettingthemostoutofasinglegeometricpictureinwhichbothoftheecientsets,orfrontiers,canbeseen,namelythepictureinFigure 2{3 ,whichwillbeexplainedinduecourse,afterTheorem4.Notethat,throughanotationalswitchbetweenxandx,onecanexpressFequivalentlyby Thus,incaseswherethedeviationmeasureDissymmetric,sothatfD(x)=fD(x),thesetFwouldmerelybethereectionofthesetF+acrossthe-axis,andtherewouldbelessofanimperativeforconsideringitseparately. AsdepictedinFigure 2{3 ,thepositiveecientfrontieristhe\right"boundaryofF+,incontrasttoG+beingthewholeboundary.Inthesameway,thenegativeecientfrontier

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isthe\left"boundaryofF,incontrasttoGbeingthewholeboundary.Onlythesepartialboundarieswillreallyhavearoleinwhatfollows,butitisconvenientmathematicallytoworkwithG+andGthemselves.Forconvenienceofcomparisons,Figure 2{4 posesallthesesetsinthereversedcoordinatesystemthatiscustomaryinnance.There,thepositiveecientfrontierbecomesan\upper"boundaryandthenegativeecientfrontiera\lower"boundary. Figure2{4: Ecientsetsincoordinatestraditionalfornance

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2.20 )and( 2.21 )aresuretobeattained,immediatelyyieldthedescriptionsclaimedforF+andF. Therelationsin( 2.22 )specializetodawellknownpropertyinconvexanalysis:theasymptoticslopeofaniteconvexfunctionalonganyhalf-linedependsonlyonthedirectionofthehalf-line,notonitsstartingpoint(see[ 18 ,Theorem8.5]).Here,wearelookingatsuchslopesalonghalf-linesinthe-spaceofFigure 2{2 thatareparalleltothepositiveornegative-axis.Onthepositive-axisitself,dislinearbecauseofthepositivehomogeneityinProposition7(b):wehaved(0;)==d(0;1)forall>0: Incidentally,theasymptoticslopeofG+ontherightagreeslikewisewiththeasymptoticslopeofGontheleft,butthisfactwillnotplayanyrolehere.(TheportionsofG+ontheleftandGontherightwoulddropoutifwewrotetheconstraintinP(;)asaninequalityinsteadofanequation.)

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Weareinpositionnowtoanswerthequestionofhowthetangencyrelationshipassoci-atedwiththeclassicalone-fundtheorem,asinFigure 2{1 ,canbeextendedtoourframeworkofgeneraldeviationmeasures,asacomplementtotheone-fundresultsinTheorems3and30. Fortheinequalityconditioninsidethisdescriptiontohold,itonlyhastoholdwhen>0or<0,sinceitmustthenholdautomaticallyfor=0bythecontinuityofd.Indeed,becauseofthepositivehomogeneityofdinProposition7(b),itmerelyhastoholdfor=1andfor=1,inorderforthisconclusiontobereached. Inthecaseof=1,theinequality[r0]d(;)comesdownto(r0)d+().Havingthisholdforall2IRmeansthatthelinein(;)-spacethrough(r0;0)withslopedoesnotcrossabovethegraphofd+.

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Inthecaseof=1,theinequality[r0]d(;)comesdownto[+r0]d().Withaswitchofnotationbetweenand,thisbecomes[r0]d().Havingthatholdforall2IRmeansthatthelineinquestiondoesnotcrossbelowthegraphofd.Thus,thecharacterizationofd0in( 2.23 )reducestothegraphicalcharacterizationclaimedinthetheorem. Now(a)and(b)areobviousfromtherepresentationsofG+andGinProposition9.Ontheotherhand,(c)followsfromthemonotonicityinthecurvaturesofG+andG(i.e.,oftheleftandrightderivativesofthefunctionsd+andd,duetotheirconvexityandconcavity),asexpressedthroughProposition8andtheclaimthereaboutasymptoticslopes. Figure 2{3 illustratesthegeneralsituationdescribedinTheorem4.Twopossiblevaluesoftherisk-freerater0areindicated,correspondingtoalternatives(a)and(b)ofthetheorem.Notethepossibilityofmorethanonepointof\tangency,"andontheotherhand,thepossibilityofarangeofr0valuesallyieldingthesamepointoftangency.Alternative(c)ofTheorem4correspondstor0-linehavingthesameslopeasthediagonallineshownindashes.Typicallytheremightbeonlyonesuchline,associatedwithauniquethresholdrate,butsometimestherecouldbeafamilyofparallellinescorrespondingtoanintervalofr0rates.Thiswillbethesubjectofthenextsection,andeventually,Figure 2{5 Thesamebasicrelationshipsunderliethereversed-coordinatepictureinFigure 2{4 ,ofcourse,buttheretheycannotbedescribedsosimplyintermsofslopes.Alinehavingsloped0(1)inFigure 2{3 turnsintoalinehavingslope1=d0(1)inFigure 2{4 ,soforinstance,theoptimalvalueinproblemP0(1)emergesinsteadasthereciprocalofthelowestoftheslopesofallthelinesthrough(0;r0)thatliebetweenthetwoecientsets.Theawkwardnessofthiskindofstatement,insistingonreciprocals,isanotherofthereasonswhywehavechosentogiveprioritytothepresentationinFigure 2{3

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Wesaythat(;)isaLagrangemultipliervectorforP(;)when infxL(;)(x;;)=optimalvalued(;)inP(;). (2.25) Thisdenition,thestandardoneforaconvexprogrammingproblemlikeP(;)(cf.[ 18 ]),getsaroundthefactthattheobjectivefunctionfD(x)neednotbedierentiableeverywherewithrespecttox.Welet (2.26) Underourassumptions,theLagrangemultipliersetM(;)isalwaysnonempty,con-vexandbounded.ThisistruefromthegeneraltheoryofconvexprogrammingproblemsbecausetheoptimalsolutionsettoP(;)isalwaysnonemptyandbounded,andtheopti-malvalued(;)isalwaysnite;cf.[ 25 ],[ 18 ].Moreover,themultipliervectorsforP(;)areknownfromthattheorytobethe\subgradients"ofthe(optimal-value)functiondatthepoint(;).Accordingly,theyfurnishtheformula wheretheleftsidedenotestheone-sideddirectionalderivativeofdat(;)withrespecttoavector(0;0)andisdenedby Suchderivativesexistbecausedisconvex.

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2.11 )ofProposition5,weneedonlylookatthecasewhere=1.AsseeninProposition9,thecostsx>eofthevectorsx2S0(1)arethevaluesofthatminimize'overIR.Suchvaluesformanonempty,closed,boundedintervalinIR,inasmuchasS0(1)isanonempty,closed,bounded,convexsubsetofIRn(cf.Proposition7);thisintervalmaywellcollapsetojustonevalue,ofcourse.Theissueistheextenttowhichthevaluesofthatminimize'maybepositive,negativeorzero. Asanite,convexfunctiononIR,'hasrightandleftderivatives'0+()and'0()whicharenondecreasingasfunctionsof,with'0()'0+().Theminimumof'isattainedatifandonlyif'0()0'0+(). Wecantestthisconditionat=0.If'0+(0)<0,theminimumof'canonlybeattainedatsome>0,whereasif'0(0)>0,itcanonlybeattainedatsome<0.If'0(0)<0<'0+(0),itcanonlybeattainedat=0.When'0+(0)=0,theminimumis

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Figure2{5: Thresholdvaluesfortherisk-freerate

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attainedat=0,butitisconceivablethat'mightbeconstantoversomeinterval[0;"](with">0),andtheminimumwouldalsobeattainedthenbythepositivevaluesofinthatinterval.Likewise,when'0(0)=0,theminimumisattainedat=0,butitisconceivablethat'mightbeconstantoversomeinterval[";0],andtheminimumwouldalsobeattainedthenbythenegativevaluesofinthatinterval. Thecrucialleftandrightderivatives'0+(0)and'0(0)areobtainablefromtheone-sideddirectionalderivativesofd:'0+(0)=d0(0;1;1;r0);'0(0)=d0(0;1;1;r0): 2.27 )tellsusthenthat'0+(0)=max;f+r0j(;)2M(0;1)g;'0(0)=min;f+r0j(;)2M(0;1)g: 2.27 )thatd(0;1)=max;f0+1j(;)2M(0;1)g=min;f0+1j(;)2M(0;1)g:

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Similarly,whenr0>^r+0,thereexistsbyProposition5andTheorem5(a)anx2S0()havingx>e<0.Then,bysettingx=x=jx>ejand==x>e,wegetx>e=1andhavex2S0().Thisxfurnishesamasterfundofnegativetype. Ontheotherhand,Theorem5(a)makesclearthatamasterfundofpositivetypecannotexistwhenr0>^r0,butmightexist(bytheargumentjustgiven)whenr0=^r0.Likewise,amasterfundofnegativetypecannotexistwhenr0<^r+0,butmightexistwhenr0=^r+0. TheinterpretationcomingfromTheorems5and6isthatwhentherisk-freerater0ishighenough(specically,abovethethresholdrate^r+0),itisadvantageous,forinvestorswhoseattitudestowardriskarecapturedbytheparticulardeviationmeasureDunderinvestigation(anditsassociatedriskenvelopeQ),totakeanet\shortposition"inthe

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market(anx-portfoliowithnegativecost)andinvestattherisk-freerateallthemoneythatisobtainedthatway. TherelationbetweenthresholdbehaviorandtheecientsetgeometryinFigure 2{3 isindicatedinFigure 2{5 .Ordinarily,itcanbeexpectedthat^r0=^r+0,inwhichcasetheuniedthresholdvaluecouldbedenotedsimplyby^r0.TheexplanationisthatthesevaluesaredeterminedintheproofofTheorem5fromrightandleftderivativesoftheconvexfunction'()=d(;r0+1),andsuchderivativeshavetocoincidealmosteverywhere.When^r0=^r+0,thereisonlyonelinethattsbetweenthetwoecientsets. Thereasonwhycaseswith^r0<^r+0cantrulyoccurisseen,fromthisvantagepoint,tobetiedtothefactthattherightandleftderivativesof'maydierinsomeplaces,duetothefunctiondnotbeingdierentiable.ButitcanalsobeunderstoodfromtheremarksmadeearlieraboutthegeometryinFigure 2{2 .Whenthecurvethrough(0;1)inFigure 2{2 hasacornerthere,onehasarangeofslopesr0correspondingtocasesforwhichtheminimuminthereducedformatofProposition7occurswith=0.Thisrangeofslopesismarkedbythetwothresholdvalues^r0and^r+0,asshowninFigure 2{6 Allowanceforcornerpointsreallydoeshavetobemade,becauseofdeviationmeasuressuchastheonein( 2.8 ),forinstance.Therewehave sothatfDispiecewiselinearandthecurvesinFigure 2{6 arepolygonal.Asidefromthemodelingpotentialofthiskindofformula,itcouldalsocomeupinnumericalmethodsinwhichtheriskenvelopeQassociatedwithDisapproximatedprogressivelybysetsformedbygeneratingnitelymanyelementsQj2Q.Suchapproximationyields(29)asasubstituteforthemaxformulaforfDinProposition3(e). InsightintocircumstancesinwhichcornerpointsaresurenottobepresentwillbefurnishedlaterinProposition11anditscorollary,andinExample7. Itshouldbenotedthat,althoughTheorem6conveysthecircumstancesinwhichmasterfundsofonetypeortheotheraresuretoexist,itsaysnothingaboutwhentheymightbeunique.Thatisanentirelyseparateissue.Uniquenesscouldfailontwogrounds.Therstisthepossibilityofmorethanonepointoftangencywherether0-linemeetsthefrontier,

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asseeninFigure 2{3 .Thesecondariseswhenmorethanoneportfoliocanyieldthesamepointonthefrontier.Itmaybeanticipatedthatthesephenomenaare\rare,"buttheycannotreadilybeeliminated,apriori,intheabsenceofasuitablestrictconvexitypropertyofD.Rockafellaretal.demonstrated[ 23 ,Example4],however,thattherequiredversionofstrictconvexityisunavailable,ingeneral,forcoherentdeviationmeasuressuchaslowersemideviation,lowerrange,andCVaR,andthesamecanbeseenformixedCVaRandmeanabsolutedeviation. Incontrasttotheseobservations,andthefactsinTheorem6,boththeexistenceanduniquenessofamasterportfolioseemtobetakenforgrantedinmuchoftheliteratureonportfoliooptimization.Thebeliefiswidespread,moreover,thatamasterportfolioofpositivetypealwayssuces,regardlessofthemagnitudeoftherisk-freerater0.Ourhopeisthattherigorousmethodologypursuedinthischapterwillhelptodispelsuchmisconceptions. Figure2{6: Thresholdintervaltiedtocornerbehavior

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11 ,Proposition1].WethenhaveatourdisposalthedualrepresentationofDintermsofitsassociatedriskenvelope,asinpart(a)ofTheorem2,whichinparticularcanbeexpressedbycovarianceswithriskenvelopes OfspecialinteresttousinwhatfollowswillbethesubsetofQonwhichthemaximuminthisformulaisattainedforagivenX,namely ThisassistsinthestatementofoptimalityconditionsforproblemsinwhichDisminimized,throughitsconnectionto\subgradients"ofD. Bythestandarddenitioninconvexanalysis,asadaptedtotheprobabilityframeworkofourspaceL2(),asubgradientofDatXisanelementY2L2()suchthatD(X0)D(X)+E[Y(X0X)]forallX02L2.Thenotationisusedthat@D(X)=fsetofallsubgradientsYofDatXg: 11 ,Theorem5]thatinfact andfurthermorethat,foranyY2@D(X)onehasEY=0andD(X)=E[XY]=covar(X;Y).

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SubgradientsofthefunctionfD(x)=D(x>r)canbederivedfromthoseofDbyakindofchainrule.AsubgradientoffD(x)atapointx2IRnisofcourseavectory2IRnsuchthatfD(x0)fD(x)+(x0x)>yforallx02IRn.Thesetofsuchyisdenotedby@fD(x). Anumberofbackgroundfactsfromconvexanalysis[ 18 ]areworthrecalling.BecausefDisconvexandniteeverywhere,thesubgradientset@fD(x)isalwaysnonempty,convexandcompact.ItreducestoasingletonfygifandonlyiffDisdierentiableatx,inwhichcasetheuniqueelementy=(y1;:::;yn)isthegradientrfD(x),sothat (see[ 18 ,Theorem25.1]).Indeed,theconvexityandnitenessoffDguaranteethatthiscaseofdierentiability,inwhich@fD(x)reducessimplytofrfD(x)g,holdsfor\almostevery"x2IRn. Butunfortunately,thereisnoeasywaytoknow,ingeneral,whetheraparticularxcalculatedtobeoptimalwillhappentobesuchapointofdierentiability.MostofthedeviationmeasuresDofinterestinourgeneralframeworknecessarilydoleadtofunctionsfDforwhichdierentiabilitycanfailatasignicantclassofpointsx.Inconsequence,thesimplicationsaccruingfromdierentiabilitycannotbetakenforgranted. Apossiblehelpsometimescouldbetheestimatethat ify2@fD(x);then@f @xi(x)yi@+f @xi(x)fori=1;:::;n; where(@fD=@xi)(x)and(@+fD=@xi)(x)denotetheleftandright(one-sided)partialderiva-tivesoffDwithrespecttoxiatx(whichexistbecausefDisconvex).Theconverseimpli-cationisgenerallyfalse;theestimatein( 2.34 )isnotenoughtopindownyasasubgradientatx.Whentheleftandrightpartialderivativescoincideforeachi,however,onedoesnecessarilyhavefDdierentiableatxwith( 2.33 )holding.

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2.33 ). 25 ,Theorem19]requires,forinstance,theexistenceofapointintherangeofTatwhichDiscontinuous,andthisrequirementismetunderourassumptionsA4andA5,asnoted.Itcharacterizes@fD(x)asthesetofvectorsoftheformT(Y)forY2D(X),whereTistheadjointlineartransformationfromL2()toIRn.ThatadjointtransformationtakesYtothevectorinIRnhavingthecomponentsyiin( 2.35 ).Thatconrmstherstdescriptionof@fD(x),andtheseconddescriptionthenfallsimmediatelyoutof( 2.32 ).Thefactthatx>y=fD(x)wheny2@fD(x)isobviousthenfromthefactthatE[XY]=D(X)whenY2@D(X). Itisclearthatwhen@D(X)reducestoasingletonfYg,thecharacterizationof@fD(x)yieldsasingletonfyg,inwhichcasefDisdierentiableatxand( 2.33 )holds,asrecalledabove.

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convexprogramming,theconditionbothnecessaryandsucientfortheoptimalityofxis(thefulllmentoftheconstraintalongwith)theexistenceofaLagrangemultiplier0suchthattheLagrangianexpressionL(x;)=fD(x)+[(x>[rr0e]) attainsitsunconstrainedminimumatthisx,with=0ifx>[rr0e]>.ByProposition5,wenecessarilyhavex>[rr0e]=inoptimality,however.Since>0,thatentailsx6=0,sofD(x)>0byProposition3(a).Theconditionforanunconstrainedminimum,L(x0;)L(x;)forallx0,translatesintofD(x0)fD(x)+(x0x)>[(rr0e)]forallx: 2.37 )holdingforsomey2@fD(x).ItimpliesbyProposition10thatx>[(rr0e)]=fD(x),fromwhichitfollows(evenwithoutknowinginadvancethat0,aswedo)that=fD(x)=x>[rr0e]=fD(x)=>0. ItmustbeemphasizedthattheoptimalityruleinTheorem7isvalidregardlessofthecostofthex-portfolio.Itcanbeappliedinparticulartomasterfunds,however,bywayofTheorems5and6,aswillbecarriedoutshortlyinTheorem8.FormanychoicesofthedeviationmeasureD,aprecisedescriptionofthevectorsy2@fD(x)thatentertheruleisavailablethroughProposition10andtheanalysisofdeviationsubgradientsY2@D(X)andriskenvelopesQ2QXthatwehavealreadycarriedoutinexamples[ 11 23 ].Thedetailswillnotbelistedhere,butwewilldrawonthenbelowinaseriesexamplesconcernedwithmasterfunds. ThestatementofTheorem7hasbeenchosentokeepclosetotheoptimalityconditionsthatwouldbeanticipatedwhenfDisadierentiablefunction(awayfromtheoriginofIRn,whereitsdierentiabilityisimpossible).Thentheyi'sarethepartialderivativesin( 2.33 ),anditmaybeimaginedthatasolutionx=(x1;:::;xn)couldbedeterminedfromthen+1equationsinthen+1unknownsx1;:::;xnandthatcorrespondthentooptimality,

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namely Apracticalshortcominginthisapproachisapparent,however,inthefactthatthepartialderivativesdependnonlinearlyonx1;:::;xn,ingeneral,andalthoughthisdependencewouldbecontinuous,itwouldnotlikelybedierentiable.(ThetwicedierentiabilityoffDisrarelytobeexpectedinoursetting.)Solvingsystemsofnonlinearequationsdirectlyisaformidabletaskevenbynumericalmethodswhentheexpressionsintheequationsarenotdierentiable.Thisistrueallthemorewhenthesolutionisnotguaranteedtobeunique,evenlocally|afurtherdicultywhich,onthebasisoftheremarksattheendoftheprecedingsection,cannotbeshovedaside. Anyway,thereisnoneedtoreduceoptimalityconditionstoasystemofequationsinordertogaininsightfromthem.ThesubgradientexpressionsinTheorem7providebothpracticalandtheoreticalinformationwhichcanreadilybeutilized.NumericalmethodsofoptimizationforsolvingproblemP0(),makinguseoftheseconditions,canbesubstitutedveryeectivelyfornumericalmethodsofsolvingnonlinearequations.SuchoptimizationtechniquescantakeadvantageofspecialfeatureslikethemaxformulaforfDinProposition3(e)obtainedfromtheriskenvelopeQ,whichrelatestotheformoftheyi'sin( 2.36 ),forexample,butthisisnottheplacetopursuethattopic. TheoptimalityconditionsinTheorem7canberestatedinadierentmannerbyrecognizingthat,sincemustturnouttobeequaltofD(x)=,thisratiocanbesubstitutedforin( 2.37 ),moreoverwithreplacedbyx>[rr0e].Theconditionswereachbythatrouteare rir0=yi Theseequationsmoreoverembodytherequirementthatx>[rr0e]=,sincethatfollowsfromthembyProposition10throughmultiplyingeachequationbyxiandaddingup. Thecriterionforoptimalityin( 2.39 )producesimportantinformationabouttheport-foliosthatfurnishmasterfunds.

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(b)Amasterfundofnegativetypeisfurnishedbyxifandonlyifxhascostx>e=1andthereisacoecientvector2B(x)suchthat (c)Allcoecientvectors2B(x)havethepropertythat @xi(x)i1 @xi(x)fori=1;:::;n; 2.39 ),withthefactsinProposition10aboutvectorsy2@fD(x).Inthelightofhavingx>e=1,theequationsin( 2.41 )asserttheexistenceofy2@fD(x)suchthat rir0=yi

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ThatisequivalenttohavingxinthesolutionsetS0(),andsincethecostofxis1,correspondstoxfurnishingamasterfundofpositivetypeinthesenseofDenition1. Thecaseofamasterfundofnegativetypein(b)isentirelyparallel,exceptforbeingadjustedtoxhavingcost1.Sincei[(EX)r0]=ix>[rr0e]inthatcase,theycorrespondagaintohaving(47)holdforsomey2@fD(x).Therelationsin( 2.40 ),( 2.43 ),( 2.44 )and( 2.45 ),simplytranslatepropertiesinProposition10fromytoy=fD(x). TheswitchinTheorem8(b)fromEXtoEXamountstoaswitchfromthex-portfolio,whichconstitutesanetshortposition,toitsopposite,the~x-portfoliofor~x=x,whichconstitutesanetlongposition.Theappearanceofiinplaceofiin( 2.42 ),correspondstoreversing,accordingly,thevariouscorrelationsin( 2.40 ). Regardlessofthetypeofmasterfund,theequationin( 2.43 )canbeinterpretedaspro-vidingguidancetotheallocationofriskamongtheinstrumentsi=1;:::;nindeterminingx. ThegeneralityofTheorems7and8deservesemphasis.Otherresearchersworkingwithnonstandarddeviationmeasureshavedealtwithspecialclassesofmeasuresandhavetypicallynarrowedthescopeoftheirresultsbysupposingtheuniquenessoftheoptimalportfolioinquestion,orfurtherinthecaseofamasterfund,thatitisofpositivetype.TheyhavealsoreliedonthefunctionfDbeingdierentiable.Theorems7and8,incontrast,donothavetheselimitations.

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11 ,Examples14and18]. Inthissetting,aslongastherisk-freerater0isnottoohigh(inthesenseofthethresholdinTheorem5),thereisauniquemasterfundofpositivetype:x,andareuniquelydeterminedsubjecttothex-portfoliohavingunitcost.Thecoecientsiin(48)turntherelationsin( 2.41 )intothestandardCAPMequationsfortheexpectedrateofreturnofthismasterfund(or\marketportfolio"). Theseclassicalcovariancerelationshavebeeninterpretedinthecaseofamasterfundofpositivetype Thisisbasedconceptuallyonasuppositionthatallinvestorsseekessentiallytominimizestandarddeviation,whenputtingtogetheraportfolioataspeciedlevelofexpectedgain. ItistemptingtothinkthattheequationsofTheorem8in( 2.41 )mightbeabletotakeonsucharoleasin(49)morewidely,forotherdeviationmeasures,butonemustbecarefulnottojumpdirectlytosuchaconclusion.Weareoperatingherefromadistinctlydierentstandpoint,wheretheinvestorsemployinganyparticulardeviationmeasureDareviewedonlyasasubgroupofalltheinvestors,perhapsjustasmallsubgroup.Thereislittlereasontobelievethattheactionsofsuchasubgroupoughttohaveadetermininginuenceonmarketbehaviorasawhole. 24 ,p.168],hesetsupafunctionofthe\weights,"ourxi's,andclaimsthatbyde-terminingwherethepartialderivativesofthisfunctionvanish,thefundinquestionwillbedetermined.Thefunctionisnonconvex,however,sothisisjustanecessarycondition,notasucientcondition,andcouldcorrespondtoamaximumaswellasaminimum.Anyway,heneglectstheissueofwhetherapointwherethederivativesvanishevenexists.Inthisway,thethresholdphenomenonwiththerisk-freerateismissedentirely.

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Anotherissuewhichmustnotbeignored,ingeneral,isthatthecoecientsiinTheorem8mightnotbeuniquelydetermined.Thiscouldhappenin( 2.40 )becauseofYorQnotbeinguniquelydeterminedbytheconditionsathandwithrespecttox,butitcouldalsooccurin( 2.40 )or( 2.45 )fromxnotevenbeingtheonlysolutiontoproblemP0().Stillanotherpossibilityisthatxmightbetheuniquesolutionforthis,andyetanotherportfolio,correspondingtoavaluedierentfrom,mightfurnishadierentmasterfund.Thiscouldarisefroma\atspot"ontheecientfrontier;itoccursinFigures 2{3 and 2{4 Ofcourse,itisconceivablenonethelessthat,throughstatisticalanalysis,therelations( 2.41 )inTheorem8withrespecttoone,ormaybeseveralalternativedeviationmeasuresincombination,mayleadtointerestingpredictivemodelsoftype(49)withadvantagesovertheclassicalCAPM.(Theunderlyingassumptionoftheclassicalmodelisanywaynotbeyondcontroversy.)Thatisnotatopictobetakenupinthischapter,however. Intheexamplesthatfollow,wearecontentmainlytoseewhattherelationscomingfromTheorem8looklikeasmasterfundcharacterizations,andtonotecomparisonswiththe\beta"formulasderivedbyotherresearchersunderassumptionslikedierentiabilityanduniqueness.Ineachcase,thesamecoecientsworkformasterfundsofnegativetypeaswellasonesofpositivetype,inlinewiththealternativeformsoftheequationsin( 2.41 )and( 2.42 ). 23 ],Example6.

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LowersemideviationisamongthemeasurescoveredbyMalevergneandSornette[ 13 ].Thoseauthors,althoughconcernedespeciallywith\moments,"basedtheirresultsonax-iomsaimedatcoveringawideclassofmeasuresof\deviation"type.Theydidnotrequireconvexityorcontinuity,orinvokethosepropertiesanywhere,sotheunderpinningstotheirassertionsoftheexistenceanduniquenessofoptimalportfoliosappearstobewithoutfoun-dation.Thesameistrueoftheirclaimsofhavingdeterminedmasterfundsofpositivetypewithoutmakinganyrestrictionontherisk-freerate. 2.40 )comingfromsuchadensityfunctionQ.Moreover,ifthesetf!2jX(!)=VaR(X)ghasprobability0,asistrueinparticularwhenther.v.r=(r1;:::;rn)iscontinuouslydistributed,thenfDisdierentiableatxandthecoecientsicanbeexpressedbyconditionalexpectations: 11 ,Example20].Clearly,Qisuniquelydetermined(uptotheusualequivalenceinL2())bytherelationsin( 2.50 )forXwhenthereiszeroprobabilityofXtakingonthevalueVaR(X).ThenfDisdierentiableatxbyProposition10.Otherwise,though,Qmightnotbeuniquelydetermined,andfDcouldthusfailtobedierentiableatx.Indeed,whenPfX
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thevaluesofQonthesetf!2jX(!)=VaR(X)gcanbeselectedarbitrarilyfromtheinterval[0;1],subjectonlytoarrangingthatPfXVaR(X)g=.Itmaynotbepossibleinthatsituationtopassfromtheformulaforiin( 2.40 )totheformulain( 2.51 ). TheversionoftheCVaRoptimalityrelationsin( 2.51 )isinterestingforthereasonthatthenumeratorsofthebetacoecientsgivetheconditionalexpectationofthedownsideofrisubjecttoXbeinginitslower-tail.Asnoted,however,thisversionisvalidwhenriscontinuouslydistributed,butnotnecessarilywhenthedistributionofXhasaprobabilityatomatVaR(X). InpreviousworkonCVaRmasterfunds,Tasche[ 14 ],Bertsimas[ 15 ]andAcerbiandSimonetti[ 16 ]haveavoidedtheissueofdiscontinuitiescomingupintheprobabilitydis-tributionsandhasmoreoverrequiredthedierentiabilityoffD.Theneedforathresholdassumptionontherisk-freerate,inordertobeassuredoftheexistenceofamasterfundofpositivetype,didnotgetaddressed,nordidtheissueofnonuniquenessofsuchafund,evenwhenitexists. 2.40 )comingfromsuchaQ,whichitselfisanotherdensityfunction.Ifthesetsf!2jX(!)=VaRk(X)gfork=1;:::;mallhaveprobability0,asistrueinparticularwhenr=(r1;:::;rn)iscontinuouslydistributed,thenfDisdierentiable

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23 ,Example2]thencomesintoplay.Accordingtothatrule,QconsistsofallQ=Pmk=1kQkwithQkbelongingtotheriskenvelopeforDk.Thentoo,sinceQX,foranyr.v.X,consists,bydenition,oftheelementsQthatmaximizecovar(X;Q)subjecttoQ2Q,wehaveQ2QifandonlyifQ=Pmk=1kQkforachoiceoffunctionsQk2(Qk)X.ItremainsonlytoutilizeforeachoftheCVaRdeviationmeasuresDkthedescriptionof(Qk)XinthepatternofExample3. 2.40 )comingfromsuchadensityfunctionQ.Whenthesetofstates!2suchthatX(!)=infXconsistsofaunique!(havingnonzeroprobability),thenQisuniquelydeterminedfromX,sofDisdierentiableatxandthecoecientsicomeoutas 11 ],Example19. (2.56)

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2.40 )comingfromsuchaY(inwhichcasecovar(ri;Y)=covar(ri;V),actually).Ifthemiddlesetinthisformulahasprobability0,asistrueinparticularwhenther.v.r=(r1;:::;rn)iscontinuouslydistributed,thenfDisdierentiableatxandthecoecientsiaredeterminedby ThesubgradientsofanintegralfunctionalsuchasJareknowninconvexanalysistobecharacterizedbytherulethatV2@J(U)ifandonlyifV(!)2@u'(!;U(!)),where@u'(!;U(!))referstothesubgradientsetof'(!;u)withrespecttouatu=U(!).ThiscorrespondstoVsatisfyingtherelationsin( 2.57 ). Konno[ 17 ]hasinvestigatedmeanabsolutedeviationwitha(!)1undertheassump-tionthattheri'shaveamultivariatedistributiongivenbyadensityfunctiononIRn,andwiththathehasobtainedsimilar's.Inhissetting,theuniquenessofamasterfundisnotassured,though,sincemeanabsolutedeviationlacksthekindofstrictconvexityneededforthat.Shortpositionsaresaidtobeexcluded,whichwouldmakecomparisonsdicultwiththeoptimizationproblemwetreathere,buttheconstraintsagainstshortingaresuppressedinthedevelopmentsbyassumingtheirLagrangemultiplierscanbesetequalto0.The

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optimalportfolioisassumedneverthelesstoinvolvenoshorting,sothepotentialneedforamasterfundofnegativetypedoesnotcomeintoview. Itispossiblenow,bybuildingonthesubgradientdevelopmentsintheprecedingsection,toindicateinmoredetailwhatthisinvolves.TheLagrangianfunctionforP(0;1)isL(0;1)(x;;)=fD(x)x>e+[1x>r]; 2.24 ),andM(0;1)consistsofthepairs(;)suchthatinfxL(0;1)(x;;)=d(0;1),asnotedin( 2.25 ).Therearenosignrestrictionsonthesemultipliersand,apriori,sincetheconstraintsinP(0;1)areequations.

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whichcanbewrittenasfD(x)fD(x)+[xx]>[e+r].Havingitholdforallx2IRnisthesameassayingthate+risasubgradienty2@fD(x),asclaimedin( 2.59 ).Applyingthedescriptionofsuchsubgradientsyin( 2.35 )ofProposition10,wegetthecharacterizationclaimedin( 2.60 ). : Althoughthenumericalapproachinwhichthepossiblemultipliervectors(;)arecalculatedasbyproductsoftheoptimizationinP(0;1)itselfmaybeallthatcanbecountedoningeneral,itisinterestingtonotethat,intheclassicalcaseofstandarddeviation,ananalyticformulaforthethresholdcanbederived. e>1e: 2.60 )mustbe[XEX]=(X).Then(61)saysthate=[x=(X)]r,sox=(X)[e+r]andconsequentlyx=(X)1[e+r]: 2.62 ).

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Thereplacementofstandarddeviationbyotherdeviations,suchasarisefromcondi-tionalvalue-at-riskandotherrisknotions,inaccordancewithcurrenttrends,bynomeanscausestheclassicalapproachtooptimizationout-dated.Instead,itenrichesthatapproachbymakingadegreeofcustomizationavailable.One-fundtheoremsstillreignasawayofsimplication,eventhoughthedesignatedfunds,intheirdependenceonthedeviationmeasure,canbedierentfordierentclassesofinvestors. Utilizingtoolsofconvexanalysis,wehavefurthermoredevelopedaschemefordeter-miningoptimalityinproblemsofminimizingdeviationorrisk.Wehaveshownthatriskenvelopeshavemajorsignicanceinsolvingsuchproblemsandhaveillustratedthepartic-ularsinanumberofsettings.Theresultsopenthewayformanyapplicationsandadvancesintheirnumericalmethodology. Furthermore,optimalitycanstillbecharacterizedbycovariancerelations.However,optimalitywithrespecttonetshortpositionsintheriskyinstrumentsmustbeanalyzedinadditiontooptimalitywithrespecttonetlongpositionsinordertodeterminehowaninvestormaywishtoactwithrespecttothecurrentrisk-freerate.Thecovariancerelationsthatareobtainedfurnishadditionalinformationaboutthebehaviorofriskyinstrumentsinvarioussituations.Thisinformationcouldbeusefulinpracticalanalysisevenifnolongerassociatedwithnotionsofequilibriuminwhichallinvestorsareattractedtoasinglemasterfund.

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26 ].Allofthem,asastartingpoint,assumesomemeasureofportfo-lioperformance,whichconsistsofatleasttwocomponents:evaluatingexpectedportfolioreward;andassessingexpectedportfoliorisk.Fromtheoreticalprospective,therearetwowell-knownapproachestomanageportfolioperformance:ExpectedUtilityTheoryandRiskManagement,whichareusuallyconsideredwithinaframeworkofaone-periodormulti-periodmodel. IfweareinterestedinRiskManagementapproachtoportfoliooptimizationwithinalongterm,whatarethefunctionalsforassessingportfolioriskthataccountfordierentsequencesofportfoliolosses?Letportfoliobeoptimizedwithintimeinterval[0;T],andletW(t)beportfoliovalueattimemomentt2[0;T].Oneofthefunctionalsthatwearelookingforisportfoliodrawdowndenedbymax2[0;t]W()W(t)!,W(t),which,indeed,accountsforasequenceofportfoliolosses.Whataretheadvantagestoformulateaportfoliooptimizationproblemwithaconstraintonportfoliodrawdown?Toanswertothisquestion,drawdownregulationsinrealtradingstrategiesanddrawdowntheoreticalaspectsshouldbeaddressedrst. 57

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hisrevenues.CommodityTradingAdvisor(CTA)determinesthefollowingrulesregardingmagnitudeanddurationoftheirclients'accountsdrawdowns 27 ]obtainedanexactanalyticalsolutiontoportfoliooptimizationwithconstraintonmaximaldrawdownbasedonthefollowingmodel CvitanicandKaratzas[ 28 ]generalizedthismodel[ 27 ]tomulti-dimensioncase(severalriskyassets).IncontrasttoGrossmanandZhou[ 27 ]andCvitanicandKaratzas[ 28 ],Chekhlovetal.[ 29 ]denedportfoliodrawdowntobethedropofthecurrentportfoliovaluecomparingtoitsmaximumachievedinthepastuptocurrentmomentt,i.e.max2[0;t]W()W(t),andintroducedone-parameterfamilyofdrawdownfunctionals,entitledConditionalDrawdown(CDD).Moreover,Chekhlovetal.[ 29 ]consideredportfoliooptimizationwithaconstraintondrawdownfunctionalsinasetupsimilartotheindextrackingproblem[ 30 ],whereanindexhistoricalperformanceisreplicatedbyaportfoliowithconstantweights.Chekhlovetal.[ 29 ]proposedthefollowingsetup

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TheCDDisrelatedtoValue-at-Risk(VaR)andConditionalValue-at-Risk(CVaR)measuresstudiedbyRockafellarandUryasev[ 21 20 ].Bydenition,withrespecttoaspeciedprobabilitylevel,the-VaRofaportfolioisthelowestamountsuchthat,withprobability,thelosswillnotexceedinaspeciedtime,whereasthe-CVaRistheconditionalexpectationoflossesabovethatamount.VariousissuesaboutVaRmethodologywerediscussedbyJorion[ 31 ].TheCDDissimilartoCVaRandcanbeviewedasamodicationoftheCVaRtothecasewhentheloss-functionisdenedasadrawdown.CDDandCVaRareconceptuallyrelatedpercentile-basedriskperformancefunctionals.OptimizationapproachesdevelopedforCVaRaredirectlyextendedtoCDD.TheCDDincludestheaveragedrawdownandmaximaldrawdownasitslimitingcases.Ittakesintoaccountboththemagnitudeanddurationofthedrawdowns,whereasthemaximaldrawdownconcentratesonasingleevent|maximalaccount'slossfromitspreviouspeak. However,Chekhlovetal.[ 29 ]onlytestedthesuggestedapproachtoportfolioopti-mizationsubjecttoconstraintsondrawdownfunctionals.TheCDD[ 29 ]wasnotdenedasatrueriskmeasureandthereal-lifeportfoliooptimizationexamplewasconsideredbasedonlyonthehistoricalsamplepathsofassets'ratesofreturn. Thischapterisfocusedon

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OurstudydevelopsconceptofdrawdownmeasurebygeneralizingthenotionoftheCDDtothecaseofseveralsamplepathsforportfoliouncompoundedrateofreturn.Def-initionofdrawdownmeasureisessentiallybasedonthenotionofCVaR[ 32 21 20 ]andmixedCVaR[ 11 ]extendedtoamulti-scenariocase.DrawdownmeasureusestheconceptofriskprolingintroducedbyRockafellaretal.[ 11 ],namely,drawdownmeasureisa\multi-scenario"mixedCVaRappliedtodrawdownloss-function. Fromtheoreticalprospective,drawdownmeasuresatisesthesystemofaxiomsdeter-miningdeviationmeasures[ 11 23 ].Thoseaxiomsare:nonnegativity,insensitivitytocon-stantshift,positivehomogeneityandconvexity.Moreover,drawdownmeasureisanexamplegeneralizingpropertiesofdeviationmeasurestoadynamiccase.Wedevelopoptimizationtechniquesforecientcomputationofdrawdownmeasureinthecasewheninstruments'ratesofreturnaregiven. SimilartotheMarkowitzmean-varianceapproach[ 3 ],weformulateandsolveanopti-mizationproblemwiththerewardperformancefunctionandCDDconstraints.Thereward-CDDoptimizationisapiece-wiselinearconvexoptimizationproblem[ 18 ],whichcanbereducedtoalinearprogrammingproblem(LP)usingauxiliaryvariables. Linearprogrammingallowssolvinglargeoptimizationproblemswithhundredsofthou-sandsofinstruments.Thealgorithmisfast,numericallystable,andprovidesasolutiondur-ingonerun(withoutadjustingparameterslikeingeneticalgorithmsorneuralnetworks).Linearprogrammingapproachesareroutinelyusedinportfoliooptimizationwithvariouscriteria,suchasmeanabsolutedeviation[ 33 ],maximumdeviation[ 34 ],andmeanregret[ 30 ].ZiembaandMulvey[ 35 ]discussedotherapplicationsofoptimizationtechniquesinthenancearea. 1;N,bythesetofpointsft0=0;t1;t2;:::;tN=Tg,andsupposetherearemriskyassetswithratesofreturndeterminedbyrandomvectorr(tk)=(r1(tk);r2(tk);:::;rm(tk))attimemomentstkfork= 1;N.Wealsoassumethattherisk-freeinstrument(orcash)withtheconstantrateofreturnr0isavailable.Theithasset'srateofreturnattimemoment

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1;mandx0(tk)denetheproportionofthecurrentcapitalinvestedintheithriskyassetandrisk-freeinstrumentattk,respectively.Consequently,aportfolioformedofthemriskyassetsandtherisk-freeinstrumentisdeterminedbythevectorofweightsx(tk)=(x0(tk);x1(tk);x2(tk);:::;xm(tk)).Thecomponentsofx(tk)satisfythebudgetconstraint Bydenition,therateofreturnoftheportfolioattimemomenttkis Portfoliooptimizationcanbeconsideredwithinaframeworkofaone-periodormulti-periodmodel.Aone-periodmodelinportfoliooptimizationassumestheithasset'sratesofreturnforalltk,k= 1;N,tobeindependentobservationsofarandomvariableri.Inthiscase,thevectorofportfolioweightsisconstantandportfoliorateofreturnisarandomvariabler(p)presentedbyalinearcombinationofrandomassets'ratesofreturnri,i= 1;m,andconstantr0,i.e.r(p)=mPi=0rixi.Atraditionalsetupforaone-periodportfoliooptimizationproblemfromRiskManagementpointofviewismaximizingportfolioexpectedrateofreturnsubjecttothebudgetconstraintandaconstraintontherisk maxxE(r(p))s:t:Risk(r(p))d;mPi=0xi=1: Riskoftheportfoliocanbemeasuredbydierentperformancefunctionals,dependingoninvestor'sriskpreferences.Variance,VaR,CVaRandMeanAbsoluteDeviation(MAD)areexamplesofriskfunctionalsusedinportfolioRiskManagement[ 11 ].Certainly,solv-ingoptimizationproblem( 3.3 )withdierentriskmeasureswillleadtodierentoptimalportfolios.However,allofthemarebasedonaone-periodmodel,whichdoesnottakeintoaccountthesequenceoftheasset'sratesofreturnwithintimeinterval[0;T].

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Amulti-periodmodelinportfoliooptimizationisintendedforcontrollingandoptimiz-ingportfoliowealthoveralongterm.Itisessentiallybasedonhowtheasset'sratesofreturnevolvewithinthewholetimeinterval.Moreover,ineachtimemomenttk,k= 0;N,theremightbeacapitalinoworoutowintoorfromtheportfolioandportfolioweightsxi(tk),i= 1;m,mightbere-balanced.Inthiscase,theportfoliowealthattkfork= 1;Nisdened whereY(tk1)=F+(tk1)F(tk1)istheresultingcapitalowattk1(inowF+(tk1)minusoutowF(tk1)),whichcanbepositiveornegative. AportfoliooptimizationproblemcanalsobeformulatedbasedontheExpectedUtilityTheory(EUT).AccordingtotheEUT,aninvestorwithadditivelyseparableconcaveutilityfunctionU(:)choosesaconsumptionstreamfC0;C1;:::;CN1gandportfoliotomaximizeEN1Pk=0U(C(tk);tk)+B(W(tN;x(tN)))!,whereB(:)istheconcaveutilityofbequest.NotetheEUTisfocusedonmaximizationofinvestor'sconsumption.However,ariskmanagerwhorunsahedgefundandwishestoincreasecapitalinowbyattractingnewinvestorswouldbemoreinterestedinmaximizingportfoliowealthatthenalmomenttN=Tanddecreasingportfoliodropsoverthewholetimeinterval[0;T].Inthiscase,RiskManagementapproachismoreadequatetoformulateaportfoliooptimizationproblem maxxP(W)s:t:R(W)d;mPi=0xi(tk)=1;k= 0;N; whereP(W)andR(W)areperformanceandriskfunctionals,respectively,dependingonstreamW=(W1;W2;:::;WN). Supposetheoptimizationproblem( 3.5 )isconsideredunderthefollowingconditions 0;N,i.e.he/shecanonlyoptimizeportfoliorateofreturnbychoosingportfolioweightsxi(tk).

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Accountingfortheseconditions,howcanthemanagerevaluateportfolioperformanceover[0;T]andecientlysolve( 3.5 )?Beforetoanswertothisquestion,thefollowinglegitimateissuesregardingproblemformulation( 3.5 )shouldbeaddressed 3.5 ) max0jkfWj(x(tj))g: Apossibleproblemformulationistoconsiderportfoliooptimizationwithdrawdownconstraintsincontinuousdynamics[ 27 28 ],forinstance PrfDD(W;t);8t2[0;T]g=1: Inthiscase,portfoliodrawdownshouldnotexceedgivenvalue2[0;1]almostsurelyforallt2[0;T].However,insteadofimposingtheconstraint( 3.7 )forallt2[0;T],weareinterestedinmaximizingportfolioexpectedrateofreturnwhilecontrollinganintegralcharacteristicofportfolioperformance.Weentitlesuchacharacteristictobeadynamicperformancefunctional(DPF).Inthiscase,followingRiskManagementmethodology,wewouldbeabletoconstructanecientfrontierestablishingthedependencebetweenthe

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expectedrateofreturnofoptimalportfoliosandcorrespondingvaluesoftheDPF.Devel-opingDPFbasedonthenotionofportfoliodrawdownandsolvingareal-lifeasset-allocationproblemwiththesefunctionalsisthesubjectofthischapter. 1;Ndetermineasam-plepath(timeseries)oftheportfolio'srateofreturn,then,bydenition,theuncompoundedcumulativeportfoliorateofreturnattimemomenttkis 1;N: Tosimplifynotations,weusewkinsteadofwk(x(tk)),assumingthatwkisalwaysafunctionofvectorx(tk).Furtherinthissection,weconsideronlyasinglesamplepathofwk,k= 1;N,whichwedenotebyvectorw,i.e.w=(w1;:::;wN). Notethatcomponents(w1;:::;wN)and(1;:::;N)ofvectorswand,are,infact,timeseriesw1;:::;wNand1;:::;N,respectively,wherethekthcomponentsofwandcorrespondtotimemomenttk.Since0isalwayszero,wedonotincludeitintodrawdowntimeseries.Moreover,althoughAD(w)andarethesamedrawdowntimeseries,werefertonotationAD(w)toemphasizeitsdependenceonwandtonotationwheneverweusedrawdowntimeseriesjustasvectorofnumbers. Figure 3{1 illustratesanexampleoftheabsolutedrawdownandacorrespondingsamplepathofuncompoundedcumulativerateofreturnw.Startingfromt0=0,uncom-poundedcumulativerateofreturnwgoesupandtherstcomponentofequalszero.Whenwdecreases,goesup.Whentimeserieswachievesitslocalminimum,absolutedrawdownachievesitslocalmaximum.ThisprocesscontinuesuntiltN=T.

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Figure3{1: Timeseriesofuncompoundedcumulativerateofreturnwandcorrespondingabsolutedrawdown. 1.Nonnegativity:AD(w)0. 2.Insensitivitytoconstantshift:AD(w+const)=AD(w). 3.Positivehomogeneity:AD(w)=AD(w),80. 4.Convexity:ifw=wa+(1)wbisalinearcombinationofanytwosamplepathsofuncompoundedcumulativeratesofreturn,waandwb,with2[0;1],thenAD(w)AD(wa)+(1)AD(wb). 3.9 ).Property4isprovedbasedonmax0tfwa+(1)wbgmax0tfwag+(1)max0tfwbg,2[0;1]. NoteDDdoesnotsatisesthepropertieswhichADdoes(advantageofAD).ThedierencebetweentheADandDDissimilartothedierencebetweenabsoluteandrelativeerrorsinameasurement.TheADandDDfunctionalscanbeusedinRiskManagementandStatisticstocontrolabsoluteandrelativedropsinarealizationofastochasticprocess.However,inthischapterwearefocusedonapplicationsofdrawdownfunctionalsinportfoliooptimization.Sincefurtherinthischapter,wedealonlywiththeabsolutedrawdownfunctional,AD,theword\absolute"canbeomittedwithoutconfusion.

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20 ]and,asspecialcases,includestheMaxDDandAvDD. 1;N,witht0=0andtN=T,AvDDandMaxDDfunctionalsaredened,respectively AvDD(w)=1 TodeneConditionalValue-@-Risk(CV@R)andCDD,weintroduceafunction(s)suchthat whereIfksgisanindicatorequalto1,iftheconditionincurlybracketsistrue,andequaltozero,iftheconditionisfalse,i.e.Ifcsg=8><>:1;cs;0;c>s;c2R: 3{2 explainsdenitionoffunction(s).Forthethresholdsshownonthegure,function(s)equals5 8,sinceksfor5valuesofk,namely,k=2;3;4;7;8. Theinversefunctionto( 3.12 )isdened 1;N,arenonnegative,wedene1(0)tobezero.

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Figures 3{3 and 3{4 illustrateleftandrightcontinuousstepfunctions(s)and1(),respectively,whichcorrespondtodrawdowntimeseriesshownonFigure 3{2 Figure3{2: DrawdowntimeseriesandindicatorfunctionIfcsg Ifweareabletopreciselycount(1)100%oftheworstdrawdowns,then(())=1()=.Forsuchavalueoftheparameter,theCV@Rofk,k= 1;N,isdenedasthemeanoftheworst(1)100%drawdowns.Forinstance,if=0,thenCV@Ristheaveragedrawdown,andif=0:95,thenCV@Ristheaverageoftheworst5%drawdowns.However,inageneralcase,(())=1(),followedfromdenition( 3.13 ).Itmeansthat,ingeneral,wearenotabletopreciselycount(1)100%oftheworstdrawdowns.Inthiscase,theCV@Rbecomesaweightedaverageofthethreshold()andthemeanoftheworstdrawdownsstrictlyexceeding().

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Figure3{3: Function(s) Figure3{4: Inversefunction1()

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1;N,CV@Risformallydenedby (1)NXk2k; 1;No. 3.16 )appearsbecauseofinequality1().If(1)100%oftheworstdrawdownscanbecountedprecisely,then1()=andthersttermintheright-handsideof( 3.16 )disappears.De-nition( 3.16 )followsfromtheframeworkoftheCVaRmethodology[ 21 20 ].CloserelationbetweentheCVaRandCV@Risdiscussedinthefollowingremark. 3.16 ),andfunctionalCVaR[ 11 ](p.7,example4),arelinearlydependent,i.e.ifXisanarbitraryrandomvariablethen CV@R(X)=1 1(E(X)+CVaR(X)): Thus,useoftheCV@RorCVaRisonlythematterofconvenience. 1;N,tobeobservationsofa\randomvariable",-CDDistheCV@RofalossfunctionAD(w). 21 20 ],itisusefultodiscussCDDpropertiesbasedonpropertiesofCVaR.Becauseoflinearrelation( 3.17 ),wecanreplaceCVaRbyCV@R. 1.Constanttranslation:CV@R(+const)=CV@R()+const,82[0;1]. 2.Positivehomogeneity:CV@R()=CV@R(),80and82[0;1].

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4.Convexity:if=a+(1)bisalinearcombinationofanytwodrawdownsam-plepathsaandbwith2[0;1],thenCV@R()CV@R(a)+(1)CV@R(b). 3.17 ),properties1{4aredirectconsequenceofCVaRproperties[ 11 ]. 1.Nonnegativity:(w)0,82[0;1]. 2.Insensitivitytoconstantshift:(w+const)=(w),82[0;1]. 3.Positivehomogeneity:(w)=(w),80and82[0;1]. 4.Convexity:ifw=wa+(1)wbisalinearcombinationofanytwosamplepathsofuncompoundedcumulativerateofreturnswaandwbwith2[0;1],then(w)(wa)+(1)(wb). 3.10 )andAvDD( 3.11 )arethespecialcasesofthe-CDDfunc-tional(thisnotationisusedtoemphasizeCDDdependenceon),namely, 3.19 ),weassumethat(1)<1.Basedonthisassumption,inthecaseof=1,wehave(1)=1(1)=1(1)=(1),i.e.function

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3.13 ),(0)=0,0=nkjk= 1;Noand,consequently,0(w)=1 11Z1(q)dq; 3.16 ). 1;Jobethesetoftheorderedvaluesofk,k= 1;N,whereJisthenumberofdierentvaluesofk,k= 1;N,suchthats1
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Takingthelastrelationsintoaccount,forany2(0;1),theintegralintheright-handsideof( 3.20 )ispresented1Z1(q)dq=(qj)sj+1Zqj1(q)dq=((()))()+1 3.16 )withaccuracyofmultiplier(1)1. Onlytwocasesarelefttoconsider,namely,when=0and=1.Assuming1(1)<1,wehave,respectively,0(w)=1R01(q)dq=1 11R1(q)dq!=1(1)=MaxDD(w): CV@R(X)=1 11ZF1X(q)dq;CVaR(X)=1 Relation( 3.17 )canbeveriedbasedon( 3.22 ).CVaRmethodologywasthoroughlydevel-opedbyRockafellarandUryasev[ 21 20 ]. 3{2 .AccordingtoFigure 3{4 ,(0:7)=1(0:7)=6,and,consequently,fromFigure 3{3 ,((0:7)=(6)=0:75.Usingformula( 3.16 ),weobtainCV@R0:7()=(0:750:7) 10:76+1 10:7(1+5) 8=1 66+5 12(1+5).Toverifythisresult,wecancalculateCV@R0:7()basedon( 3.20 ).Namely,followingFigure 3{4 ,wehaveCV@R0:7()=1 10:7((0:750:7)6+(0:8750:75)1+(10:875)5)=1 66+5 121+5 125. 3{2 ,MaxDD(w)=5andAvDD(w)=1 88Pk=1k.

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1)d()0; 2)1R0d()=1; mixedCDD,isdened Obviously,themixedCDDpreservesallpropertiesof(w)statedinproposition4.Afundmanagercanexiblyexpresshisorherriskpreferencesbyshaping(). 1)nonnegativeon[0;1]; 2)nondecreasingon[0;1]; 3)1R0()d=1. Therelationbetween()in( 3.23 )and()in( 3.24 )isd()=1 1d(): 3.20 ),consider+(w)=1R01 11R1(q)dq!d()=1R01 11R01(q)Ifqgdq!d()=1R01(q)1R01 1Ifqgd()!dq=1R01(q)qR01 1d()!dq=1R01(q)(q)dq;

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where()=R01 1qd(q)satisesallproperties1){3).Indeed,()isnonneg-ativeandnondecreasing,sinced()=1 1d()0.Moreover,1R0()d=1R01R01 1qIfqgd(q)d=1.Obviously,conditions1){3)arenecessarilysatisedbyfunction(),sincetheyarederivedfromthepropertiesoffunction().However,iffunction()satisesconditions1){3)thenitissucientfor( 3.24 )tobeconstanttrans-lating,positivelyhomogeneous,monotonicandconvexwithrespectto.Thelastfactcomesfromadirectvericationofthoseproperties. 32 ].Thisconclusionisaconsequenceofageneralcoherencyprinciple,stating:thegreaterriskis,themoreitshouldbepenalized[ 1 ]. 1;L.Inthiscase,themixedCDDisexpressed +(w)=LXi=1ii(w); whereLPi=1i=1andi0.Consequently,\spectrum"functionispresentedby 3.26 )isapositivenondecreasingfunction.

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3.16 )and( 3.20 )requiretocalculatethevalueof()rst,whichdoublescomputationaltime.However,thereisanoptimizationprocedurethatobtainsthevaluesofthreshold()andCDDsimultaneously.Thisprocedureisespeciallyimportantinalargescaleoptimization. Inthecasewhenatimeseriesofdrawdownsisgiven,computationofthe-CDDisreducedtocomputationofCV@R(). (1)NNPk=1zks:t:zkky;zk0;k= 1;N; (1)NNXk=1[ky]+; where[ky]+=maxfky;0g,andestablishthefollowingrelation CV@R()=minyh(y): Thederivativeofh(y)withrespecttoyispresented dyh(y)=11 (1)NNXk=1Ify
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whered (1)((y0))andd+ (1)((y+0))areleftandrightderivatives,respectively,whichcoincidewitheachotherforallyexcepty=nkjk= 1;No.Accordingto( 3.30 )and( 3.31 ),anoptimalvalueyshouldsatisfyinequalities(y0)(y+0); 1;No.However,if(())=,thenthereisaclosedintervalofoptimalvaluesy,withtheleftendpointof(),namely,y2[();(+0)],where((+0))>.Hence,twocasesareconsidered: Inbothcases,equality[ky]+=(ky)Ifkyg=(ky)Ifk>()gholdswithrespecttoallk,k= 1;N,foranyxedy.Thus,basedonthisfact,weobtainminyh(y)=h(y)=y+1 (1)NNPk=1[ky]+=1 111 (1)NNPk=1kIfk>()g=((())) (1)NPtk2k; SinceexpressionNPk=1[ky]+isminimized,itcanequivalentlybepresentedbythesumofnonnegativeauxiliaryvariableszk0,k= 1;N,withimposingadditionalconstraintszkky,k= 1;N. (1)N;k= 1;N:

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3.32 )isdualtolinearprogrammingproblem( 3.27 ).Basedondualitytheory,optimalvaluesoftheobjectivefunctionsin( 3.27 )and( 3.32 )shouldcoincide. Problem( 3.32 )canbesolvedbythestandardgreedyalgorithminO(nlog2n)time.Thealgorithmsortsitemsaccordingtotheir\costs"nkjk= 1;No.Letbacdenotetheintegerpartofrealnumbera.Obviously,q-variables,correspondingtothelargestb(1)Nc\costs,"haveoptimalvaluesequalto1 (1)N,andtheq-variable,correspondingtothe(b(1)Nc+1)th\cost"inthesortedorder,hasoptimalvalueequalto1b(1)Nc Formulation( 3.32 )iscloselyrelatedtothepresentationofCV@Rbasedontheconceptofariskenvelope,whichisaclosed,convexsetofprobabilitiescontaining1.RiskenvelopetheorywasdevelopedbyRockafellaretal.[ 11 23 ]. Suppose,asamplepathofinstrument'sratesofreturn(r1;:::;rN),correspondingtotimemomentsft1;:::;tNg,isgiven.Inthiscase,uncompoundedcumulativeinstrument'srateofreturnattkiswk=kPl=1rl,andtheCDDispresentedintheformof(w). (1)NNPk=1zks:t:zkuky;ukuk1rk;u0=0;zk0;uk0;k= 1;N; 3.33 )isadirectconsequenceof( 3.27 ).Usingrecursiveformulak=[k1rk]+,constraintzkkyin( 3.27 )isreducedtozkuky,wherenonnegativeauxiliaryvariablesuksatisfyadditionalconstraintsukk1rk,k= 1;N,withu0=0.

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(1)N;qk0;k0;N+1=0;k= 1;N: 3.34 )isdualtolinearprogrammingprogram( 3.32 ). Theorem2andallitscorollariescanbeeasilygeneralizedtothecaseofmixedCDD. 1;Noanddiscreteriskprolei=d(i),i= 1;L,themixedCDD,+(w),iscomputedby (1)NNPk=1zik!s:t:zikukyi;ukuk1rk;u0=0;zik0;uk0;i= 1;L;k= 1;N: 3.35 )isadirectconsequenceofmixedCDDdenition( 3.25 )andoptimizationproblem( 3.33 ).Noticethatauxiliaryvariablesukdonothaveindexi,sincetheydeterminethedrawdownsequencesameforalli. Letdenoteadiscretesetofrandomevents,i.e.=f!jjj= 1;Kg,andletpjbetheprobabilityofevent!j(8j:pj0,andKPj=1pj=1).Supposerj(tk)=(r1j(tk);r2j(tk);:::;rmj(tk)),k= 1;N,isthejthsamplepathfortherandomvectorofriskyassets'ratesofreturn,correspondingtorandomevent!j2andtimeinterval[0;T]presentedbythediscretesetoftimemomentsft0=0;t1;t2;:::;tN=Tg.Consequently,thejthsamplepathfortherateofreturnanduncompoundedcumulativerateofreturn

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ofaportfoliowithcapitalweightsx(tk)=(x0(tk);x1(tk);x2(tk);:::;xm(tk))aredened,respectively, 1;N: Tosimplifynotations,weusewjkinsteadofwjk(x(tk))implyingthatwjkisalwaysafunctionofx(tk).Inamulti-scenariocase,wdenotesmatrixfwjkg,j= 1;K,k= 0;N. Denition6.Inamulti-scenariocase,theAD(w)isamatrix-functionaldenedon[0;T] 1;K;k= 1;N: AllADpropertiesstatedinProposition1holdinamulti-scenariocase.Indeed,basedon( 3.38 ),properties1{4inProposition1canbeverieddirectly.MatrixAD(w)isinterpretedtobedrawdownsurfacejk,(!j;tk)2[0;T]. AvDD(w)=1

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Figure 3{5 illustratesdrawdownsurfacejkandthresholdplane(). Figure3{5: Drawdownsurfaceandthresholdplane (1)NXjk2pjjk; 1;No. 3.44 ),canbepresentedinthealternativeform 11Z1(q)dq; 3.42 ). 1;N,correspondingtorandomevents!j2withprobabilitiespjsuchthatKPj=1pj=1.DeninganindicatorfunctionforXtobeX(s)=1 3.42 )),multi-scenarioCV@RmaybedeterminedsimilartoasingleperiodCV@R,namely,CV@R(X)=1 11R1X(q)dq.

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Astrictmathematicaldenitionofthedrawdownmeasureisgivenbelow. +(w)=1Z0(w)d(); 3.46 ). 1.Nonnegativity:+(w)0,82[0;1]. 2.Insensitivitytoconstantshift:+(w+const)=+(w),82[0;1]. 3.Positivehomogeneity:+(w)=+(w),80and82[0;1]. 4.Convexity:ifw=w1+(1)w2isalinearcombinationofanyw1andw2with2[0;1],then+(w)+(w1)+(1)+(w2).

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(1i)NNPk=1KPj=1pjzijk!s:t:zijkujkyi;ujkuj(k1)r(p)jk;ujk0;uj0=0;zijk0;i= 1;L;j= 1;K;k= 1;N: (1i)NNXk=1KXj=1pj[jkyi]+1A; (1i)NNPk=1KPj=1pjzijk!s:t:zijkjkyi;zijk0;i= 1;L;j= 1;K;k= 1;N; Inthiscase,optimalassetallocationmaximizestheexpectedvalueofuncompoundedcumulativeportfoliorateofreturnatthenaltimemomenttN=Tsubjecttoaconstraintondrawdownmeasure maxx2XE!(w(T;!;x))=KPj=1pjwjN(x)s:t:+(w(x)); whereXisthesetoflinear\technological"constraintsand2[0;1]isaproportionoftheinitialcapitalallowedtoloose.

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IncontrasttoGrossmanandZhou[ 27 ]andCvitanicandKaratzas[ 28 ],whoconsideredvectorofportfolioweightstobeafunctionoftimewithin[0;T],weassumeportfolioweightsx(tk)tobestaticforalltk,k= 0;N.Thisspecialstrategycanbeachievedbyportfoliorebalancingateverytk,k= 0;N.Justicationofthisassumptiondependsonaparticularcasestudy.Basedontheassumptionmade,uncompoundedcumulativeportfoliorateofreturnwisrewritten Theorem3.Problem( 3.49 )isreducedtolinearprogramming(LP)problem (1i)NNPk=1KPj=1pjzijk!;zijkujkyi;ujkuj(k1)r(p)jk(x);ujk0;uj0=0;zijk0;i= 1;L;j= 1;K;k= 1;N; (1i)NNXk=1KXj=1pj[jk(x)yi]+1A: AccordingtoProposition10,drawdownmeasuremaybepresentedby +(w(x))=LXi=1iCV@Ri((x))=minyH(x;y): Consequently,problem( 3.49 )isreducedto maxx2XKPj=1pjwjN(x)s:t:minyH(x;y);

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Thekeypointoftheproofistoshowthatminimumintheconstraintof( 3.54 )mayberelaxed,i.etoshowthatproblem( 3.54 )isequivalentto maxx2X;yKPj=1pjwjN(x)s:t:H(x;y); TheproofofthisfactisconductedbyrelaxingconstraintminyH(x;y)Cin( 3.54 ),namely,problem( 3.54 )isequivalentlyrewrittenmin0maxx2X0@KXj=1pjwjN(x)+minyH(x;y)1A; However,problem( 3.56 )istheLagrangerelaxationof( 3.55 ).Hence,( 3.55 )isequivalentto( 3.54 ).AccordingtoTheorem4andProposition10,LP( 3.51 )isadirectconsequenceof( 3.55 ). 3.51 )issimplied,respectively, 1;K;k= 1;N; maxu;x2XKPj=1pjwjN(x)s:t:1 1;K;k= 1;N:

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3.51 ).Inthiscase,ecientfrontierisacurveexpressingdependenceofoptimalportfolioexpectedrewardKPj=1pjwjN(x())onportfoliorisk. min0(G(x();y())+(1+(1)2))=min0((G(x();y())+1)+(1)(G(x();y())+2))min0(G(x();y())+1)+(1)min0(G(x();y())+2): Afundmanagerisinterestedinsuchavalueof2[0;1],forwhichtherisk-adjustedreturn()ismaximal.Itisinterpretedtobethebestbalancebetweentheriskaccepted

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(1i)NNPk=1KPj=1pj~zijk!1;~zijk~ujk~yi;~ujk~uj(k1)r(p)jk(~x);~ujk0;~uj0=0;~zijk0;i= 1;L;j= 1;K;k= 1;N: 3.60 )then()=max2[0;1]()=KPj=1pjwjN(~x),withoptimalvalue=1mPl=0~xlandcorrespondingoptimalportfolioxl=~xl,l= 0;m. 3.51 ),theproblemofmax2[0;1]maxx2X1KPj=1pjwjN(x)isreducedtoLP( 3.60 )bychangingvariables~xl=xl=,~yi=yi=,~ukj=ukj=,~zijk=zijk=,l= 0;m,i= 1;L,j= 1;K,k= 1;N.Set~Xmayincludeadditionalvariablev=1=.Forinstance,aboxconstraintxminxlxmaxfromthesetXistransformedtoxminv~xlxmaxv,whichisanelementof~X. 3.7.1StaticAssetAllocation 27 ]asamathematicalprogrammingproblem.Then,theproblemwasgeneralizedtoamulti-dimensionalcasebyCvitanicandKaratzas[ 28 ].

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IncontrasttoGrossmanandZhou[ 27 ]andCvitanicandKaratzas[ 28 ],weareinter-estedinaconstantsetofweightsthatoptimizesacertainportfolioofassets,whicharenotassumedtohavealog-browniandynamics.Thisproblemisstimulatedbyseveralimportantpracticalnancialapplications,particularlyrelatedtotheso-calledhedge-fundbusiness. ACommodityTradingAdvisor(CTA)companyisahedgefundthatnormallytradesseveral(sometimes,morethana100)futuresmarketssimultaneouslyusingsomemathe-maticalstrategiesthatitbelieveshavecertainedge.Suchacompanymanagessubstantialassetsasapartofallhedgefunds,bysomeestimates,closeto$100BN.MostoftheCTAcommunitytradesthe,so-called,long-termtrend-followingsystems,buttherearenowmul-tipleexamplesofshort-termmean-revertingtradingsystemsaswell.Thesesystemsmaybeviewedassomefunctionsoftheindividualfuturesmarketpricerealizedpriortothepresenttime.Thesestrategiesnormallyhaveasubstantialsmoothing-outeectonthefuturespricesandhaveclosetostationaryproperties.EveryCTA,then,hastoallocateacertainportionofoverallrisk(oroverallcapitalthatitmanages)toeachandevery\mar-ket".Duetoasubstantiallevelofstationarityofthestrategies,eachCTAcalculatestheweightsaccordingtoacertaininternalproprietaryweightallocationprocedure.Normally,thissetremainsxedanddoesnotchangeunlessacertainmarketgetsaddedorremovedfromtheset,whichnormallyhappenswhenanewsystemisintroduced,whenacertainmarketdisappears(likeDeutscheMarkorFrenchFrancin1999),oranewmarketisbeingadded.AstandardpracticeintheCTAcommunityistousesomeversionoftheclassicalMarkowitzmean-varianceapproach. Anotherimportantexampleofstaticassetallocationcomesformtheso-called,FundofFund(FoF)business.Intherecentseveralyearsthissectorofhedgefundshasexperiencedasubstantialgrowth.AtypicalFoFmanagergivesallocationsofitsclients'capitaltoasetofpre-selectedmanagers,normallybetween5and25.Itdoessofairlyinfrequently,becauseofliquidityconstraintsimposedbymanagersthemselves,butthisisnottheonlyreason.FoFviewsequityreturnstreamsasfairlystationarytimeserieswithsomeattractivereturn,risk,andcorrelationproperties,whichneedsometimetopresentthemselves.Unlesssomeunexpectedeventhappens,theallocationsaregivenforasubstantialperiodoftime,onaverageof2yearsormore.AgroupofanalystsinatypicalFoFisresponsiblefornding

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aconstantsetofweights,whichmakesatotalportfoliooftheFoFtobeattractivetoitsclients. Bothofthesetypicalcasesarefacedwithaproblemofndingaconstantsetofweights,whichoptimizetheirportfoliosinacertainsense.Thepracticalgoalofthischapteristofacilitatethisprocesswithaclearandstatisticallysoundalgorithm,whichutilizesanewlydesignedsetofrisk-measuresbasedonanotionofanequitydrawdown. Despitetheirknownpotentialdrawbacks,itisawell-acceptedand,moreover,recom-mendedpractice[ 36 ],istostudyhistoricalback-testedstrategyresultsofahedgefundand,basedontheseresults,obtainanestimateoftheinherentriskusingsomeriskmeasures.TheonlypopularquantitativeriskmeasureisVaR[ 36 ].VariousinsucienciesoftheVaRmeasurearealsowidelyknown.Webelievethattheresultsdevelopedinourstudywouldfacilitateunderstandingofhowthiscanbeachieved. 37 ]whouniedthedisconnectedideas;andre-samplingemergedasarobustmethodofestimatingcondenceintervalsofsomemeasur-ablefunctionsoverastatisticalsampleofdata.Methodisparticularlyusefulforthetimeserieswhereobtainingotherrealizationsofthedatamaybedicultorevenimpossible. Bootstrapisaformofre-samplingtheoriginaldatasetbootstrap,which\re-sampleswithreplacement."Sometimes,thesimplestversionofitiscalled\nonparametricboot-strap."Themethodoriginallywasappliedtosomesociologicalandbiologicalapplications,stayingintheshadeforstatistical,engineeringandnancialapplicationsupuntilthe1990s.Duetotheirintrinsic\onerealizationonly"-nature,thenancialtimeseriescouldbeoneofthebestapplicationsforre-samplingmethods. Withinnancialapplications,astrongparticularinterestinobtainingestimatesofcertainmeasurablequantities(suchasrateofreturn,orstandarddeviation),comesfromthedevelopmentoftradingsystems.Itiswellknown,thataproblemofactualusingover-ttedtradingsystemscanpossiblyleadtosubstantialnanciallosses.Therefore,itishardtounderestimatetheimportanceofaproblemofdiscoveringhowover-ttedaparticulartradingsystemis.Amongafewexamples,onecanmentionasingleassettradingsystem,

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forexample,asystemwhichtradesaback-adjustedcontinuous10-yearU.S.GovernmentNotefuturescontract,or,amoregeneralportfoliooptimizationproblemsuchasallocationofweightsbetweenseveralassetsinaportfoliosubjecttocertainconstraints. Ourstudyconsidersaparticularexampleofoptimalportfolio-allocationproblem.ThisexamplecouldbeveryrelevantforglobalCTAmanagers,whoapplycertaintradingsys-tems(veryfrequently,long-termtrend-followingsystems)acrossawidesetofglobalfuturesmarketsattemptingtotakeadvantageofpricemovementsoccurringinthesemarkets.Nor-mally,aftertheyarecontentwiththeirtradingsystem,theyhavetomakeadecisionofallocatingtheirportfolioriskbetweenvariousmarkets. Inthisexample,wearegivenasetofsamplepathsofcertainfuturestradingsystems(inthisparticularcase,somelong-termtrend-followingsystem)asappliedtoasetof32dierentglobalfuturesmarkets.Thesystemincludeslong,shortoratmarkets,andalwaystradesthesamenumberofcontractswiththeaveragetradelengthfromonetotwomonths. Hereisalistofthemarketswiththeircorrespondingexchangesthatweretradedbythesystem.TickersymbolsofFutureSourceareusedfortheirabbreviation.Inalphabeticalorderoftickersymbol: 1. AAO-TheAustralianAllOrdinariesIndex(OTC); 2. AD-AustralianDollarCurrencyFutures(CME); 3. AXB-Australian10-YearBondFutures(SFE); 4. BD-U.S.Long(30-Year)TreasuryBondFutures(CBT); 5. BP-BritishPoundSterlingCurrencyFutures(CME); 6. CD-CanadianDollarCurrencyFutures(CME); 7. CP-CopperFutures(COMEX); 8. DGB-German10-YearBond(Bund)Futures(LIFFE); 9. DX-U.S.DollarIndexCurrencyFutures(FNX); 10. ED-90-DayEuroDollarFutures(CME); 11. EU-EuroCurrencyFutures(CME); 12. FV-U.S.5-YearTreasuryNoteFutures(CBT); 13. FXADJY-AustralianDollarvs.JapaneseYenCrossCurrencyForward(OTC); 14. FXBPJY-BritishPoundSterlingvs.JapaneseYenCrossCurrencyForward(OTC);

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15. FXEUBP-Eurovs.BritishPoundSterlingCrossCurrencyForward(OTC); 16. FXEUJY-Eurovs.JapaneseYenCrossCurrencyForward(OTC); 17. FXEUSF-Eurovs.SwissFrancCrossCurrencyForward(OTC); 18. FXNZUS-NewZealandDollarCurrencyForward(OTC); 19. FXUSSG-SingaporeanDollarCurrencyForward(OTC); 20. FXUSSK-SwedishKronaCurrencyForward(OTC); 21. GC-Gold100Oz.Futures(COMEX); 22. JY-JapaneseYenCurrencyFutures(CME); 23. LBT-Italian10-YearBondForward(OTC); 24. LFT-FTSE-100IndexFutures(LIFFE); 25. LGL-LongGilt(U.K.10-YearBond)Futures(LIFFE); 26. LML-AluminumFutures(COMEX); 27. MNN-FrenchNationalBondFutures(); 28. SF-SwissFrancCurrencyFutures(CME); 29. SI-SilverFutures(COMEX); 30. SJB-JGB(Japanese10-YearGovernmentBond)Futures(TSE); 31. SNI-NIKKEI-225IndexFutures(SIMEX); 32. TY-10-YearU.S.GovernmentBondFutures(CBT). Thesemarketsincludemostmajorassetclassestradedthroughfutures:xed-income(short-termandlong-term,bothdomesticandinternational),internationalequityindices,currenciesandcross-currencies,andmetals.Givensetof32timeserieswithdailyratesofreturncoversaperiodoftimebetween6/12/1995and12/13/1999.Timeismeasuredintradingdaysonly,withaconventionof5workdaysperweek,withaddingpreviousdayclosingdataforholidayswithmissingdata. Abasicversionofnon-parametricbootstrapre-samplinggenerates\children"samplesfromtheoriginal\father"sampleinthefollowingway:itllsouta\child"withfather'sdailyratesofreturninrandomorder\withreplacement",i.e.whenthesamedailyrateofreturncanbepulledouttwiceormore.Well-knowndicultyinobtainingare-sampledprobabilitydistributionfunctionbysuchaprocedureisthatiftheoriginal\father"time

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serieshascertainauto-correlationstructure,itwillbetotallylostinthe\children"-re-samplesbecauseofrandommixinginre-samplegeneration.Atthesametime,namelythoseauto-correlationpropertiesofthetimeseries,ifpresent,shouldberesponsibleforthetrend-followingsystemshavingpositiverateofreturn.Toremedythesituation,wewilluseamodicationofasimplebootstrapre-sampling,whichiscalledblock-bootstrapre-sampling.Hereisabriefdescriptionoftheprocedure. First,weneedtoempiricallystudythecorrelationpropertiesofthetimeseriesinvolved.Foralldataseries,wehavenumericallycalculatedtheirauto-correlationcoecientsC(n)fortheperiodof200days,wheren=200isnumberofdaysinaperiod.Thecut-oof200tradingdayswaschoseninsuchawaythatthemeasurementsofcorrelationcoecientwouldstillhavesomestatisticalaccuracyonasamplelengthof1076daysused. Next,weempiricallyfoundathresholdfortheabsolutevalueoftheauto-correlationcoecientsequalto2.5%,abovewhichthevaluesofcoecientlargerthanthisthresholdarestatisticallysignicant.Then,reducingnumberofdaysnintheperiodfrom200to0,foralltimeseries,wefoundtherstvaluenthatviolatesconditionC(n)2:5%.Inthiscase,thevalueofn,whichprovidesthestatisticallysignicantcorrelationlengthsforallconsideredtimeseries,is100tradingdays. Now,insteadofrandomlypickinganindividualdailyreturnfromtheoriginaldataseries,wepickun-interchangedblocksofdailyreturnsoflength100tradingdays,startingfromarandomstartingpoint.Toensureconsistencyacrossalltimeseries,andpreservethecross-marketcorrelationstructure,wechoosethesamestartingpointforall32timeseries.Thatis,weusethesamerandomstartingpointforallmarkets,thendrawanotherstartingpoint,anduseitacrossallmarketsagain,etc.,untilthenecessarynumberof\children"re-sampleswillbelled-in. 1;32.Thischoicewasdictatedbytheneedtohavetheresultantmargin-to-equityratiointheaccountwithinadmissiblebounds,whicharespecicforaparticularportfolio.Infuturestradingsetup,\technological"constraintsareanalogoustothe\fully-invested"conditionfromclassicalSharpe-Markowitztheory[ 3 ],

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whichmaketheecientfrontierstrictlyconcave.Intheabsenceoftheseconstraints,theecientfrontierwouldbeastraightlinepassingthrough(0,0),duetothevirtuallyinniteleverageofthesetypesofstrategies.Ifallpositionsareequaltothelowerbound0.2,thenthesumofthepositionsis0:232=6:4andtheminimalleverageis6.4.However,ifallpositionsareequaltotheupperbound0.8,thenthesumofthepositionsis0:832=25:6andthemaximalleveragebecomes25.6.Theoptimalallocationofweightspicksboththeoptimalleverageandproportionsbetweeninstruments.Anothersubtleissuehastodowiththestabilityoftheoptimalportfoliosiftheconstraintsare\toolax".Itisamatterofempiricalevidencethatthemorelaxtheconstraintsare,thebetterportfolioequitycurveyoucangetthroughoptimalmixing,andthelessstablewithrespecttowalk-forwardanalysistheseresultswouldbe.Theabovesetofconstraintswasempiricallyfoundtobebothleadingtosucientlystableportfoliosandprovidingenoughmixingoftheindividualequitycurves. Wesolvedoptimizationproblems( 3.57 ),( 3.58 )and( 3.51 )withMaxDD,AvDDand0.8-CDD(=0:8)measures,respectively,inthecasesof1-historical,100and300samplepathsgeneratedforall32instruments.AlloptimizationproblemsweresolvedusingCPLEXpackage.ThegraphsofecientfrontiersandtableswithoptimalportfoliocongurationsforoptimizationproblemswithMaxDD,AvDD,and0.8-CDDinallthreecases:1,100and300samplepathsarepresentedbyFigures 3{6 3{8 3{10 andTables 3{1 | 3{9 ,respectively.We,also,enclosetherisk-adjustedreturns(annualizedrateofreturndividedbythecorrespondingvalueofariskmeasure)foreachofthesecases,seeFigures 3{7 3{9 and 3{11 .Thesolutionsachievingmaximalrisk-adjustedreturnsareboldfaced,seeTables 3{1 | 3{9

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Figure3{6: Ecientfrontiers:AverageDrawdown Figure3{7: Optimalrisk-adjustedreturns:AverageDrawdown

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Figure3{8: Ecientfrontiers:0.8-ConditionalDrawdown Figure3{9: Optimalrisk-adjustedreturns:0.8-ConditionalDrawdown

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Figure3{10: Ecientfrontiers:MaximumDrawdown Figure3{11: Optimalrisk-adjustedreturns:MaximumDrawdown

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Table3{1: AverageDrawdownoptimization:1samplepath 23.9 51.7 56.8 60.7 64.3 67.4 69.6 70.4 AvDD,% 3.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 Risk-adj.return 7.98 8.62 8.12 7.59 7.15 6.74 6.33 5.86 0.20 0.20 0.20 0.63 0.46 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.80 0.80 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.65 CD 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 CP 0.20 0.20 0.20 0.62 0.71 0.80 0.80 0.80 DX 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.29 0.52 0.76 0.80 0.80 0.80 0.80 FXBPJY 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.49 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.79 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.27 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSG 0.70 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.79 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.20 0.80 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.80 0.80 JY 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 LIIB 0.20 0.22 0.73 0.80 0.80 0.80 0.80 0.80 LMAL 0.20 0.45 0.80 0.80 0.80 0.80 0.80 0.80 MANB 0.20 0.20 0.20 0.20 0.77 0.80 0.80 0.80 SF 0.20 0.20 0.20 0.39 0.73 0.80 0.80 0.80 SFAO 0.20 0.76 0.80 0.80 0.80 0.80 0.80 0.80 SFBD 0.22 0.80 0.80 0.80 0.80 0.80 0.80 0.80 SI 0.20 0.20 0.20 0.20 0.20 0.20 0.24 0.80 SIJB 0.20 0.32 0.46 0.47 0.50 0.77 0.80 0.80 SINI 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.25 0.80 0.80 UXBU 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80

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Table3{2: AverageDrawdownoptimization:100samplepaths 20.8 26.4 36.1 55.8 61.5 66.3 70.1 73.1 AvDD,% 3.5 4.0 5.0 8.0 9.0 10.0 11.0 12.0 Risk-adj.return 5.94 6.61 7.22 6.98 6.83 6.63 6.38 6.09 0.20 0.20 0.20 0.36 0.77 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.20 0.25 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 CD 0.44 0.38 0.77 0.80 0.80 0.80 0.80 0.80 CP 0.20 0.20 0.36 0.80 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.48 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.35 0.80 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.20 0.20 0.54 0.64 0.70 0.79 0.80 FXBPJY 0.20 0.29 0.69 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.20 0.22 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.48 0.45 0.20 0.51 0.80 0.80 0.80 0.80 FXEUSF 0.24 0.47 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.20 0.20 0.74 0.80 0.80 0.80 0.80 FXUSSG 0.26 0.36 0.74 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.56 0.73 0.72 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.38 0.80 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.34 0.78 0.80 JY 0.20 0.20 0.20 0.62 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.20 0.51 0.68 0.80 0.80 0.80 LIIB 0.20 0.20 0.20 0.44 0.72 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.23 0.38 0.42 0.80 MANB 0.20 0.20 0.20 0.20 0.20 0.80 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.20 0.20 0.64 0.80 SFAO 0.20 0.31 0.42 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 SI 0.21 0.46 0.70 0.80 0.80 0.80 0.80 0.80 SIJB 0.20 0.20 0.20 0.32 0.46 0.64 0.80 0.80 SINI 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.60 UXBU 0.21 0.58 0.80 0.80 0.80 0.80 0.80 0.80

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Table3{3: AverageDrawdownoptimization:300samplepaths 20.5 26.1 35.4 55.4 60.8 65.3 69.0 71.9 AvDD,% 3.5 4.0 5.0 8.0 9.0 10.0 11.0 12.0 Risk-adj.return 5.85 6.52 7.08 6.93 6.76 6.53 6.27 5.99 0.20 0.20 0.20 0.51 0.80 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.20 0.20 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 CD 0.24 0.32 0.72 0.80 0.80 0.80 0.80 0.80 CP 0.20 0.20 0.47 0.80 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.20 0.20 0.23 0.20 0.63 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.37 0.80 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.20 0.20 0.42 0.49 0.60 0.69 0.80 FXBPJY 0.20 0.20 0.66 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.20 0.27 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.62 0.73 0.29 0.69 0.80 0.80 0.80 0.80 FXEUSF 0.23 0.52 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.20 0.20 0.62 0.80 0.80 0.80 0.80 FXUSSG 0.22 0.33 0.74 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.59 0.69 0.65 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.24 0.80 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.22 0.62 0.72 JY 0.20 0.20 0.20 0.70 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.20 0.56 0.57 0.80 0.80 0.80 LIIB 0.20 0.20 0.20 0.45 0.72 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.20 0.41 0.46 0.80 MANB 0.20 0.20 0.20 0.20 0.70 0.80 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.20 0.35 0.80 0.80 SFAO 0.20 0.25 0.38 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 SI 0.21 0.37 0.52 0.80 0.80 0.80 0.80 0.80 SIJB 0.20 0.20 0.20 0.38 0.50 0.69 0.80 0.80 SINI 0.20 0.20 0.22 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.50 UXBU 0.29 0.69 0.80 0.80 0.80 0.80 0.80 0.80

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Table3{4: 0.8-ConditionalDrawdownoptimization:1samplepath 23.3 25.5 31.9 52.9 57.9 61.8 65.0 70.3 0.8-CDD,% 5.7 6.0 7.0 12.0 14.0 16.0 18.0 23.0 Risk-adj.return 4.09 4.24 4.56 4.41 4.14 3.86 3.61 3.06 0.20 0.20 0.20 0.20 0.42 0.55 0.33 0.80 BD 0.20 0.20 0.20 0.20 0.20 0.44 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.56 CD 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 CP 0.20 0.20 0.20 0.20 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.72 0.80 0.80 0.80 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.25 0.26 0.37 0.29 0.36 0.80 0.80 FXBPJY 0.77 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.33 0.39 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.80 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.25 0.40 0.80 0.80 0.80 0.80 0.80 FXUSSG 0.42 0.47 0.65 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.20 0.20 0.33 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.80 JY 0.20 0.25 0.60 0.80 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.20 0.20 0.80 0.80 0.80 0.80 LIIB 0.20 0.20 0.49 0.80 0.80 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.26 0.59 0.48 0.80 MANB 0.20 0.20 0.20 0.20 0.20 0.80 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.20 0.20 0.61 0.80 SFAO 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 SI 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.80 SIJB 0.20 0.21 0.20 0.38 0.60 0.80 0.80 0.80 SINI 0.47 0.58 0.60 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.80 UXBU 0.20 0.23 0.52 0.80 0.80 0.80 0.80 0.80

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Table3{5: 0.8-ConditionalDrawdownoptimization:100samplepaths 19.4 24.7 30.1 53.6 60.1 65.7 70.0 74.5 0.8-CDD,% 6.2 7.0 8.0 14.0 16.0 18.0 20.0 23.0 Risk-adj.return 3.12 3.53 3.76 3.83 3.76 3.65 3.50 3.24 0.20 0.20 0.20 0.29 0.62 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.20 0.20 0.74 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.55 CD 0.20 0.20 0.20 0.58 0.75 0.80 0.80 0.80 CP 0.20 0.20 0.20 0.62 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.20 0.20 0.20 0.28 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.24 0.50 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.20 0.20 0.36 0.45 0.60 0.79 0.80 FXBPJY 0.20 0.40 0.51 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.20 0.20 0.79 0.80 0.80 0.80 0.80 FXEUJY 0.39 0.54 0.49 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.20 0.43 0.67 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.20 0.20 0.75 0.80 0.80 0.80 0.80 FXUSSG 0.20 0.39 0.52 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.51 0.74 0.73 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.24 0.67 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.24 0.80 JY 0.20 0.20 0.20 0.41 0.70 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.20 0.35 0.72 0.80 0.80 0.80 LIIB 0.20 0.20 0.20 0.57 0.75 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.20 0.20 0.37 0.80 MANB 0.20 0.20 0.20 0.20 0.20 0.77 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.20 0.24 0.80 0.80 SFAO 0.20 0.20 0.32 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.20 0.39 0.49 0.74 0.80 0.80 SI 0.20 0.20 0.26 0.80 0.80 0.80 0.80 0.80 SIJB 0.20 0.20 0.20 0.58 0.69 0.80 0.80 0.80 SINI 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.80 UXBU 0.20 0.47 0.78 0.80 0.80 0.80 0.80 0.80

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Table3{6: 0.8-ConditionalDrawdownoptimization:300samplepaths 19.5 29.8 53.3 59.6 65.1 69.3 72.4 73.5 0.8-CDD,% 6.2 8.0 14.0 16.0 18.0 20.0 22.0 23.0 Risk-adj.return 3.14 3.73 3.80 3.73 3.62 3.46 3.29 3.19 0.20 0.20 0.36 0.72 0.80 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.20 0.72 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.66 CD 0.20 0.20 0.47 0.71 0.80 0.80 0.80 0.80 CP 0.20 0.25 0.80 0.80 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.20 0.38 0.62 0.80 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.57 0.80 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.20 0.40 0.49 0.57 0.72 0.80 0.80 FXBPJY 0.20 0.50 0.80 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.58 0.66 0.80 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.20 0.72 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.20 0.63 0.80 0.80 0.80 0.80 0.80 FXUSSG 0.21 0.49 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.57 0.68 0.80 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.44 0.80 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.62 0.80 JY 0.20 0.20 0.59 0.80 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.39 0.72 0.80 0.80 0.80 0.80 LIIB 0.20 0.20 0.49 0.70 0.80 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.20 0.39 0.80 0.80 MANB 0.20 0.20 0.20 0.20 0.80 0.80 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.35 0.80 0.80 0.80 SFAO 0.20 0.27 0.80 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.51 0.68 0.80 0.80 0.80 0.80 SI 0.20 0.20 0.73 0.80 0.80 0.80 0.80 0.80 SIJB 0.20 0.20 0.56 0.68 0.80 0.80 0.80 0.80 SINI 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.20 0.62 0.80 UXBU 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80

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Table3{7: MaximumDrawdownoptimization:1samplepath 24.3 54.6 58.8 62.6 65.5 67.6 69.3 70.4 MaxDD,% 7.5 15.0 18.0 21.0 24.0 27.0 30.0 33.0 Risk-adj.return 3.24 3.64 3.27 2.98 2.73 2.50 2.31 2.13 0.20 0.20 0.20 0.20 0.49 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.80 0.80 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.73 CD 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 CP 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 DX 0.33 0.80 0.80 0.80 0.80 0.80 0.80 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXADJY 0.20 0.49 0.79 0.80 0.80 0.80 0.80 0.80 FXBPJY 0.80 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.63 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.31 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSG 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.80 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.20 0.20 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.72 0.80 JY 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.20 0.80 0.80 0.80 0.80 0.80 LIIB 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 LMAL 0.20 0.23 0.20 0.20 0.20 0.20 0.20 0.80 MANB 0.20 0.20 0.20 0.33 0.80 0.80 0.80 0.80 SF 0.20 0.20 0.32 0.80 0.80 0.80 0.80 0.80 SFAO 0.48 0.80 0.80 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 SI 0.20 0.20 0.20 0.20 0.20 0.20 0.80 0.80 SIJB 0.20 0.55 0.80 0.80 0.80 0.80 0.80 0.80 SINI 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.20 0.20 0.73 0.80 0.80 UXBU 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80

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Table3{8: MaximumDrawdownoptimization:100samplepaths 21.3 32.2 55.5 60.8 65.6 69.5 72.6 74.0 MaxDD,% 9.6 12.0 21.0 24.0 27.0 30.0 33.0 36.0 Risk-adj.return 2.21 2.68 2.64 2.53 2.43 2.32 2.20 2.06 0.20 0.20 0.25 0.20 0.70 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.38 0.80 0.80 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.35 0.80 CD 0.20 0.20 0.45 0.49 0.73 0.74 0.80 0.80 CP 0.12 0.80 0.80 0.80 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.20 0.20 0.80 0.80 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.44 0.80 0.80 0.50 0.80 0.80 0.80 FXADJY 0.20 0.30 0.71 0.80 0.80 0.80 0.80 0.80 FXBPJY 0.20 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.20 0.44 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSG 0.34 0.49 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.74 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.20 0.59 0.80 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.21 0.39 JY 0.20 0.20 0.29 0.63 0.70 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 LIIB 0.20 0.20 0.40 0.80 0.80 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.64 MANB 0.20 0.20 0.20 0.29 0.28 0.20 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.20 0.55 0.80 0.80 SFAO 0.35 0.36 0.80 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 SI 0.60 0.74 0.80 0.80 0.80 0.80 0.80 0.80 SIJB 0.20 0.20 0.20 0.28 0.80 0.80 0.80 0.80 SINI 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.21 0.48 0.71 0.76 0.80 0.80 UXBU 0.20 0.66 0.80 0.80 0.80 0.80 0.80 0.80

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Table3{9: MaximumDrawdownoptimization:300samplepaths 21.3 31.1 54.4 59.6 64.1 68.1 71.3 72.7 MaxDD,% 9.8 12.0 21.0 24.0 27.0 30.0 33.0 36.0 Risk-adj.return 2.18 2.59 2.59 2.49 2.38 2.27 2.16 2.02 0.20 0.20 0.36 0.20 0.46 0.80 0.80 0.80 BD 0.20 0.20 0.20 0.20 0.80 0.80 0.80 0.80 BP 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.79 CD 0.20 0.20 0.23 0.35 0.50 0.76 0.80 0.80 CP 0.50 0.76 0.80 0.80 0.80 0.80 0.80 0.80 DX 0.20 0.20 0.20 0.20 0.25 0.80 0.80 0.80 ED 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 EU 0.20 0.42 0.80 0.76 0.80 0.80 0.80 0.80 FXADJY 0.20 0.25 0.64 0.80 0.80 0.80 0.80 0.80 FXBPJY 0.29 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FXEUBP 0.20 0.21 0.80 0.80 0.80 0.80 0.80 0.80 FXEUJY 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 FXEUSF 0.20 0.21 0.80 0.80 0.80 0.80 0.80 0.80 FXNZUS 0.20 0.20 0.68 0.80 0.80 0.80 0.80 0.80 FXUSSG 0.26 0.48 0.80 0.80 0.80 0.80 0.80 0.80 FXUSSK 0.80 0.80 0.80 0.80 0.80 0.80 0.80 0.80 FY 0.20 0.20 0.20 0.20 0.20 0.54 0.72 0.80 GC 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 JY 0.20 0.20 0.21 0.61 0.80 0.80 0.80 0.80 LIFT 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 LIGI 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 LIIB 0.20 0.20 0.51 0.80 0.80 0.80 0.80 0.80 LMAL 0.20 0.20 0.20 0.20 0.20 0.20 0.26 0.70 MANB 0.20 0.20 0.23 0.31 0.31 0.20 0.80 0.80 SF 0.20 0.20 0.20 0.20 0.20 0.56 0.80 0.80 SFAO 0.27 0.37 0.80 0.80 0.80 0.80 0.80 0.80 SFBD 0.20 0.20 0.80 0.80 0.80 0.80 0.80 0.80 SI 0.20 0.59 0.80 0.80 0.80 0.80 0.80 0.80 SIJB 0.20 0.25 0.24 0.46 0.80 0.80 0.80 0.80 SINI 0.20 0.41 0.80 0.80 0.80 0.80 0.80 0.80 TY 0.20 0.20 0.20 0.48 0.67 0.70 0.80 0.80 UXBU 0.20 0.61 0.80 0.80 0.80 0.80 0.80 0.80

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portfoliooptimizationproblem.Thesetechniques,ifimplementedinamanagedaccounts'environment,willallowatradingorriskmanagertoallocateriskaccordingtohis/herpersonalassessmentofextremedrawdownsandtheirdurationonhis/herportfolioequity. WebelievethathoweverattractivetheMaxDDmeasureis,thesolutionsproducedusingthismeasureinportfoliooptimizationmayhaveasignicantstatisticalerrorbecausethedecisionisbasedonasingleobservationofthemaximalloss.WhereasCDDcontrolstheworst(1)100%ofdrawdowns,andduetostatisticalaveragingwithinthatrange,obtainsabetterpredictivepowerfortheriskinthefuture,leadingtoamorestableportfolio.OurstudyindicatesthattheCDDwithanappropriatelevel(=0:8,i.e.,optimizingoverthe20%oftheworstdrawdowns)generatesamorestableweightsallocationthanthatproducedusingMaxDDmeasure. Numericalresultsoftheconsideredreal-lifeasset-allocationproblemwithdrawdownmeasuredrawthefollowingconclusions

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38 39 40 ] 41 ] 42 ] 43 44 45 46 47 48 49 50 ] 51 ] Weareinterestedindevelopingecientoptimizationapproachescapabletosolveabroadclassofapplicationsrelatedtotrajectoryoptimization.Thischapter,beingtherststepinaccomplishingthistask,isprimarilyfocusedonoptimalpathplanningforanaircraftinatreatenvironment.Thethreatisassociatedwiththeriskofaircraftdetectionbyradars,sensorsorSAM.Thechapterdevelopsanalyticalanddiscreteoptimizationapproachestooptimaltrajectorygenerationthatminimizetheriskofaircraftdetectionwith:1)variableaircraftRadarCross-Section(RCS);2)dierenttypesofdetectinginstallations;3)arbitrarynumberofdetectinginstallations;4)constraintontrajectorylength;andsuggestsecientalgorithmsforsolvingformulatedriskminimizationproblem. 106

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Optimaltrajectorygenerationisafundamentalrequirementformilitaryaircraftightmanagementsystems.Thesesystemsarerequiredtotakeadvantageofallavailableinfor-mationinordertoperformintegratedtaskprocessing,reducepilotworkloadsandprovideupdatesatregulartimeintervalssucientforthreatavoidance[ 39 ].Amodelforoptimalroutinganaircraftinathreatenvironmentisdevelopedbasedonspeciedmissionobjec-tives,availableresources(fuelcapacity),limitationsonaircraftcontrolwhileminimizingriskexposure.Ingeneral,itaddressesuncertaintyanddynamicsinherenttooptimalpathplanningandmakesidealizingassumptionswithrespecttogeometricalandphysicalprop-ertiesofanaircraftandthreatenvironment.Despitenumerousstudiesinthisarea,onlyafewconsideredriskoptimizationproblemswithtechnologicalconstraints.Zabarankinetal.[ 40 ]suggestedanalyticalanddiscreteoptimizationapproachesforoptimalriskpathgenerationintwo-dimensional(2D)spacewithconstantRCS,arbitrarynumberofsensorsandaconstraintonpathlength. Thischapterdevelopsa3Dmodelforminimizingriskofaircraftdetectionbyradars,sensorsorSAMwithvariableRCS.Themodelisdeterministicandstatic,sinceitassumesnouncertaintyinaircraftdetectionandradarlocationsandconsidersneitheraircraftkine-maticsequationsnorparametersforaircraftcontrolduringaight.Theriskofdetectionisassumedtobeindependentonaircraftspeed.Thismodelextendsthe2Driskminimizationproblemofaircraftdetectionbysensors[ 40 ],to ThepurposeofthissimpliedmodelisanalyzingtheimpactofvariableRCSonthe3Dgeometryofoptimaltrajectoriessubjecttoaconstraintontrajectorylengthandevaluatingperformanceofthedevelopeddiscreteoptimizationapproachwithrespecttorunningtimeandaccuracy.Veriedoptimizationtechniqueswillbeappliedinoptimalpathplanningwithactual-tabulatedRCS.

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Wedevelopedanalyticalanddiscreteoptimizationapproachesforsolvingformulatedtrajectoryoptimizationproblemwithaconstraintontrajectorylengthandarbitrarynum-berofdetectinginstallations(sensorsorradars).ThroughtechniquesofCalculusofVari-ations,thenecessaryoptimalityconditionsforasolutiontotheriskminimizationproblemwerereducedtoanonlinearvectorialdierentialequation.Inthecaseofasingleradar,weobtainedananalyticalsolutiontothisequationexpressedbyaquadrature.AnalyticalsolutionsareintendedforconceptualunderstandingandanalyzingtheimpactofvariationinRCSonthegeometryofoptimaltrajectoriesandtestingperformanceofthedevelopeddiscreteoptimizationapproachinthecaseofasingleradarin2Dand3Dspaces.Althoughwehavemadesignicantprogressinthedevelopmentoftheanalyticalapproach,ndingananalyticalsolutiontothevectorialdierentialequationinthecaseofanarbitrarynum-berofinstallationsisstillanopenissue.Thisisoneofthemainreasonsforaddressingdevelopmentofdiscreteoptimizationapproaches. Severaldiscreteoptimizationapproachesareavailablefornumericalsolvingproposedriskminimizationmodel.Alltheseapproachesmaytentativelybedividedintothreemajorcategories Eciencyofdiscreteoptimizationapproachesinoptimalriskpathplanningessentiallydependsontypeofriskfunctionals,technologicalconstraints,andaschemeoftrajectoryapproximation[ 39 ].Gradient-basedalgorithmsareveryecientwhentheriskofdetec-tionisdeterminedbysmoothanalyticalfunctionals.However,whiledynamicprogrammingandNFoptimizationareglobaloptimizationapproaches,gradient-basedalgorithmsmostlikelyndonlylocallyoptimalsolutionsinthecasewhenriskfunctionalsarenonconvex.Manyofthepreviousstudiesontrajectorygenerationformilitaryaircraftareconcentratedonfeasibledirectionalgorithmsanddynamicprogramming[ 38 ].Thesemethodstendtobecomputationallyintenseand,therefore,arenotwellsuitedforonboardapplications.Toimprovecomputationtime,JohnandMoore[ 39 ]usedsimpleanalyticalriskfunctions.Basedonsuchanapproach,theydevelopedlateralandverticalalgorithmstooptimizeight

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trajectorywithrespecttotime,fuel,aircraftnalposition,andriskexposure.Neverthe-less,thesealgorithmsarenotintendedforsolvingoptimizationproblemswithtechnologicalconstraints,suchasaconstraintonthetrajectorylength.Zabarankinetal.[ 40 ]demon-stratedeciencyofNFoptimizationapproachinsolvingriskminimizationproblemwithaconstraintontrajectorylengthandarbitrarynumberofsensorsin2Dspace.ThemainadvantagesofusingNFoptimizationapproachare Inspiteoftheseadvantages,thecomplexityofNFalgorithmssubstantiallydependsonthecoarsenessofanetwork,inparticularonthenumberofarcs.Consequently,precisionforanoptimalsolutionshouldreasonablybespecied.Recently,Tsitsiklis[ 52 ]andPoly-menakosetal.[ 53 ]suggestedDijkstra-likeandcorrecting-likemethodsforecientsolvingacontinuous-spaceshortestpathproblemin2Dplane.Inthiscase,ndingagloballyopti-maltrajectoryemploysdiscretizationofHamilton-Jacobiequation[ 52 ],whichturnsouttobeanecientsynthesisofanalyticalanddiscreteoptimizationtechniques.ThissupportsthephilosophythatusinganalyticalpropertiesofobjectivefunctionsinNFoptimizationleadstomoreecientalgorithms.Sinceourgoalisgeneratinggloballyoptimaltrajectoriesandonthenextstepapplyingdevelopedoptimizationapproachinoptimalpathplanningwithactual-nonsmoothRCS(inthiscaseutilizinganalyticalpropertiesofriskfunctionalsislimited),weconsideredNFoptimizationapproach. Weapproximatedanadmissibledomainforaircrafttrajectorybya3Dnetworkwithaexiblestructureandpresentedaircrafttrajectorybyapathinthisnetwork.NFop-timizationapproachreducedoptimalriskpathgenerationwithaconstraintontrajectorylengthtotheConstrainedShortestPathProblem(CSPP).Developmentofecientnetworkstructureswithrelativelysmallnumbersofarcsandnodeswhilepreservingexibilityfortrajectoryapproximationisoneofthekeyissuesinreductionofapproachcomputationaltime.

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TosolvetheCSPPin2Dand3Dcases,weusedtheLabelSettingAlgorithm(LSA)withapreprocessingprocedure[ 54 55 ]andnetworkstructuresmoothing.Theeciencyofthediscreteoptimizationapproachisdemonstratedbyseveralnumericalexampleswithvariousellipsoidshapes,constraintsontrajectorylengthinthecasesofone,twoandthreeradars.Forthecasewithasingleradar,wecomparedanalyticalandnumericalsolutionsandfoundthatsolutionscoincidewithhighprecisionin2Dcaseandareveryclosein3Dcase.Thefactthatdiscretetrajectoriesareclosertocorrespondinganalyticalonesin2Dcasecanbeexplainedbydierentexibilityof2Dand3Dnetworkstructuresintrajectoryapproximation.LSArunningtimeinall2Dtestingexamplesisonlyseveralseconds,indicatingthatthisNFalgorithmisfastenoughforuseinonlineapplicationswitharelativelysmallnumberofarcsinagraph.However,itisalsoknownthattheCSPPisanNP-hardproblemand,consequently,noexactpolynomialalgorithmsshouldbeexpected.Numericaltestsina3DcaserevealthatLSArunningtimestronglydependsontheshapeofellipsoid.Thisphenomenonhasbeenanalyzedfromoptimizationperspectiveandanimprovementforpreprocessingprocedurehasbeensuggested. Chapter4isorganizedasfollows:section2develops3Dmodelfortrajectoryopti-mizationwithvariableRCSsubjecttoaconstraintontrajectorylength;section3considersnecessaryoptimalconditionsforcalculusofvariationsproblemwithanonholonomiccon-straintandmovableendpoint;section4derivesthevectorialdierentialequationforndingoptimaltrajectoryinageneralcaseandobtainsanalyticalsolutiontothisequationinthecaseofasingleradar;section5reducesoptimalpathplanningtotheCSPPandpresentstheLSAwithpreprocessingprocedureandsmoothingcondition;section6conductsnu-mericalexperimentswithvariousellipsoidshapesandconstraintsontrajectorylengthinthecasesofone,twoandthreeradars;section7analyzesresultsofnumericalexperimentsfromoptimizationandvariableRCSperspectives;section8discussesmainanalyticalandnumericalresultsandconcludesthechapter.

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in3DspacetryingtominimizethecostofdetectionfromNradarslocatedintheareaofinterest.Wemodeltheaircraftbyanaxisymmetricalellipsoidwiththeaxes'lengthsa,bandb.Theaxiswithlengthaistheaxisofellipsoidsymmetry,whichorientsadirectionofaircrafttrajectory.Ellipsoidshapeisdenedbyparameter=b=a.Casesof=1,<1and>1correspondtosphere,elongatedandcompressedellipsoids,respectively,seeFigure 4{1 Figure4{1: Ellipsoidshapeisdenedbyparameter=b=a 1;N,determinepositionofellipsoidgeometricalcenterandpositionoftheithradar,respectively.Atrajectoryoftheellipsoid'scenterisassumedtobeapathoftheaircraft.Wedeneatrajectoryasafunctionofitscurrentlengths,i.e.r=r(s)=(x(s);y(s);z(s)).Suchaparameterizationisalsoknowntobethenaturaldenitionofacurve.Vector_r(s)=d dsr(s)=(_x(s);_y(s);_z(s))determinesadirectionofaircrafttrajectorythatcoincideswiththeaxisofellipsoidsymmetry.Since(ds)2=(dx)2+(dy)2+(dz)2,vector_r(s)mustsatisfycondition_r2=_x2+_y2+_z2=1.Thelengthofvectorri(s)=r(s)qi=(xai;ybi;zci),denotedbyjjri(s)jj,denesthedistancefromtheaircrafttotheithinstallation(seeFigure1),i.e.jjri(s)jj=p TheRCSoftheaircraftexposedtotheithradaratpoint(x;y;z)isproportionaltotheareaoftheellipsoid'sprojectiontotheplaneorthogonaltovectorriRCSi=iSi;

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Figure4{2: 3Dmodelforoptimalpathplanninginathreatenvironment wheretheconstantcoecientidependsontheradar'stechnicalcharacteristicssuchasthemaximumdetectionrange,theminimumdetectablesignal,thetransmittingpoweroftheantenna,theantennagainandthewavelengthofradarenergy. ThemagnitudeofellipsoidprojectionareaisgivenbytheformulaSi=bp RCSi=ia2+b2 ThepurposeofpresentingRCSiintheformof( 4.1 )isthefollowing.Sincetheaircrafthasalimitedsize,weassumethevaluep Theriskfunction(alsoreferredtoascostfunction)fordetectionoftheaircraftbytheithradarisproportionaltotheithRCSandreciprocaltothen-thpowerofthedistancebetweentheaircraftandtheithradar,jjrijjn(casesofn=2andn=4correspondtosensor

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andradar,respectively)namely,C(ri;_r)=RCSi/jjrijjn=ia2+b2 wherewi=i,NPi=1iandNPi=1wi=1. WeassumetheriskofdetectionfromNradarsatpointr=(x;y;z)tobethesumofriskfunctions( 4.2 )foralli= 1;N L(r;_r)=NXi=1C(ri;_r)=2 Thetotalriskofdetectionistheintegralof( 4.3 )alongaircrafttrajectorywithlengthl,i.e. TheriskminimizationproblemisndingatrajectoryP=r(s)=(x(s);y(s);z(s)),0sl,frompointAtopointB,havingcoordinatesrA=(xA;yA;zA)andrB=(xB;yB;zB),respectively,withtheminimalriskofdetectionsubjecttoaconstraintontrajectorylength minPF(r;_r)s:t:_r2=1;r(0)=rA;r(l)=rB;ll: Theformofriskfunctional( 4.4 )impliesthateithertheriskisindependentonaircraftspeed,oraircraftspeedisalwaysaunit.Underassumptionofunitspeed,sbecomestimevariablet,totallengthlbecomestotaltimeTand( 4.5 )isviewedasaproblemofoptimalcontrolwithF(r;v)=TR0L(r(t);v(t))dt,withv=_r.Whatevertheinterpretationof( 4.5 )

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is,analysistechniquesarethesame.Tosolveproblem( 4.5 ),calculusofvariationsandnetworkowoptimizationapproachesareaddressed. Wewanttomentionthe2Ddynamicmodelforminimizingtheriskofsubmarinedetectionbyanetworkofsensors[ 41 ].Inthatmodel,theriskfunctionalconsidersdierentdirectionsofthepowerradiationandvariablespeedofasubmarineTZ0NXi=1Si(12cos(2i(t))) 4{2 ),i.e.ri(t)isthedistancebetweenthesubmarineandtheithsensorandi(t)isthecorrespondingangle,whichnowbothdependontimet;r0tdenotessubmarinespeedattimemomentt;Siisthesensitivitycoecientassociatedwiththeithsensor;1and2areparameters,whichcorrespondtodoublingtheradiatedpowerrelativetosmallspeeds(usually,1=0:0003<<1)andadjustmentofpowerradiationindierentdirections(21;when2>0,powertendstoberadiatedmoststronglybroadside[ 41 ],2isarbitrarilysetto0.5),respectively.Theterm12cos(2i(t))maybeconsideredassubmarinecross-sectionin2Dspace.TheOptimalControlapproach,suggestedtosolvethemodel,startswithsomefeasibletrajectoryprovidedbyanobserverandtransformsittolocallyoptimalonebysteepest-descenttechnique. 4.5 )inthecaseofasingleradar.Weconsiderthefollowinggeneralformulation minr(r;_r;l); (r;_r;l)=lZ0L(r(s);_r(s))ds;

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wherer(s)=(x(s);y(s);z(s)),_r(s)=(_x(s);_y(s);_z(s)). Anecessaryconditionfortheexistenceofafunctionalextremumrequiresthetotalvariationofthefunctionaltobeequaltozero.However,becauseofconstraint( 4.10 ),( 4.6 ){( 4.10 )istheproblemwiththemovableendpoint,r(l),whichmeansthatvariationofthetotalcurvelength,l,isnotzero.Notevariationsx,yandzaredependantbyvirtueofnonholonomicconstraint( 4.9 ).Lagrangemultipliermethodisusedtoseparatedierentialexpressionsinthefunctionalvariation. Letr=(x;y;z),_r=(_x;_y;_z),@L @r=(@L @x;@L @y;@L @z)and@L @_r=(@L @_x;@L @_y;@L @_z).ApplyingtheLagrangemultipliermethodtoproblem( 4.6 ){( 4.7 )withconstraint( 4.9 ),thefunctional( 4.7 )isrewrittenas(L;';;l)=lR0(L(r;_r)+(s)'(_r))ds.Bydenitionthevariationofthisfunctionalis=lR0(L(r;_r)+'(_r)+')ds+(L+')js=ll=lR0@L @rr+@L @_r_r+@' @_r_r+'ds+(L+')js=ll=lR0h@L @rd ds@L @_rd ds@' @_rr+'ids+h@L @_r+@' @_rris=l+(L+')js=ll: 4.8 ),thevariationratthestartingandnishingpointss=0ands=l+l,respectively,shouldbezero,i.e.r(0)=0andr(l+l)=0.Thelastconditionisusedtocalculatethevariationrats=l.Namely,fromr(l+l)r(l)+_rl=0weobtainr(l)=_rl.Usingthelastequality,thevariationisrearrangedintheform=lR0h@L @rd ds@L @_rd ds@' @_rr+'ids+hL+'@L @_r+@' @_rris=ll: 4.9 ),allthreevariations(x;y;z)becameindepen-dent,thenecessaryconditionsforanextremum,i.e.=0,arereducedtotheconstraint( 4.9 )andthefollowingequations @rd ds@L @_rd ds@' @_r=0;

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and @_r+@' @_rrs=l=0: Vectorialequation( 4.11 )hastherstintegral.Indeed,thescalarproductof( 4.11 )with_rgives@L @rd ds@L @_rd ds@' @_r_r=0; @_r_r@' @_r=const: Lagrangemultiplier,(s),isderivedfrom( 4.13 ) @_r+cL_r@' @_r; wherecL=constisanunknownconstant.Substitutionof( 4.14 )into( 4.11 )leadstothevectorialdierentialequationfordeterminingoptimalr @rd ds@L @_r+@' @_r @_rL_r@L @_r+cL!=0; whichalongwiththenonholonomicconstraint( 4.9 )andboundaryconditions( 4.8 )arenecessaryconditionsforanextermum.Notethatequations( 4.15 )and( 4.9 )aredependentinthesensethatthescalarproductof( 4.15 )with_risreducedtor@' @_r=0,whichisthedierentialof( 4.9 ). Inthecasewhenconstraintllisactive,i.e.l=l,equation( 4.12 )isexcludedfromdetermininganoptimalsolution,sinceinthiscasecurvetotallengthisxedand,therefore,thevariationlshouldequalzerobydenition.Ifconstraintllisinactive,thenfrom( 4.12 )and( 4.13 )wehavecL=0. However,( 4.15 )with( 4.9 )and( 4.8 )areonlythenecessaryconditionsforanoptimalsolutiontosolveminimizationproblem( 4.6 ){( 4.10 ),since( 4.15 ),( 4.9 )and( 4.8 )ndanextremaltrajectory,whicheitherminimizesormaximizesthefunctional. Inthecaseofactivelengthconstraint(variationliszero),sucientconditionforanextremal,r,minimizingfunctional( 4.7 )isformulated

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(a)all_rsucientlycloseto_r(weakminimum);(b)all_r(strongminimum); thefollowingrelationholdslZ0(L(r;_r)+'(_r))dslZ0(L(r;_r)+'(_r))ds; 4.14 )calculatedatr.Thisconditionisreducedtovericationofwetherthesecondvariationofthefunctional(L;';;l)atrisgreaterthanorequaltozero. 4.5 )isaparticularcaseofageneralproblemofminimizingafunctionalwithanonholonomicconstraintandamovableendpoint.ThroughtechniquesofCalculusofVariations,theprevioussectionreducedthenecessaryconditionsforanextremaltrajectorythatsolvesthisgeneralproblemtoavectorialdierentialequation.Thelastoneplaysacentralroleinanalyzingandsolving( 4.5 ). Introducinganewfunction andusingnotation_gi=d dsgi,weformulatenecessaryconditionsforoptimaltrajectorysatisfying( 4.5 ). 4.5 )shouldnecessarilysatisfythefollowingvectorialdierentialequation

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4.5 )isaparticularcaseoftheproblem( 4.6 )-( 4.10 )consideredinsection3.Inthecaseof( 4.19 )wehave@' @_r=2_randconsequently@' @_r._r@' @_r_r.Substitutingthelastequalityintothegeneralvectorialdierentialequation( 4.15 )derivedinsection3,weobtainthevectorialdierentialequationfordetermininganoptimaltrajectoryr(s),0sl, @rd ds@L @_r+_rL_r@L @_r+cL=0: IntroducinganewconstantLbyrelationcL=2 dsg(ri;_r;L),wherefunctiong(ri;_r;L)isdenedby( 4.16 ),weverifythatthefollowingrelationsholdfor( 4.3 )L_r@L @_r+cL=2 @L @rd ds@L @_r=2 4.20 )toequation( 4.17 ). Noteequation( 4.17 )andconstraint( 4.19 )aredependentinthesensethatthescalarproductof( 4.17 )with_risreducedtoNPi=1wi1_r2_girgi=0,whichbecomesidentityif( 4.19 )issatised. 4.17 )maybepresentedindierentforms.Usingrelation( 4.5 ),wehaveri 4.17 )becomesNXi=1wi_r[ri_r] ds(_rgi)=0: 4.17 )mayalsobepresentedinamatrixform.DenotingGN1=0BBBBBBBB@w1g1w2g2...wNgN1CCCCCCCCA;R3N=r1

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( 4.17 )isrewrittenasR_G=d ds(_r(e>G)): 4.17 )isjustamatterofconvenienceinconductinganalyticalmanipulationsornumericalanalysis.Dierentialequation( 4.17 )maybesolvednumericallybyanappropriategradient-basedalgorithm,however,inthiscasewearenotguaranteedobtainingagloballyoptimalsolution. Derivingananalyticalsolutionto( 4.17 ){( 4.19 )withanarbitrarynumberofradarsisreducedtondingthesecondintegralforequation( 4.17 )(therstoneisnonholonomicconstraint( 4.19 )),whichstillremainstobeanopenissue.Thenexttheoremshowshowthesecondintegralandacorrespondinganalyticalsolutionarefoundinthecaseofasingleradar. 4.17 )with( 4.18 )and( 4.19 )isreducedtoanonlinearrst-orderdif-ferentialequationwithrespecttofunction=() 1

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4.17 )isderivedinthecaseofasingleradar,withoutlossofgenerality,weassumethattheradarislocatedattheoriginofthesystemofcoordinates,thatis,(a1;b1;c1)=(0;0;0),andr1=r.FunctionsL(r;_r),g(r;_r;L)andequation( 4.17 )inthiscasearepresented,respectively,L(r;_r)=2 r_r_r_grg=0: ds([r_r]g)=0; [r_r]g=C; whereC=(C1;C2;C3)isaconstantvector.Since(r[r_r])=0andg(r;_r;L)60,thescalarproductof( 4.24 )withrleadstoCr=0; [rArB]r=0; orhxx+hyy+hzz=0;

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where(hx;hy;hz)arethecomponentsofvector[rArB](hx;hy;hz)=(yAzByBzA;zAxBzBxA;xAyBxByA); 4.25 )bya2Dpolarsystemofcoordinates(;).Apointwithcoordinates(x(;);y(;);z(;))shouldsatisfy( 4.25 )identically.Supposetheoriginofthepolarsystem(;)coincideswiththeoriginoftheoriginal3Dsystemofcoordinates,i.e.point(0;0;0).Letbeacounterclockwiseangleproducingleft-handedscrewwiththevector[rArB]andcountedfromtheuppersideoftheplanexy.Introducingnotationscos=hx 4.25 )aredeterminedbythefollowingrelationsx(;)=(sincoscoscossin);y(;)=(coscos+sincossin);z(;)=sinsin: 4.24 )isreducedtothefollowingscalarequation whereCisunknownconstantscalarvalue.Sincer2=jjrjj2=2,functiong(r;_r;L)isrewrittenasg(;_;L)=1 4.26 )andconstraint( 4.19 ),expressedintermsof(;)as_2+2_2=1,determineasystemofdierentialequationsforndingoptimal(s)and

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withboundaryconditions(0)=A,(0)=A,(l)=B,(l)=B,where(A;A)and(B;B)aregivenbyA=jjrAjj;A=arccosxAsinyAcos d.Usingrelation_=0_withthesecondequationof( 4.27 )wepresent_and_as_=0 4.27 )excludesvariablesfromthesystem( 4.27 )andreducesittothenonlinearrst-orderdierentialequation( 4.21 )determiningasafunctionofwithboundaryconditions( 4.22 ).Sincevariableswasexcludedfrom( 4.27 )(thesecondequationof( 4.27 )issatisedidentically)weshouldincludeconstraintontrajectorylengthintheformof( 4.23 ). Noteitdoesnotmatterwhatsign,plusorminus,wechoosefor_in_=1 4.24 )anddenoteitbyanewconstant. 4.21 )(orsystem( 4.27 ))isonlythenecessaryconditionforatrajectorytobejustanextremal,since( 4.21 )ndstrajectoriesminimizingthefunctional( 4.4 )undergivenconditionsaswellasmaximizingit.Sucientconditionforasolutiontosystem( 4.21 )tobeanoptimaltrajectory(;),i.e.tominimizethefunctional,requiresthesecondvariationofthefunctionalat(;)tobegreaterthanorequaltozero. Inthecaseofasingleradar,theriskfunctionalwiththerelaxedconstraint_2+2_2=1ispresentedinpolarcoordinatesbyF=lZ0L(;_;_)ds;L(;_;_)=2

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where= dsL00_()2+L00__(_)2+L00__(_)2+2L00__+2L00____=;=ds=2 ds1 2+g: 4.27 ),wecanuse( 4.27 )torearrangeP,Qandtheothertermsintheintegralof2Fand,thus,obtaindierentequivalentexpressionsfor2F.However,vericationofthecondition2F0forall,_and_,eveninthisparticularcase,isnotatrivialtask. Weconneourselveshereonlytovericationofnecessaryconditionsforaminimum.Inorderthatanextremal(;)tominimizethefunctional,itshouldnecessarilysatisfytheLegendreconditionsL00__=;=0;L00__L00__L00__L00__=;=0; Althoughananalyticalvericationofweatheraparticularextremaltrajectorymini-mizesthefunctionaliscumbersome,thegraphofthistrajectoryimmediatelyrevealswhat

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kindofanextremalitis.Indeed,ifthelinepassingthroughpointsAandBseparatesthetrajectoryandtheradar/sensor,i.e.thetrajectorymovesawayfromadetectinginstallation(thetrajectoryis\concave"),thenitminimizestherisk,andvise-versa,ifthetrajectorymovestowardsthedetectinginstallation(thetrajectoryis\convex"),thenitmaximizestherisk. Ananalyticalsolutiontoequation( 4.21 )withboundaryconditions( 4.22 )andcon-straint( 4.23 )ispresentedinthenexttheorem. 4.21 )withconditions( 4.22 ),( 4.23 )isgivenbythefollowingquadrature wereduce( 4.21 )tothealgebraicequation( 4.29 )withrespectto,whichisaparticularcaseofthefollowingquarticequation2(n2)CL2222+(12)22=0: 4.21 ).Duetothecumbersomeformoftheexpressions

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fortherootsofequation( 4.29 )wedonotpresentthemhere.Supposethat(;L;C)isarootfor( 4.29 ),thenaccordingto( 4.30 ),derivative0isexpressed0=q 4.28 ). Notearootfor( 4.29 )dependsonvaluesofLandC.WhichrootshouldbechosenwithrespecttoLandCandwhataretheestimatesforLandCarethesubjectofthenexttheorem. Thequadrature( 4.28 )isconsideredtobeananalyticalsolution,sincetherootsofthequarticequation( 4.29 )maybeexpressedbyCardan's(Cardan-Ferrari's)formulasanalyt-ically.Therearetwospecialcaseswhenthequadrature( 4.28 )issimplied. n1arcsinCn1AA. 4.29 )satisfying>0is=q 4.28 )leadsto()=A n1arcsinCn1A; 4.31 ).

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Inthecaseofn=2,function( 4.31 )representsanarcofacirclepassingthroughtheoriginofthesystemofcoordinatesandpointsAandB.Figure 4{3 illustratesbehavioroffunction()=sin1 Figure4{3: Function()=sin1 33 4.31 )canbedeterminedonlywhenjBAj
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(xA;yA)=(0:25;0:25),(xB;yB)=(1:75;0:25)andradarposition(0;0).Figure 4{5 showsthesameoptimaltrajectoriesfora\spherical"aircraft(=1)forn=4withthesameconstraintsontrajectorylength,l,in3Dspacewith(xA;yA;zA)=(0:25;0:15;0:2),(xB;yB;zB)=(1:75;0:15;0:2).Similarexampleforn=2wasconsideredbyZabarankinetal.[ 40 ]. Figure4{4: Optimaltrajectoriesforthecaseof\sphere"withdierentconstraintsonthelength,l,inthetrajectories'plane Wecomparedanalyticalsolutionsforoptimaltrajectoriesinthecaseswithradarsandsensors.Asensorisanantennacapablejusttoreceiveasignalgeneratedbyaircraftmovement,whereasaradarsendsasignalanddetectsitsreectionfromanaircraft.Theriskofdetectionbyasensorisreciprocaltothesquareddistancebetweenthesensorandtheaircraft.Analyticalsolutionforanoptimaltrajectorywithaconstraintontrajectorylengthinthecaseofasinglesensorisexpressedbytheellipticsine[ 40 ].Figure 4{6 comparesoptimaltrajectorieswiththesameconstraintontrajectorylengthl=3:2fora\spherical"aircraftinthecasesofasinglesensorandsingleradar.Asitisexpectedbasedonriskfunctions,anoptimaltrajectoryismoresensitivetoaradarthantoasensorwithinproximitytoaninstallationandvise-versa.

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Figure4{5: Optimaltrajectoriesforthecaseof\sphere"withdierentconstraintsonthelength,l,in3Dspace Figure4{6: Comparisonofoptimaltrajectoriesintrajectories'planeforthecaseswithasinglesensor(n=2)andsingleradar(n=4)withthesameconstraintonthelength,l=3:2

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ThenexttheoremprovidessomeinsightsregardingboundsofunknownsandCfacilitatingnumericalimplementationof( 4.28 )and( 4.29 ). 4.29 )hasauniquerootwithininterval[min;max]where q 4.29 )withrespecttofeasibilityofandtheassumptionofL'spositivity. TherstpartestablishesboundsforCdependingonL.Usinginequality=q 4.29 )isreducedton1CL20or,equivalently,toLn+1Cn11.Applyingagain,thelastinequalityisreducedtoLnCn11,whichisrearrangedintheform Since( 4.36 )holdsforallfeasible,weobtainCminL+(n1).Expres-sionL+(n1)isaconvexfunctionwithrespectto,achievingitsglobalmini-mumat0=L

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theassumptionofL0,positivityofCisobvious.Indeed,rewriting( 4.29 )intheformn2CL2p 4.33 ). Thesecondpartndsboundsfor,i.e.interval[min;max]containingasingleroot.Thispartincludesthefollowingconsecutivesteps. 4.29 )andsatisfyingtheconditionL0.Thatis,fromL= 2C1 q Thenweutilizeupperandlowerestimatesforp 4.29 )reducesitton2CL21n2CL2.Theseinequalitiesgivetheupperandlowerestimatesforwhen1 Noteif=1then( 4.38 )providesanexactvaluefortheroot=C1L2+(n2). 4.29 )ton2CL2p Combininginequalitywith( 4.37 ),( 4.38 )and( 4.39 )forbothcasesk1and>1,weobtain( 4.34 )and( 4.35 ). Finally,toprovethatequation( 4.29 )hasasinglerootintheinterval[min;max],weshowthatthefunctionf()=n2CL2p df()=Cn2q

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Thersttermandthenominatorofthesecondtermintheexpressionofd df()areincreasingfunctionswithrespectto.Forminthersttermisalwaysnonnegativedueto( 4.37 )andthenominatorofthesecondtermisalwayspositivebasedon( 4.38 )and( 4.39 ).Consequently,d df()ispositiveon[min;max],whichmeansthatf()isamonotonicallyincreasingfunction. Sinceministhemaximumofthreevalues( 4.34 ),wecheckthesignoff()foreachofthem. 4.36 ). q q Inthecaseofmaxgivenby( 4.34 ),weusep

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(xB;yB)=(1:75;0:25),andin3Dspace(xA;yA;zA)=(0:25;0:15;0:2),(xB;yB;zB)=(1:75;0:15;0:2).Figures 4{7 4{8 and 4{9 compareoptimaltrajectoriesforsphere,elongatedandcompressedellipsoids.Table 4{1 presentsvaluesfortheoptimalrisk,L,CandC'sestimate( 4.33 )forallconsiderednumericalexampleswithdierentandl. Figure4{7: Optimaltrajectoriesforsphere(=1:0)andelongatedellipsoids(=0:5,0.1)forn=4andl=3:2shownintrajectory'splane Figure4{8: Optimaltrajectoriesforsphere(=1:0)andcompressedellipsoids(=2:0,10)forn=4andl=3:2shownintrajectory'splane AnalyzingoptimaltrajectoriesinFigures 4{4 4{5 4{6 4{7 4{8 and 4{9 andcompu-tationalresultsinTable 4{1 wecanconcludethefollowing

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Figure4{9: Optimaltrajectoriesforsphere(=1:0),elongated(=0:1)andcompressed(=2:0)ellipsoidsforn=4andl=3:2in3Dspace Table4{1: Optimalrisk,L,CandC'sestimate l 2.6 9.792116 4.763580322 5.369280470 5.658081121 1.0 3.2 8.421726 1.040107422 1.759684438 1.807289381 1.0 4.0 7.966210 0.300707031 0.712062456 0.712568693 0.1 3.2 0.468371 1.451660156 2.282777298 2.320693404 0.5 3.2 3.980716 1.993432500 2.908499104 2.943880665 2.0 3.2 12.464087 0.610351562 1.143055224 1.211725076 10.0 3.2 14.845494 0.109076172 0.251462743 0.333055390

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Weproposenetworkow(NF)optimizationapproachtodirectlysolvetheoriginalproblem.ThisapproachreducesoptimalriskpathgenerationwithaconstraintonthelengthtotheConstrainedShortestPathProblem(CSPP)fora3Dnetwork,whichcanecientlybesolvedbyNFoptimizationalgorithms.ThereareseveraladvantagesofusingNFoptimization 4.2 ). However,duetoNP-hardnatureoftheCSPP,nopolynomialalgorithmsolvestheCSPPexactly.Itmeansthatinaworstcase,computationaltimefortheCSPPwillex-ponentiallydependonthenumberofarcsinanetwork.Consequently,coarsenessofthenetworkshouldbespeciedreasonably.

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ofundirectedarcs.Atrajectory(x(:);y(:);z(:))isapproximatedbyapathPinthegraphG,wherepathPisdenedasasequenceofnodeshj0;j1;:::;jpisuchthatj0=A,jp=Bandhjk1;jki2Aforallkfrom1top.LetgraphGbea3Dgridofnodes(rectangularparallelepiped)ofnxnynzsizewithedgesorientedalongcoordinateaxesx,y,zandhavingnx,nyandnznumbersofunitsegmentsineachedge,respectively.Similarly,in2DcasegraphGisa2Dgridofnodes(rectangle)ofnxnysizewithedgesorientedalongcoordinateaxesx,yandhavingnxandnynumbersofunitsegmentsineachedge,respectively.StructuresofarcsassignedinGin2Dand3DcasesareshowninFigures 4{10 and 4{11 ,respectively.A2Dnetworkwitharcsstructure,showninFigure 4{10 ,contains(nx+1)(ny+1)nodesand2(8nxnynxny) arcs,wherenx1andny1.In3DcasethetotalnumberofnodesandarcsinanundirectedGwitharcsstructure,asshowninFigure 4{11 ,are(nx+1)(ny+1)(nz+1)and2(49nxnynz8nxny8nxnz8nynz+nx+ny+nz); 4{11 ).Allthesenumbersshouldbedoubleddueto\undirectness"ofthegraph.Thus,thetotalnumberofarcsjustinasinglecubeis56.Moreover,inordertoprovidesucientamountoffeasibledirectionsforatrajectory(i.e.toavoid\naivediscretization,"sometimesreferredtoasthedigitizationbias[ 52 ]),weassignnotonlyaxisanddiagonalbutalsoso-called\long-diagonal"arcsconnectingoppositevertexesofanytwoneighborcubes(seeFigure 4{11 ).However,inthiscase,networkstructurebecomesverycondense.Forexample,arelativelysmall3Dundirectednetworkof404040containsabout69,000nodesand6,200,000arcs.ItwouldbenaivetoassumethatevenaveryecientNFalgorithmiscapabletondaconstrainedshortestpathinthisnetworkwithinseconds(atleastatthecurrentmomentofthetechnologicalprogress).Obviously,amaintaskinthiscaseisdevelopmentofecientnetworkstructureswithrelativelysmallnumbersofarcsandnodes,whilepreservingexibilityfortrajectoryapproximation,ratherthanndingthe

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mostecientNFalgorithm(althoughthisisalsoaquitelegitimatequestion).However,thechapteronlypartiallyaddressestheissueofecientnetworkstructures,sincethisisaseparatesubjectfordiscussion,whichcallsforaseparatepublication.Zabarankinetal.[ 40 ]showedthatexistingNFalgorithms[ 54 ]arequiteecientinndingaconstrainedshortestpathinanetworkwithabout100,000arcs. Figure4{10: Structureofarcsineverynodeina2Dnetwork:\1"{axisarcs,\2"{diagonalarcs,\3"{longdiagonalarcs 4{12 LetNibethesetofnodesconnectedtonodei.Forinstance,for2DnetworkstructureshowninFigure 4{10 ,setNiforeachiconsistsof16nodesproducing4axis,4diagonaland8longdiagonalarcswithnodei.LetTAibeasubgraphstartingfromnodej0=Aalongarchj0;ii,i2Nj0.NowTAi=fj0;ig.Ifj2Ni=fj0gsatisesconditionej0ieijp 2,whereeijistheunitvectoralongarchi;ji,thenjisaddedtothesubgraphTAi=TAi[fjg.Thenextstepistoexaminenewaddednodes,i.e.forallj2TAi=fj0;igcheckeijejkp 2,k2Nj.IfnodeksatisesthisconditionthenTAi=TAi[fkgandsoon.TAiisfullwhen

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Figure4{11: Structureofarcsineverynodeina3Dnetwork thereisnonodesleftsatisfyingthecondition.Similarly,weconstructTAiforalli2Nj0.ThenthewholeprocessisrepeatedforTBi. Figure4{12: Networksmoothingandcurvatureconstraint Toavoid\sharpturns"inaircrafttrajectory,wemayuseacurvatureconstraint,whichalsocanbeimposedbyaircraftcontrollimitations.Analytically,foranygiventriadofarcs,curvatureconstraintisexpressedbyejk2jk1ejkjk+1cos,where,forinstance,maybe

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sinceaconstantconstraintontrajectorycurvaturemaypreventfromobtaininganoptimalsolution. FindingagloballyoptimalriskpathsubjecttolengthconstraintisthetaskforNFoptimization.NetworkstructuresmoothingwillbeintegratedintoaNFalgorithmasaconditioneliminatinginadmissiblearcsinanetworkratherthanimplementedasaseparateprocedure.Consequently,smoothingconditionisconsiderednowasanadjustmentfortheNFalgorithmratherthanpropertyofnetworkstructure. 4.5 )areavailable.Hereweconsideroneofthem.Letvectorrjkwithcomponentsx(jk),y(jk)andz(jk)determinepositionofnodejk.ThenapathP=rj1;rj2;:::;rjpisapiece-wiselinearcurve(brokenline)withvertexesatpointsrjk,k= 1;p.Anypointonthearchjk1;jkicanbedenedbyvectorrk(t)=(1t)rjk1+trjkwitht2[0;1].Thus,lengthdierentialdsandderivative_rforeacharcareds=jjrjkrjk1jjdt;_rk=rjkrjk1 1;p: 4.4 )andtrajectorylengtharepre-sented,respectively wherejjrjkrjk1jjandC(rjk1;rjk)arethelengthandriskindexofthearchjk1;jki,respectively.ToderivetheformulaforC(rjk1;rjk)wecomputetheriskaccumulatedalongthearchjk1;jkifromtheithradarlocatedatqi=(ai;bi;ci).Substitutingrik(t)=

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4.2 ),wehave 2dt; whereli;jk=jjrjkqijj,sjk1jk=jjrjkrjk1jjand'i;jk1jk2[0;]istheanglebetweenvectorsrjk1qiandrjkrjk1(seeFigure 4{13 ),i.e.'i;jk1jk=arccos(rjk1qi)(rjkrjk1) 4{13 illustratesa3Dnetworkforsolvingtheriskminimizationproblem.BrokenlineABisapathintheareawiththeithradar,whilesjk1jkisthelengthofarchjk1;jkibetweennodesjk1andjkinthispath.Magnitude'i;jk1jkistheanglebetweenvectorrjk1qiandarchjk1;jkidirectedfromnodejk1tonodejk. Figure4{13: 3Dnetworkforsolvingtheriskminimizationproblem

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Integral( 4.42 )canecientlybeapproximatedbytheGaussianquadrature.Iff(t)isaboundedsmoothfunctionon[0;1]thentheGaussianquadratureis1Z0f(t)dtJXj=1hjf(tj); 4{2 presentsvaluestjandweightcoecientshjfortheGaussianquadratureforJ=16. Table4{2: CoecientsfortheGaussianquadratureforJ=16 tj 0.096540088514727800567 0.095638720079274859419 0.093844399080804565639 0.091173878695763884713 0.087652093004403811143 0.083311924226946755222 0.078193895787070306472 0.072345794108848506225 0.065822222776361846838 0.058684093478535547145 0.050998059263376176196 0.042835898022226680657 0.034273862913021433103 0.025392065309262059456 0.016274394730905670605 0.007018610009470096600 4.5 )isap-proximatedby minPpPk=1C(rjk1;rjk)s:t:pPk=1jjrjkrjk1jjl;rj0=rA;rjp=rB: Ifforallk= 1;p,rjkisvariable(notxedinnodesofanetwork),then,inthecaseofactiveconstraintpPk=1jjrjkrjk1jj=l,optimalityconditionsfor( 4.43 )canbederivedbystandardcalculus @rjkC(rjk1;rjk)+C(rjk;rjk+1)=ejk1jkejkjk+1;k= 1;(p1);

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whereistheLagrangemultiplierfortheconstraintin( 4.43 )andejk1jk=rjkrjk1 4.44 )maybesolvednumericallybyagradient-basedalgorithm.However,inthiscase,wemostlikelyobtainonlylocallyoptimalsolution.Moreover,insteadofsolving( 4.44 )wecouldnumericallysolvedierentialequation( 4.17 ). 4.43 )asanetworkowoptimizationproblem,letcjk1jk=C(rjk1;rjk);sjk1jk=jjrjkrjk1jj; minPpPk=1cjk1jks:t:pPk=1sjk1jkl: Thedierencebetween( 4.43 )and( 4.45 )isthat( 4.43 )stillpreservesanalyticalproper-tiesoftheriskandlength,whereas( 4.45 )completely\forgets"aboutthenatureofobtainedcjk1jkandsjk1jkvalues.TheCSPP( 4.45 )iscloselyrelatedtotheShortestPathProb-lemwithTimeWindows(SPPTW)andalsototheResourceConstrainedShortestPathProblem(RCSPP),whichusesavectorofweights,orresources,ratherthanascalar.TheseproblemsaresolvedincolumngenerationapproachesforVehicleRoutingProblemswithTimeWindows(VRPTW)andinlong-haulaircraftroutingproblems.Undertheassump-tionofcostandweightintegrality,theCSPPwasshowntobeaNP-hardproblem[ 55 ].Itmeansthatinaworsecase,theCSPPissolvedintimeexponentiallydependingonthenumberofarcs.AlgorithmsforsolvingtheCSPParedividedintothreemajorcategories

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Thelabelsettingalgorithmisthemostecientinthecasewhentheweightsarepositive[ 56 ].TheLagrangeanrelaxationalgorithmisbasedonthesubgradientoptimization[ 57 ]andcuttingplane[ 58 ]methods,andecientforsolvingtheLagrangeandualproblemoftheCSPPinthecaseofoneresource.ScalingalgorithmsusetwofullypolynomialapproximationschemesfortheCSPPbasedoncostscalingandrounding[ 59 ].Therstschemeisageometricbisectionsearchwhereasthesecondoneiterativelyextendspaths.WesolvetheCSPP( 4.45 )bytheLabelSettingAlgorithm(LSA)withapreprocessingprocedure[ 55 ].

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givenbycij.LetQcsjbetheleastcostpathfromstojandcj theproblemisinfeasible. bycij.LetQcjtbetheleastcostpathfromjtotandcjbethe costofthepath:cj=R(Qcjt). givenbysij.Qlsjistheminimumlengthpathfromstojandljis thelengthofthispath:lj=l(Qlsj). givenbysij.Qljtistheleastlengthpathfromjtotandlj if if if if

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goto SetLs=f(0;0)gandLi=;foralli2Vnfsg. InitializeIiaccordinglyforeachi2V. SetTi=;foreachi2V.

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If 2; (i)isapredecessornode*/ by(Wqj;Cqj)8q2Ij 40 ]demonstratedeciencyoftheNFoptimizationapproachinoptimaltrajectorygenerationin2Dspacewitharbitrarynumberofsensors(n=2)forthecaseofsphere(=1).ThissectiontestscomplexityoftheCSPP( 4.45 )andexibilityoftheproposed3DnetworkstructureinoptimaltrajectorygenerationwithvariableaircraftRCSin3Dspace.Wecomputeddiscretesolutionsusing2Dand3DnetworksforthesamedataconsideredinExamples2and3inthecaseofasingleradar(n=4).Radarposition,coordinatesofpointsAandBandtestingvaluesforaconstraintontrajectorylengthareexactlythesame.In3Dcase,theCSPPwassolvedbytheLSAwithandwithoutsmoothingcondition.AllcalculationswereconductedusingaPCwithXeon3.08GHzand3.37GbofRAM. Weused2Dand3Dnetworks,withstructuresasshowninFigures 4{10 and 4{11 ,tocomparediscreteoptimizationtrajectorieswithanalyticalonesinthecaseofasingleradar.

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2Dnetworkisaspecialcaseof3Donewithnz=0.Ittestsdiscretesolutionsinthetrajecto-ries'planedeterminedbypointsA,Band(0;0;0)(radarposition).Weassociatenodesofa3Dgraphwithintegervectors(i;j;k)forming3Dintegergrid.Consequently,thesetofarcslengthsinanintegergridwithstructureasshowninFigure 4{11 isn1;p Wecalculatedconstrainedshortestpathsdependingonellipsoidshape(parameter)andlengthconstraint,l,andcomparedoptimalriskvaluesR2DandR3D(in2Dand3Dnetworkoptimization,respectively)withthe\true"ones,obtainedbyanalyticalsolutionsapproach.Valuesofl2Dandl3Darelengthsofconstrainedshortestpathsin2Dand3Dcases,respectively.Wewereinterestedinthefollowingparameters:numberofnodesleftafterpreprocessing,Nprep,costupperboundinpreprocessing,U,preprocessingtime,Tprep,numberoflabelstreatedintheLSA,Nlabels,andrunningtimeoftheLSA,TLSA,measuredinseconds.Alltheseparametersarehelpfulinevaluatingperformanceofthediscreteoptimizationapproach.WeanalyzedtheimpactofusingsmoothingconditiononaccuracyofdiscretesolutionsandLSArunningtimein3Dcase.

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Numericalresultsof2Dnetworkoptimizationfordierentvaluesofandlarepre-sentedinTables 4{3 and 4{4 .Figures 4{14 and 4{15 compareanalyticalanddiscreteoptimizationsolutionsin2Dspacewithparameters:a)n=4,=1:0,l=2:6,3.2,4.0;andb)n=4,=0:1,2.0,l=3:2,respectively.Thesmoothcurvesaretheoptimaltra-jectoriesobtainedbytheanalyticalapproachandthenonsmoothcurvesarethoseobtainedbysolvingtheCSPP.Analyticalandcorrespondingdiscreteoptimizationtrajectoriesareclosetoeachother,whichvalidatesbothapproaches.Noteforthecaseofk=10:0,valuesofoptimalriskfordiscretetrajectoriesinTables 4{3 4{4 4{5 4{6 and 4{7 arelesserthantheriskvalueforthecorrespondinganalyticalsolution.Duetointegerapproximationofarcslengths,thetotallengthofthosepathsaregreaterthantheirintegerrepresentations. Table4{3: 2Dnetworkpreprocessing:singleradar l Npr 2.6 9.792116 91.336509 837 0.359 1.0 3.2 8.421726 91.336509 1260 0.313 1.0 4.0 7.966210 35.693792 1703 0.500 0.1 3.2 0.468371 15.942982 1281 0.484 0.5 3.2 3.980716 66.836609 1265 0.329 2.0 3.2 12.464087 12.858975 764 0.547 10.0 3.2 14.845494 14.84242y 0.359

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Table4{4: 2DnetworkoptimizationwithLSA:singleradar l 2.6 9.792116 2.592 9.983805 85461 0.609 1.0 3.2 8.421726 3.1995 8.504245 224524 2.047 1.0 4.0 7.966210 3.9933 8.004489 423056 4.750 0.1 3.2 0.468371 3.199 0.488162 329517 3.641 0.5 3.2 3.980716 3.1932 4.063807 292594 2.922 2.0 3.2 12.464087 3.1958 12.518963 60619 0.406 10.0 3.2 14.845494 3.1958 14.84242y 0 Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforthecaseofsphere(=1:0),n=4anddierentlengthconstraints,l,intrajectories'plane

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Figure4{15: Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforelongated(=0:1)andcompressed(=2:0)ellipsoidsforn=4andthesameconstraintonthelengthl=3:2intrajectories'plane Numericalresultsof3DnetworkoptimizationwithandwithoutnetworkstructuresmoothingfordierentvaluesofandlarepresentedinTables 4{5 4{6 and 4{7 .Figures 4{16 4{17 and 4{18 comparetheanalyticalanddiscreteoptimizationsolutionsin3Dspaceforthefollowingsetsofparameters:a)n=4,=1:0,l=2:6,3.2,4.0;b)n=4,=0:1,l=3:2;andc)n=4,=2:0,l=3:2,respectively.

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Table4{5: 3Dnetworkpreprocessing:singleradar l Npr 2.6 9.792116 91.336509 11518 9.516 1.0 3.2 8.421726 91.336509 22521 14.234 1.0 4.0 7.966210 8.902138 21175 18.031 0.1 3.2 0.468371 15.942982 22598 16.094 0.5 3.2 3.980716 66.836609 22553 14.875 2.0 3.2 12.464087 12.969952 15543 22.187 10.0 3.2 14.845494 14.840356y 12.781 3DnetworkoptimizationwithLSA:singleradar l 2.6 9.792116 2.5998 10.251423 1936613 766.704 1.0 3.2 8.421726 3.19805 8.525182 6644608 6597.750 1.0 4.0 7.966210 3.9997 8.040955 8066613 7252.609 0.1 3.2 0.468371 3.1987 0.554746 9930869 11519.922 0.5 3.2 3.980716 3.1963 4.11088 8427875 9069.281 2.0 3.2 12.464087 3.19895 12.529767 2529266 1220.188 10.0 3.2 14.845494 3.1953 14.83876y 8.031 3DnetworkoptimizationwithLSA&smoothingcondition:singleradar l 2.6 9.792116 2.5998 10.251423 1080091 299.735 1.0 3.2 8.421726 3.19645 8.526340 4841651 4286.844 1.0 4.0 7.966210 3.9981 8.041533 6849799 5937.016 0.1 3.2 0.468371 3.19925 0.55662 5262314 5066.953 0.5 3.2 3.980716 3.1986 4.123165 5091681 4715.875 2.0 3.2 12.464087 3.1998 12.530477 2015458 846.672 10.0 3.2 14.845494 3.1953 14.83876y 4.516

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Figure4{16: Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforsphere(=1:0),n=4withdierentlengthconstraints,l,in3Dspace Figure4{17: Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforelongatedellipsoid=0:1andparametersn=4,l=3:2in3Dspace

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Figure4{18: Comparisonofanalyticalanddiscreteoptimizationtrajectoriesforcompressedellipsoid=2:0andparametersn=4,l=3:2in3Dspace 3Dnetworkof2:31:01:25withthecorrespondingintegergridnxnyny=462025andthefollowingdataforradarspositionsandstaringandendingtrajectorypoints and Numericalresultsof3Dnetworkoptimizationinthecasesoftwoandthreeradarswithandwithoutnetworkstructuresmoothingfordierentvaluesofandthesameconstraintonthelength,l=3:2,arepresentedinTables 4{8 and 4{9 .Figures 4{19 4{20 4{21 4{22 4{23 and 4{24 illustratediscreteoptimizationtrajectoriesin3Dspacewithtwoandthreeradarsforthefollowingparameters:n=4,l=3:2,=0:1,1.0,2.0.

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Table4{8: 3Dnetworkoptimization:tworadars(smoothingisused) l Npr 3.2 3.19885 0.921916 3.086443 20342 16.547 9993019 9837.906 1.0 3.2 3.1993 4.891124 15.367339 19267 12.766 6737166 5392.109 2.0 3.2 3.1993 4.320838 7.535904 15968 16.828 3617699 2010.750 3.2 3.1993 0.922975 3.086443 20342 16.547 6428635 5556.891 3.2 3.1993 4.891411 15.367339 19267 12.766 5095577 3708.437 3.2 3.19785 4.330046 7.535904 15968 16.828 2818012 1335.859 3Dnetworkoptimization:threeradars(smoothingisused) l Npr 3.2 3.19995 1.635309 19.374493 20766 14.718 7898013 6733.031 1.0 3.2 3.19905 9.073111 28.740118 19660 16.641 5623460 3998.969 2.0 3.2 3.19905 8.62298 22.262851 18377 15.625 3982280 2285.640 3.2 3.19995 1.639800 19.374493 20766 14.718 5296123 4056.406 3.2 3.197 9.094264 28.740118 19660 16.641 4413319 2916.281 3.2 3.19905 8.62298 22.262851 18377 15.625 3155044 1634.031 Optimaltrajectoriesinthecaseoftworadarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2

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Figure4{20: Frontview:optimaltrajectoriesinthecaseoftworadarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 Figure4{21: Viewfromabove:optimaltrajectoriesinthecaseoftworadarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2

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Figure4{22: Optimaltrajectoriesinthecaseofthreeradarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 Figure4{23: Frontview:optimaltrajectoriesinthecaseofthreeradarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2

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Figure4{24: Sideview:optimaltrajectoriesinthecaseofthreeradarsforcompressedellipsoid(=2:0),sphere(=1:0)andelongatedellipsoid(=0:1)withthesamelengthconstraint,l=3:2 4{25 ;thediscrepancyinriskvaluesforoptimalpathsobtainedwithandwithoutsmoothingisnegligiblysmall,moreover,inmostcasescorrespondingoptimalpathscoincideexactly.

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Figure4{25: DependenceofLSArunningtimeontheshapeofellipsoid,(3Dnetwork,singleradar):curve\1"{nosmoothing,curve\2"{smoothingisused Figure 4{25 showsdependenceofLSArunningtimeontheshapeofellipsoid,,inthecaseof3Dspaceandasingleradarwithandwithoutnetworksmoothing.TheexcessiverunningtimefortheLSAinthecaseofveryelongatedellipsoids,(<<1,ellipsoidwith=0:1isalmostaneedle),canbeexplainedbylowestriskaccumulationsindirectionsradialtoaradar,whichareonesproducinggreatesttotallengthsfrompointAtopointB.Thiscomplicatescomparisonoflabelsinriskminimization,whilebalancinglengthconstraint.Thisideaissupportedbythefactthattherunningtimeingeneratingoptimal

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trajectoryforacompressedellipsoidwith=10:0isjustseveralseconds.Inthiscase,becauseofcompressedgeometry(forinstance,adiskyingalongitsaxisofsymmetry),theriskofdetectionaccumulatesslowerindirectionstransversaltoaradarandthosedirectionaretheonesproducinglowesttotallengthsfrompointAtopointB.Itisworthtomentionthatforsmallvaluesof,networksmoothingreducesLSArunningtimemoreeciently. Figure 4{26 illustratesdependenceofLSArunningtime,TLSA,onnumberoflabelstreated,Nlabels,ina3Dnetworkforasingleradarandvariousandlwithandwithoutnetworksmoothing.VariationsofandlhavenostrongeectonLSArunningtimebecauseofthepreprocessingprocedure.Therunningtimeisalmostlinearlydependsonthenumberoflabelstreated,which,inturn,isafunctionofnumberofnodesleftafterpreprocessing,Npr,smoothingconditionandcostupperbound,U,obtainedinpreprocess-ing.Figure 4{27 showsstrongcorrelationbetweenNlabelsandNprplottedforallandlinthecaseofasingleradar.WhileNlabelsisuniformlyreducedbysmoothingcondition,itmaybequitedierentforthesamevalueofNprbecauseofdierentcostupperboundsobtainedinpreprocessing.Obviously,thecloserUtooptimalcostis,thelowernumberoflabelswillbetreated.AccordingtoresultspresentedinTables 4{3 4{5 4{8 and 4{9 ,costupperboundsarenotcloseenoughto\true"riskvalues.Thisfactsuggeststodeveloppreprocessingproceduresobtainingmoreaccuratecostupperbounds.SuchpreprocessingmaybebasedonLagrangerelaxation[ 58 59 ]. Figure4{26: LSArunningtimeversusnumberoflabelstreated:3Dnetwork,singleradar

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Figure4{27: Numberoflabelstreatedversusnumberofnodesleftafterpreprocessing(3Dnetwork,singleradar):curves\1"and"2"correspondtoLSAandLSAwithsmoothing,respectively Theanalyticalapproach,basedoncalculusofvariations,reducestheoriginalproblemtosolvingthevectorialnonlineardierentialequation.Wederivedthisequationbasedonageneralformoftheriskfunctionalinthecasewithanarbitrarynumberofpassiveoractiveinstallations.Forthecaseofasingleinstallation,arbitraryellipsoidshapeandanyn,weobtainedananalyticalsolutiontothevectorialdierentialequation,whichisexpressedbyaquadrature.Accordingtonumericalexperimentsbasedontheanalyticalsolutions,weconcludedthat

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Obtainingananalyticalsolutiontothevectorialdierentialequationinthecasewithanarbitrarynumberofinstallationsisstillanopenissue.However,availabilityofananalyticalsolutioninthecaseofasingleinstallationsignicantlyfacilitatesconceptualunderstandingtheimpactofvariableRCSonthegeometryofoptimaltrajectoriesandtestingdiscreteoptimizationapproaches. Toaddressoptimaltrajectorygenerationin3DspaceinthecaseofvariableRCSandarbitrarynumberofradars,wedevelopeddiscreteoptimizationapproachbasedonnetworkowoptimization.Approximatingtheareaofinterestbya3Dnetworkwithaexiblestruc-tureandpresentingatrajectorybyapathinthisnetwork,NFoptimizationreducedopti-malriskpathgenerationwithaconstraintontrajectorylengthtotheConstrainedShortestPathProblem(CSPP).WesuggestedtosolvetheCSPPbyLabelSettingAlgorithm(LSA)withnetworksmoothing,whichisconsideredasanadjustmentforthealgorithmratherthanapropertyofnetworkstructure.Thiscondition,intendedforpreservingtrajectorysmoothnessand,asaresult,eliminatinginadmissiblearcsinthenetwork,canbeusedasanecessaryconstraintintrajectorygeneration.WetestedNFoptimizationapproachfor2Dand3Dnetworkswithandwithoutsmoothingcondition,withvariousellipsoidshapes,

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severalconstraintsontrajectorylengthinthecaseswithone,twoandthreeradars.Basedoncomputationalresultsoftestingexamples,wemadethefollowingconclusions Thischapterintroduced3DanalyticalmodeladdressingoptimaltrajectorygenerationwithvariableRCSsubjecttoaconstraintontrajectorylength.Developedanalyticalanddiscreteoptimizationapproachesarejustarststepinsolvingtheproposedmodelratherthanexhaustiveanswertothismatter.In3Dcase,otherNFalgorithmsforsolvingtheCSPPaswellasotherapproximationschemesfortheoriginalriskminimizationproblemmaybeaddressed.

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ThedissertationintroducedanewclassofdeviationmeasuresbygeneralizingtheaxiomsofstandarddeviationthroughtechniquesofconvexanalysisandthenanalyzedtheroleofdeviationmeasuresinportfoliooptimizationandtheCapitalAssetPricingModel.Thereplacementofstandarddeviationbyotherdeviations,suchasarisefromconditionalvalue-at-riskandotherrisknotions,inaccordancewithcurrenttrends,bynomeanscausestheclassicalapproachtooptimizationout-dated.Instead,itenrichesthatapproachbymakingadegreeofcustomizationavailable.One-fundtheoremsstillreignasawayofsimplication,eventhoughthedesignatedfunds,intheirdependenceonthedeviationmeasure,canbedierentfordierentclassesofinvestors.Utilizingtoolsofconvexanalysis,wedevelopedaschemefordeterminingoptimalityinproblemsofminimizingdeviationorrisk.Weshowedthatriskenvelopeshavemajorsignicanceinsolvingsuchproblemsandillustratedtheparticularsinanumberofsettings.Theresultsopenthewayformanyapplicationsandadvancesintheirnumericalmethodology.Furthermore,optimalitycanstillbecharacterizedbycovariancerelations.However,optimalitywithrespecttonetshortpositionsintheriskyinstrumentsmustbeanalyzedinadditiontooptimalitywithrespecttonetlongpositionsinordertodeterminehowaninvestormaywishtoactwithrespecttothecurrentrisk-freerate.Thecovariancerelationsthatareobtainedfurnishadditionalinformationaboutthebehaviorofriskyinstrumentsinvarioussituations.Thisinformationcouldbeusefulinpracticalanalysisevenifnolongerassociatedwithnotionsofequilibriuminwhichallinvestorsareattractedtoasinglemasterfund. Thedissertationproposeddrawdownmeasure,which,webelieve,isusefulforpracti-calportfoliomanagement.Thedrawdownmeasurepossessesallpropertiesofadeviationmeasureandmaybeconsideredasitsgeneralizationtoadynamiccase.Thedissertationdevelopedtheoptimizationtechniquesthatecientlysolvedanoptimalasset-allocationproblemwithConditionalDrawdown(CDD),MaximumDrawdown(MaxDD)andAverage 162

PAGE 174

Drawdown(AvDD),whichareparticularcasesofthedrawdownmeasure.Weformulatedand,forareal-lifeexample,solvedaportfoliooptimizationproblem.Thesetechniques,ifimplementedinamanagedaccounts'environmentwillallowatradingorriskmanagertoallocateriskaccordingtohis/herpersonalassessmentofextremedrawdownsandtheirdura-tiononhis/herportfolioequity.Analyzingthedierencebetweentheoptimalhistoricalandstochasticsolutions(thevectorsofinstrumentsweights),wefoundthatthesolutionsaresubstantiallydierentandfortheriskiestportfolios,thestochasticorre-sampledsolutions,providedanimprovementtotherisk-adjustedreturns.However,onaverage,re-sampledoptimalrisk-adjustedreturnsolutionsare20%to30%worsethanthosepredictedby1-pathsolutions.Thisresultsupportsthewide-spreadideathatusingonlyone(actuallyrealized)historicalpathleadtooverstatedandover-ttedresultswhichmaynotrealizeonaverageinthefuture.Althoughtheresultsofthere-sampledorstochasticoptimizationleadtoworseoptimalsolutions,thosesolutionsaremorerobusttouncertainfuture. Thedissertationdevelopedthemathematicalmodelforoptimaltrajectorygenerationwithaconstraintontrajectorylengthforanaircraftinatreatenvironment.Thethreatisassociatedwiththeriskofaircraftdetectionbyradars,sensorsorsurfaceairmissiles.Wemodelledtheaircraftbyasymmetricalellipsoidwiththeaxisofsymmetryorientingtrajectorydirection.Theriskofdetectionisproportionaltotheareaofellipsoidprojectionandreciprocaltothenth-powerofthedistancebetweentheaircraftandthisparticularinstallation.Wedevelopedanalyticalanddiscreteoptimizationapproachesforsolvingtheriskminimizationproblemsubjecttoaconstraintontrajectorylength.Theanalyticalapproachesreducedtheproblemtoanonlinearvectorialdierentialequation.Inthecaseofasingleinstallation,analyticalsolutiontothisequationisexpressedbyaquadrature,whichhasasimpleforminthecaseofa\spherical"aircraft.Obtainingananalyticalsolutiontotheequationinthecaseofanarbitrarynumberofinstallationsisstillanopenissue.Thedissertationstudiedtheimpactofavariableradarcross-section(RCS)andtrajectorylengthconstraintonoptimalvaluesoftheriskofdetectionandthegeometryofoptimaltrajectories.Basedoncomputationalresults,wefoundthattheoptimalriskismoresensitivetovariationoftheshapeofellipsoidthantovariationoftrajectorytotallength,however,variationoftheellipsoidshapehasnostrongeectonthegeometryofanoptimal

PAGE 175

trajectory.DiscreteoptimizationapproachreducedoptimaltrajectorygenerationsubjecttoaconstraintontrajectorylengthtotheConstrainedShortestPathProblem(CSPP).TheCSPPwassolvedbytheLabelSettingAlgorithm(LSA)withpreprocessingprocedureusing2Dand3Dnetworks.NumericalexperimentsrevealedstrongdependenceofLSArunningtimeontheshapeofellipsoid.Wesuggestednetworksmoothingconditionforpreservingtrajectorysmoothnessandeliminatinginadmissiblearcsinanetwork.TestingexamplesshowedthatnetworksmoothingconditionreducesLSArunningtime1.5{2.5times,whilepreservingaccuracyofoptimaltrajectories.Intestingexampleswithtwoandthreeradars,optimaltrajectorieswiththesameconstraintonthelengthbutdierentellipsoidshapesarerelativelyclosetoeachother,suggestingthat,ingeneral,ellipsoidshapehasnostrongeectonthegeometryofanoptimaltrajectory.

PAGE 176

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[15] D.Bertsimas,G.J.Lauprete,andA.Samarov,\Shortfallasariskmeasure:Propertiesoptimizationandapplications,"preprint,2000. [16] C.AcerbiandP.Simonetti,\Portfoliooptimizationwithspectralmeasuresofrisk,"preprint,2002. [17] H.KonnoandH.Shirakawa,\Equilibriumrelationsinthemean-absolutedeviationcapitalmarket,"Asia-PacicFinancialMarkets,vol.1,pp.21{35,1994. [18] R.T.Rockafellar,ConvexAnalysis,PrincetonUniversityPress,Princeton,NewJersey,1970. [19] F.Delbaen,\Coherentriskmeasuresongeneralprobabilityspaces,"preprint,2000. [20] R.T.RockafellarandS.P.Uryasev,\Conditionalvalue-at-riskforgenerallossdistri-butions,"JournalofBankingandFinance,vol.26,pp.1443{1471,2002. [21] R.T.RockafellarandS.P.Uryasev,\Optimizationofconditionalvalue-at-risk,"JournalofRisk,vol.2,pp.21{42,2000. [22] C.Acerbi,\Spectralmeasuresofrisk:acoherentrepresentationofsubjectiveriskaversion,"JournalofBankingandFinance,vol.26,pp.1505{1518,2002. [23] R.T.Rockafellar,S.Uryasev,andM.Zabarankin,\Deviationmeasuresingeneralizedlinearregression,"ResearchReport2002-9,DepartmentofIndustrialandSystemsEngineering,UniversityofFlorida,Gainesville,2002. [24] D.G.Luenberger,InvestmentScience,OxfordUniversityPress,Oxford,NewYork,1998. [25] R.T.Rockafellar,\Conjugatedualityandoptimization,"inConferenceBoardofMath.SciencesSeries,1974,number16,pp.77{91. [26] R.C.GrinoldandR.N.Kahn,ActivePortfolioManagement,McGraw-Hill,NewYork,1999. [27] S.J.GrossmanandZ.Zhou,\Optimalinvestmentstrategiesforcontrollingdraw-downs,"MathematicalFinance,vol.3,no.3,pp.241{276,1993. [28] J.CvitanicandI.Karatzas,\Onportfoliooptimizationunderdrawdownconstraints,"IMALectureNotesinMathematicsandApplications,vol.65,pp.77{88,1995. [29] A.Chekhlov,S.Uryasev,andM.Zabarankin,PortfolioOptimizationwithDrawdownConstraints,pp.263{278,RiskBooks,London,2003. [30] R.S.DemboandA.J.King,\Trackingmodelsandtheoptimalregretdistributioninassetallocation,"AppliedStochasticModelsandDataAnalysis,vol.8,pp.151{157,1992. [31] P.Jorion,ValueatRisk:ANewBenchmarkforMeasuringDerivativesRisk,IrwinProfessionalPublisher,1996. [32] C.AcerbiandD.Tasche,\Onthecoherenceofexpectedshortfall,"JournalofBankingandFinance,vol.26,pp.1487{1503,2002.

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[33] H.KonnoandH.Yamazaki,\Meanabsolutedeviationportfoliooptimizationmodelanditsapplicationtotokyostockmarket,"ManagementScience,vol.37,pp.519{531,1991. [34] M.R.Young,\Aminimaxportfolioselectionrulewithlinearprogrammingsolution,"ManagementScience,vol.44,no.5,pp.673{683,1998. [35] W.T.ZiembaandJ.M.Mulvey,WorldwideAssetandLiabilityModeling,CambridgeUniversityPress,1998. [36] \Soundpracticesforhedgefundmanagers,"AresponsetothePresident'sWorkingGroup(PWG)reportonLTCMcrisisbytheleadinghedgefunds:CaxtonCorporation,KingdonCapitalLLC,MooreCapitalManagementInc,SorosFundManagementLLC,TudorInvestmentCorporation,February2000. [37] B.EfronandR.J.Tibshirani,AnIntroductiontotheBootstrap,Chapman&Hall/CRC,NewYork,1993. [38] Y.K.ChanandM.Foddy,\Realtimeoptimalightpathgenerationbystorageofmassivedatabases,"inProceedingsoftheIEEENEACON1985,NewYork,1985,pp.516{521,InstituteofElectricalandElectronicsEngineers. [39] J.L.VianandJ.R.More,\Trajectoryoptimizationwithriskminimizationformilitaryaircraft,"AIAA,JournalofGuidance,ControlandDynamics,vol.12,no.3,pp.311{317,1989. [40] M.Zabarankin,S.Uryasev,andP.Pardalos,OptimalRiskPathAlgorithms,vol.66ofAppliedOptimization,pp.271{303,KluwerAcademicPublishers,Dordrecht,2002. [41] A.R.Washburn,\Continuousautorouters,withanapplicationtosubmarines,"Re-searchReportNPSOR-91-05,NavalPostgraduateSchool,Monterey,CA,1990. [42] A.RichardsandJ.P.How,\Aircrafttrajectoryplanningwithcollisionavoidanceusingmixedintegerlinearprogramming,"May2002,pp.1936{1941. [43] D.AssafandA.Sharlin-Bilitzky,\Dynamicsearchforamovingtarget,"JournalforAppliedProbability,vol.31,no.2,pp.438{457,1994. [44] S.J.Benkoski,M.G.Monticino,andJ.R.Weisinger,\Asurveyofthesearchtheoryliterature,"NavalResearchLogistics,vol.38,no.4,pp.468{494,1991. [45] J.N.EagleandJ.R.Yee,\Anoptimalbranch-and-boundprocedurefortheconstrainedpath,movingtargetsearchproblem,"Operationsresearch,vol.38,no.1,pp.110{114,1990. [46] B.O.Koopman,SearchandScreening:generalprincipleswithhistoricalapplications,PergamonPress,Elmsford,NewYork,1980. [47] M.Mangel,SearchTheory,Springer-Verlag,Berlin,1984. [48] L.D.Stone,TheoryofOptimalSearch,AcademicPress,NewYork,SanFrancisco,London,1975.

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[49] L.C.ThomasandJ.N.Eagle,\Criteriaandapproximatemethodsforpath-constrainedmoving-targetsearchproblems,"NavalResearchLogistics,vol.42,pp.27{38,1995. [50] A.R.Washburn,\Searchforamovingtarget:Thefabalgorithm,"OperationsRe-search,vol.31,no.3,pp.739{751,1983. [51] R.H.Bishop,D.L.Mackison,R.D.Culp,andM.J.Evans,\Spaceightmechanics1999,"1999. [52] J.N.Tsitsiklis,\Ecientalgorithmsforgloballyoptimaltrajectories,"IEEETrans-actionsonAutomaticControl,vol.40,no.9,pp.1528{1538,1995. [53] L.C.Polymenakos,D.P.Bertsekas,andJ.N.Tsitsiklis,\Implementationofe-cientalgorithmsforgloballyoptimaltrajectories,"IEEETransactionsonAutomaticControl,vol.43,no.2,pp.278{283,1998. [54] I.DumitrescuandN.Boland,\Algorithmsfortheweightconstrainedshortestpathproblem,"ITOR,vol.8,pp.15{29,2001. [55] I.DumitrescuandN.Boland,\Improvingpreprocessing,labellingandscalingalgo-rithmsfortheweightconstrainedshortestpathproblem,"preprint,2001. [56] M.DesrochersandF.Soumis,\Ageneralizedpermanentlabelingalgorithmfortheshortestpathproblemwithtimewindows,"INFOR,vol.26,pp.191{212,1988. [57] J.E.BeasleyandN.Christodes,\Analgorithmfortheresourceconstrainedshortestpathproblem,"Networks,vol.19,pp.379{394,1989. [58] G.Y.HandlerandI.Zang,\Adualalgorithmfortheconstrainedshortestpathproblem,"Networks,vol.10,pp.293{309,1980. [59] R.Hassin,\Approximatedschemesfortherestrictedshortestpathproblem,"Mathe-maticsofOperationsResearch,vol.17,pp.36{42,1992.

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In1991InishedtheRepublicanPhysical-MathematicalSchoolattachedtoformerKievStateUniversity.BothmyM.S.andPh.D.degreesIearnedinappliedmathematicsfromKievTarasSchevchenkoNationalUniversityin1996and1999,respectively.In1999IbecameaPh.D.studentinthedepartmentofIndustrialandSystemsEngineeringattheUniversityofFlorida. 169


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OPTIMIZATION APPROACHES IN RISK MANAGEMENT
AND FINANCIAL ENGINEERING

















By

MICHAEL ZABARANKIN

















A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY

UNIVERSITY OF FLORIDA


2003




































Copyright 2003

by

Michael Zabarankin
















ACKNOWLEDGMENTS

I thank my supervisors, Prof. Stanislav Uryasev and Prof. R. Tyrrell Rockafellar, and

the members of my Ph.D. committee for their help and guidance. I am also grateful to my

parents for their constant support.
















TABLE OF CONTENTS


ACKNOW LEDGMENTS .................................

LIST OF TABLES ............................. ... .....

LIST OF FIGURES .. .. ... ... ... .. ... ... ... .. ... ... ... .

A B ST R A C T . . . . . . . . . ..


page

iii

vi

vii

x


CHAPTER


1 INTRODUCTION ..................................

2 PORTFOLIO ANALYSIS WITH GENERAL DEVIATION MEASURES ...


2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10


Introduction . . . . . . . .
Deviation and Risk . .. ... .. ... ... ... .. ... ..
Portfolio Framework .. ......................
Fundamental Optimization Problem .. ..............
Efficient Sets and Frontiers .. ..................
Threshold Determination for the Risk-Free Rate .. .........
Characterization of Optimal Portfolios .. ..............
Specialized CAPM-like Relations .. ................
Multiplier Derivation of Thresholds .. ................
C conclusions . . . . . . . .


3 DRAWDOWN MEASURE IN PORTFOLIO OPTIMIZATION .........

3.1 Introduction . . . . . . . . .
3.1.1 Drawdown Regulations in Real Trading Strategies .........
3.1.2 Drawdown Notion in Theoretical Framework ............
3.2 M odel Development .............................
3.2.1 Dynamic Performance Functionals ................
3.3 Absolute Drawdown for a Single Sample Path ..............
3.3.1 Maximum, Average and Conditional Drawdowns .........
3.3.2 Conditional Value-at-Risk and Conditional Drawdown Properties
3.3.3 Mixed Conditional Drawdown ....................
3.4 Optimization Techniques for Conditional Drawdown Computation .
3.5 Multi-scenario Conditional Value-at-Risk and Drawdown Measure ...
3.5.1 Multi-scenario Conditional Value-at-Risk .. ............
3.5.2 Drawdown Measure .. .....................
3.6 Portfolio Optimization with Drawdown Measure .. ..........
3.6.1 Reduction to Linear Programming Problem .. ..........
3.6.2 Efficient Frontier .. ......................










3.7 Drawdown Measure in Real-life Portfolio Optimization . ... 86
3.7.1 Static Asset Allocation .................. ... .. 86
3.7.2 Historical Data and Scenario Generation . . 88
3.7.3 Numerical Results. .................. ...... .. 91
3.8 Conclusions .................. ............... .. 92

4 TRAJECTORY OPTIMIZATION IN A THREAT ENVIRONMENT ..... 106

4.1 Introduction. .................. .............. .. 106
4.2 Model Development . . . ......... 110
4.3 Minimization of a Functional with Nonholonomic Constraint and Movable
End Point ....... .... ... .......... ...... 114
4.4 Calculus of Variations Approach ................ . .. 117
4.5 Network Flow Optimization Approach ..... . . 134
4.5.1 Network Structure ....... . . . .. 134
4.5.2 Smoothing Procedure and Curvature Constraint . ... 136
4.5.3 Approximation Scheme . . . ..... .... 138
4.5.4 Reduction to the Constrained Shortest Path Problem ...... 141
4.5.5 The Label Settings Algorithm with Preprocessing Procedure 142
4.6 Numerical Experiments .................. ...... 145
4.6.1 2D Network Optimization . . . ... 146
4.6.2 3D Network Optimization in the Case of a Single Radar . 147
4.6.3 3D Network Optimization in Cases with Two and Three Radars 149
4.7 An !i, -i, of Computational Results ............. . 152
4.8 Conclusions .................. ............... .. 159

5 DISCUSSION ................... ................ 162

REFERENCES ................... ......... ....... 165

BIOGRAPHICAL SKETCH .................. ............ .. 169
















LIST OF TABLES
Table page

3-1 Average Drawdown optimization: 1 sample path ............... ..96

3-2 Average Drawdown optimization: 100 sample paths . . ..... 97

3-3 Average Drawdown optimization: 300 sample paths . . ..... 98

3-4 0.8-Conditional Drawdown optimization: 1 sample path . . .... 99

3-5 0.8-Conditional Drawdown optimization: 100 sample paths . ... 100

3-6 0.8-Conditional Drawdown optimization: 300 sample paths . ... 101

3-7 Maximum Drawdown optimization: 1 sample path . . ..... 102

3-8 Maximum Drawdown optimization: 100 sample paths . . .... 103

3-9 Maximum Drawdown optimization: 300 sample paths . . .... 104

4-1 Optimal risk, AL, C and C's estimate .................. 133

4-2 Coefficients for the Gaussian quadrature for J = 16 . . ... 140

4-3 2D network preprocessing: single radar .................. .. 147

4-4 2D network optimization with LSA: single radar ..... . ..... 148

4-5 3D network preprocessing: single radar .................. .. 150

4-6 3D network optimization with LSA: single radar .. . 150

4-7 3D network optimization with LSA & smoothing condition: single radar .150

4-8 3D network optimization: two radars .................. 153

4-9 3D network optimization: three radars .................. .. ..153
















LIST OF FIGURES
Figure page

2-1 C'l --ni I! efficient set: expected gain versus standard deviation . ... 22

2-2 Reduced optimization perspective .................. ... 27

2-3 Efficient sets in coordinates standard for graphs of functions . ... 29

2-4 Efficient sets in coordinates traditional for finance .............. ..30

2-5 Threshold values for the risk-free rate .................. .. 36

2-6 Threshold interval tied to corner behavior .................. ..40

3-1 Time series of uncompounded cumulative rate of return w and corresponding
absolute drawdown (. .................. .. ...... 65

3-2 Drawdown time series ( and indicator function I{c . . ..... 67

3-3 Function 7r (s) .................. ............... .. 68

3-4 Inverse function tr.(a) ................. . . 68

3-5 Drawdown surface and threshold plane .................. .. 80

3-6 Efficient frontiers: Average Drawdown .................. .. 93

3-7 Optimal ii-]:- .liusted returns: Average Drawdown . . ..... 93

3-8 Efficient frontiers: 0.8-Conditional Drawdown ................ ..94

3-9 Optimal i-1:-.- .lusted returns: 0.8-Conditional Drawdown . ... 94

3-10 Efficient frontiers: Maximum Drawdown ................ 95

3-11 Optimal ii-1:- .lusted returns: Maximum Drawdown . . ..... 95

4-1 Ellipsoid shape is defined by parameter r = b/a ..... . ..... 111

4-2 3D model for optimal path planning in a threat environment . ... 112

4-3 Function p( ) sin ) . ............... . 126

4-4 Optimal t if I, .1 for the case of -1,!. i. with different constraints on the
length, 1,, in the tI '.i I, i. -' plane ................ .. 127

4-5 Optimal t i'. I. 1. for the case of -1'!. i. with different constraints on the
length, 1,, in 3D space .................. ........ .. .. 128










4-6 Comparison of optimal t i.1 -ii ,s in trajectories' plane for the cases with a
single sensor (n = 2) and single radar (n = 4) with the same constraint on
the length, 3.2 ....... ........ ...... .. ...... 128

4-7 Optimal trajectories for sphere (K = 1.0) and elongated ellipsoids (K = 0.5,
0.1) for n =4 and 3.2 shown in tf i. II. .'y's plane . . ... 132

4-8 Optimal trajectories for sphere (K = 1.0) and compressed ellipsoids (K = 2.0,
10) for n = 4 and 1, 3.2 shown in trajectory's plane . .... 132

4-9 Optimal t1 ,i.i l.,i. for sphere (K = 1.0), elongated (K = 0.1) and com-
pressed (K = 2.0) ellipsoids for n = 4 and 1, 3.2 in 3D space ..... ..133

4-10 Structure of arcs in every node in a 2D network: "1" axis arcs, "2"
diagonal arcs, "3" long diagonal arcs ................... .... 136

4-11 Structure of arcs in every node in a 3D network ..... . ..... 137

4-12 Network smoothing and curvature constraint ................ ..137

4-13 3D network for solving the risk minimization problem . . ... 139

4-14 Comparison of analytical and discrete optimization t1 i i. I. .1 i. s for the case of
sphere (K = 1.0), n = 4 and different length constraints, 1,, in t, i.. i i .'
plane ................... .... ............. 148

4-15 Comparison of analytical and discrete optimization t i i, I .1- i. s for elongated
(n = 0.1) and compressed (K = 2.0) ellipsoids for n = 4 and the same
constraint on the length 3.2 in tf i I. 1 i. -' plane . .... 149

4-16 Comparison of analytical and discrete optimization t! I .1 i, s- for sphere
(n = 1.0), n = 4 with different length constraints, 1,, in 3D space . 151

4-17 Comparison of analytical and discrete optimization 11 i I, ..1 i, s for elongated
ellipsoid K = 0.1 and parameters n = 4, 1 = 3.2 in 3D space . ... 151

4-18 Comparison of analytical and discrete optimization t li. I 1i. for com-
pressed ellipsoid K = 2.0 and parameters n = 4, 1 = 3.2 in 3D space 152

4-19 Optimal t1, i. i bi. s- in the case of two radars for compressed ellipsoid (K =
2.0), sphere (K = 1.0) and elongated ellipsoid (K = 0.1) with the same
length constraint, = 3.2 .................. ....... .. 153

4-20 Front view: optimal trajectories in the case of two radars for compressed
ellipsoid (K = 2.0), sphere (K = 1.0) and elongated ellipsoid (K = 0.1) with
the same length constraint, = 3.2 .................. .. ..154

4-21 View from above: optimal trajectories in the case of two radars for com-
pressed ellipsoid (K = 2.0), sphere (K = 1.0) and elongated ellipsoid
(n = 0.1) with the same length constraint, = 3.2 . . .... 154

4-22 Optimal trajectories in the case of three radars for compressed ellipsoid (K =
2.0), sphere (K = 1.0) and elongated ellipsoid (K = 0.1) with the same
length constraint, = 3.2 .................. ....... .. 155










4-23 Front view: optimal trajectories in the case of three radars for compressed
ellipsoid (K = 2.0), sphere (n = 1.0) and elongated ellipsoid (K = 0.1) with
the same length constraint, l = 3.2 .................. .. ..155

4-24 Side view: optimal t i. i i.1ii. in the case of three radars for compressed
ellipsoid (K = 2.0), sphere (K = 1.0) and elongated ellipsoid (K = 0.1) with
the same length constraint, = 3.2 .................. .. ..156

4-25 Dependence of LSA running time on the shape of ellipsoid, K (3D network,
single radar): curve "1" no smoothing, curve "2" -smoothing is used 157

4-26 LSA running time versus number of labels treated: 3D network, single radar 158

4-27 Number of labels treated versus number of nodes left after preprocessing (3D
network, single radar): curves "1" and "2" correspond to LSA and LSA
with -iri. .... i1in respectively .................. ..... 159
















Abstract of Dissertation Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy

OPTIMIZATION APPROACHES IN RISK MANAGEMENT
AND FINANCIAL ENGINEERING

By

Michael Zabarankin

August 2003

Chair: Stanislav Uryasev
M i, Ir Department: Industrial and Systems Engineering

The dissertation is dedicated to development and application of analytical and discrete

optimization approaches in Risk Management and Financial Engineering. Through tech-

niques of convex .11 i,-, -i-. the dissertation rigorously generalizes the axiomatic properties

of standard deviation to a new class of deviation measures. The role of deviation mea-

sures in optimization and Financial Engineering is .111 '1-,. ..1 Optimality conditions based

on concepts of convex i_ i1-, -i-. but relying on the special features of deviation measures

are derived in support of a variety of potential financial applications, such as portfolio

optimization and the Capital Asset Pricing Model. The dissertation introduces a new one-

parameter family of risk measures called Conditional Drawdown (CDD). These measures

of risk are functionals of the portfolio drawdown (underwater) curve considered in active

portfolio management. Mathematical properties of the CDD are studied; and efficient opti-

mization techniques for CDD computation and solving asset allocation problems with CDD

measure are proposed. A real-life asset-allocation problem is .1,11-,...1 and solved using

the proposed measures. The dissertation develops a model and corresponding analytical

and discrete optimization approaches for routing an aircraft in a threat environment. The

threat is associated with the risk of aircraft detection by radar or sensor installations. The

model considers the aircraft in three dimensional space with a variable radar cross-section










and an arbitrary number of installations. The risk minimization problem subject to a con-

straint on trajectory length is reduced to network flow optimization. In the case of a single

installation, an analytical solution for this problem is obtained.
















CHAPTER 1
INTRODUCTION

The dissertation considers and develops analytical and discrete optimization ap-

proaches to various Risk Management and Financial Engineering applications. Chapter

2 considers generalized measures of deviation, as substitutes for standard deviation, in a

framework like that of classical portfolio theory for coping with the uncertainty inherent in

achieving rates of return beyond the risk-free rate. Such measures, associated for example

with conditional value-at-risk and its variants, can reflect the different attitudes of different

classes of investors. They lead nonetheless to generalized one-fund theorems as well as to

covariance relations which resemble those commonly used in capital asset pricing models

(CAPM), but have wider interpretations. A more customized version of portfolio optimiza-

tion is the aim, rather than the idea that a single i_, i- r fund" might arise from market

equilibrium and serve the interests of all investors.

The results cover discrete distributions along with continuous distributions; and there-

fore are applicable in particular to financial models involving finitely many future states,

whether introduced directly or for purposes of numerical approximation. Through tech-

niques of convex mI i', -i-. our study deals rigorously with a number of features that have

not been given much attention to this subject, such as solution nonuniqueness, or nonex-

istence, and a potential lack of differentiability of the deviation expression with respect to

the portfolio weights. Moreover we address in detail the previously neglected phenomenon

that, if the risk-free rate lies above a certain threshold, a master fund of the usual type will

fail to exist and need to be replaced by one of an alternative type, representing a "net short

1p '..-i 1 instead of a "net long p1I ... ,,11 in the risky instruments.

Chapter 2 develops the Capital Asset Pricing Model (CAPM) based on generalized

deviation measures in the general case of stock distributions. The CAPM is intended for

finding an efficient portfolio of financial instruments available in the market; and pricing

these instruments with respect to an efficient portfolio. The risk and expected rate of










return are two main characteristics associated with a portfolio. The efficient portfolio is an

optimal solution for a problem of portfolio risk minimization with constraint on the portfolio

expected rate of return. Using apparatus of convex .11 i-, -1-. we extended classical CAPM

to the class of deviation measures under the assumption that the risk-free instrument is

available in the market. It turned out, that, theoretically, there is a critical set for the values

of the rate of return of the risk-free instrument, for which an appropriate CAPM cannot

be constructed. A theorem establishing the structure of the critical set is formulated and

proved. The critical set must be a closed finite interval. One of main results is formulated

in the following form: if the rate of return of the risk-free instrument does not belong to

the critical interval, then the vector composed by the stock's expected rates of return must

belong to the set of generalized gradients of a deviation measure calculated for the efficient

portfolio. This result is illustrated by several examples using classical measures such as

standard deviation and Conditional Value at Risk.

Chapter 3 proposes a new one-parameter family of risk measures called Conditional

Drawdown (CDD). These measures of risk are functionals of the portfolio drawdown (un-

derwater) curve considered in active portfolio management. For some value of the tolerance

parameter a, in the case of a single sample path, drawdown functional is defined as the

mean of the worst (1 a) 100% drawdowns. The CDD measure generalizes the notion

of the drawdown functional to a multi-scenario case and can be considered as a generaliza-

tion of a deviation measure to a dynamic case. The CDD measure includes the Maximal

Drawdown and Average Drawdown as its limiting cases. Chapter 3 studies mathematical

properties of the CDD and develops efficient optimization techniques for CDD computation

and solving asset-allocation problems with a CDD measure. For a particular example, we

find the optimal portfolios for cases of Maximal Drawdown, Average Drawdown, and sev-

eral intermediate cases between these two. The CDD family of risk functionals is similar

to Conditional Value-at-Risk (CVaR), which is also called Mean Shortfall, Mean Access

loss, or Tail Value-at-Risk. Some recommendations on how to select the optimal risk func-

tionals for getting practically stable portfolios are provided. Chapter 3 solves a real-life

asset-allocation problem using the proposed measures.










Chapter 4 deals with Risk Management in military applications. It develops a model

and analytical and discrete optimization approaches for routing an aircraft in a threat en-

vironment. The model considers an aircraft's trajectory in three dimensional (3D) space;

and presents the aircraft by a symmetrical ellipsoid with the axis of symmetry determining

trajectory direction. The threat is associated with the risk of aircraft detection by radars,

sensors or surface air missiles. Using the analytical and discrete optimization approaches,

the deterministic problem of finding an aircraft's optimal risk trajectory subject to a con-

straint on the trajectory length has efficiently been solved. Through techniques of Calculus

of Variations, the analytical approach reduces the original risk optimization problem to a

vectorial nonlinear differential equation. In the case of a single detecting installation, the

solution to this equation is expressed by a quadrature. The discrete optimization approach

approximates the original problem by the Constrained Shortest Path Problem (CSPP) for

a 3D network with a flexible structure. The CSPP has been solved for various ellipsoid

shapes and different length constraints in the cases of several radars. The impact of ellip-

soid shape on the geometry of an optimal ti i I *r'y as well as impact of variable RCS on

performance of the discrete optimization approach have been .111 i- ,. 1 and illustrated with

several numerical examples.
















CHAPTER 2
PORTFOLIO ANALYSIS WITH GENERAL DEVIATION MEASURES

2.1 Introduction

The minimization of variance, or equivalently standard deviation, is a universally famil-

iar feature of classical portfolio theory. It has been subjected to criticism, however, because

standard deviation does not adequately account for the phenomenon of "fat ii!- in loss

distributions, and moreover penalizes ups and downs equally. In everyday applications, a

more common tool than standard deviation is value-at-risk, VaR. But that too has been

controversial because of mathematical shortcomings (lack of convexity and monotonicity, as

well as reasonable continuity) and its inability to respond to the magnitude of the possible

losses below the threshold it identifies. A related concept, conditional value-at-risk, CVaR

(also known as expected shortfall and tail-VaR), has proved to be superior in these respects

and therefore more suited for the optimization of choices in financial management.

For sound methodology in finance, a theory relating these different approaches and

allowing their effects to be compared is essential. A very important step toward such

a comprehensive theory was made by Artzner et al. [1], who introduced the notion of

a coherent risk measure, demonstrating that VaR did not provide coherency. Although

extensive motivation was given by Artzner et al. [1], i .1.~ i,; y" has not fully taken hold

in the community concerned with applications. One obstacle has been their axiom [1] that

deals with the effect of adding a constant to the return of a financial random variable. Many

have balked at that axiom, despite its explanation.

The reason for this difficulty may well be confusion over the meaning of !. -- '. Artzner

et al. [1] referred to loss as a negative outcome, whereas for many practitioners it is assumed

to refer to a shortfall relative to expectation. This is compounded by the fact that, in

applications, VaR and CVaR are typically invoked to measure such a shortfall, instead of

measuring absolute loss itself.










There is more to this than might appear on the surface. On a space of random variables

X, it is one thing to apply a risk measure to X C for some fixed constant C, and quite

another to apply it to X EX. A basic aim of this chapter is to make clear that risk

measures, more or less in the sense of Artzner et al. [1], when applied to X EX, yield a

separate class functionals that can aptly be called deviation measures. Deviation measures

satisfy different axioms and have their own significance, with standard deviation just being

one example that happens to be symmetric.

In classical portfolio theory, investors respond to the uncertainty of profits by selecting

portfolios that minimize variance, or equivalently standard deviation, subject to achieving

a specified level in expected gain [2, 3]. The well known "one-fund Ii, *' 11 [4, 5] stipulates

that this can be accomplished in terms of a single iii -i, r fund" portfolio by means of a

formula that balances the amount invested in that portfolio with the amount invested at the

current risk-free rate. The ..... irl inii:_ "CAP\ theorem furnishes covariance relations

with respect to the master fund portfolio which are interpreted as having a potential for

predicting the market behavior of financial instruments [6, 5]. An overview of "CAP I

results was provided by Grauer [7]. Extensions of the theory to account for higher moments

than variance were considered by Samuelson [8].

N.. .-, 1 i-,-. other approaches to uncer' ,ii -, have gained in popularity. Portfolios are

being selected on the basis of characteristics such as value-at-risk (VaR), conditional value-

at-risk (CVaR), or other properties proposed for use in risk assessment. These measures

have no pretension of being universal, however, VaR and CVaR depend, for instance, on the

specification of a confidence level parameter, which could vary among investors. Instead,

what is apparent in the alternative approaches currently being touted is a move toward a

kind of partial customization of responses to risk, while still avoiding (as impractical) a

reliance on specifying individual utility functions. Utility functions in finance have been

the theme in numerous publications [9, 10].

A question in this evolving environment is whether any parallels to the classical theory

persist when the minimization of standard deviation is replaced by something else. Re-

searchers have already looked into the possibilities in several special cases, under various

limiting assumptions (recognized explicitly or imbedded implicitly). Our goal, in contrast,










is to demonstrate that important parallels with classical theory exist much broader and

more, despite technical hurdles. By showing this, we hope to bring out features that have

not completely been .,11 i-,. .1. or even perceived, in the past.

We focus on the general deviation measures that were developed axiomatically by

Rockafellar et al. [11]. These were shown to be closely related to, yet distinct from, risk

measures in the sense of Artzner, Delbaen, Eber and Heath [1]; and to enjoy a number of

attractive characterizations. Our idea is to substitute such a deviation measure for standard

deviation in the setting of classical theory and investigate the consequences rigorously in

detail. Furthermore, we aim at doing so, for the first time, in cases where the rates of return

may have discrete distributions as well as cases where they have continuous distributions.

Our central result says that a basic one-fund theorem holds regardless of the particular

choice of the deviation measure, but with certain modifications. The optimal risky portfolio

need not be unique (although it often might be). More significantly, the full study of

optimality in the context of an available risk-free instrument requires an understanding not

only of an efficient frontier for risky portfolios at cost 1, but also of such a frontier for

risky portfolios at cost -1. We establish that the second frontier comes into 1p1 -, when the

risk-free rate of return exceeds a certain threshold. Moreover, we show how that threshold

can be calculated by solving an auxiliary optimization problem.

The need for an efficient frontier referring to "net short positions," along with the usual

one for "net long positions," is not surprising, in view of the diversity of measures that

investors may be using. In line with their different opinions about risk, some investors may

find the risk-free rate high enough to warrant borrowing from the market and investing that

money risk-free, while others will prefer a fund in which the !, i,'_," outweigh the -.! '! ts."

Sharpe [6, p. 507] discussed an interesting analogy in terms of a stock index futures contract

which might even consist entirely of short positions.

The emergence of a variety of different master funds, optimal for different deviation

measures, is an inescapable outcome of any theory which, like ours, attempts to cope with

the current tendency toward customization in portfolio optimization. What does it mean

for CAPM, though? A master fund identified with respect to the wishes of one class of

investors can no longer be proposed as obviously furnishing input for factor mi1 i-, -i- of the










market as a whole, because the financial markets react to the wishes of all investors. A

master fund, in our general sense, can no longer be interpreted as associated with a sort of

universal equilibrium.

Whether some such master funds, individually or collectively, might nonetheless turn

out to be valuable in factor .111- ,-i-. is an issue outside the scope of this chapter. We

do, however, prove a theorem that resembles the classical one in providing CAPM-like

covariance relations, which serve to characterize the master funds. We place the generalized

/3 coefficients in these relations in a framework from which the results in this category that

other researchers have obtained earlier, in special contexts, can readily be derived.

Included in that way are results, subject to restrictions, for the deviation measures

associated with mean-lower partial moments [12, 13], conditional value-at-risk [14, 15, 16],

and with mean absolute deviation [17]. Our CAPM-like results have far fewer restrictions.

They do not rely on the existence of density functions for the distributions that arise, or even

on the absence of probability atoms (corresponding to jumps in the distribution functions),

which would preclude applications to discrete random variables. Furthermore, they do not

require the differ 'Ji i61.1-,i of the deviation with respect to the parameters specifying the

relative weights of the instruments in the portfolio. This broad advance has been made

possible by our utilization of techniques of convex .111 i1-, -i [18] beyond standard calculus,

along with strict adherence to the fundamental principles of optimization theory.

Lack of familiarity with the mathematics of optimization has been a handicap in some

of the finance literature in this area, going all the way back to Markowitz. For example,

Markowitz [3] excluded short positions by constraining the portfolio weights to be non-

negative. He neglected, however, to take into account that Lagrange multipliers for those

inequality constraints could come into 1.1 -,. in which case a closed-form solution to the

optimality conditions for a master fund would be impossible. Supposing that the multi-

pliers can be taken to be zero is equivalent (because of convexity) to supposing that, if

shorting were allowed, there would ir-, v--,- be no short positions at optimality. There is

no support for that conviction, however, and indeed, numerical calculations are known to

produce quite different answers when shorting is allowed and when it is not. Similar loose-

ness about whether solutions to optimization problems even exist must be the reason why










the magnitude of the risk-free rate was not perceived to have an effect, and the need for

master funds representing net short positions went undetected. The need for allowing at

least some short positions in a master fund was emphasized by Sharpe [6, pp. 500, 505].

Even though the generalized CAPM-like 13 coefficients we study lack the iii. -i,"

connotations ascribed to the classical /3's, they capture characteristics which may be valu-

able in assessing the riskiness of financial instruments. In every case, the f3 of an instrument

is the ratio of a covariance expression to the generalized deviation of the random variable

giving the rate of return of a particular master fund. Instead of the covariance between the

rate of return of the instrument and the rate of return of the master fund, however, the f3 is

based on the covariance between the rate of return of the instrument and a special random

variable extracted from the rate of return of the master fund, as dictated by the particular

deviation measure. For instance

The f3 for lower semideviation measures the dependence of the instrument's rate of
return on the master fund's downside (this being just the part of the fund's random
variable that tracks underperformance).

The f3 for conditional value-at-risk relative to a chosen a-tail of losses assesses how
the instrument reacts when the master fund for this situation dips into that tail.

The f3 for a mixture of conditional value-at-risk involving several different loss tails
provides a balanced assessment based on the possibilities of poor performance of the
master funds associated with those tails.

The f3 for the lower-range deviation of an instrument measures its reaction to the
worst-case performance of a certain master fund.

Such examples, worked out near the end of the chapter, reveal that, despite departures

from classical portfolio theory in interpretation, the passage to general deviation measures

is capable of uncovering information that could be of considerable interest in financial

applications.

2.2 Deviation and Risk

We start by reviewing what we mean by deviation measures and explaining how they

are paired with risk measures, which thereby give rise to a spectrum of useful examples.

We consider a space Q, the elements w of which can represent future states or individual

scenarios (perhaps just finitely many), and suppose it to be supplied with a probability

measure P and the other technicalities that make it a legitimate probability space. We









treat as random variables (r.v.'s) the (measurable) functions X on Q for which E[X2] < oo;

the space of such functions will be denoted, for short, by 2(Q). For X in 2(Q), the mean

/t(X) and variance T2(X) are well defined, in particular:

(X) = EX = X(w)dP(w),
(2.1)
2(X) =E[X EX]2 f=[X(w) p(X)]2dP().

To assist in working with constant r.v.'s, X(w) C, the letter C will i1,---, denote a
constant in the real numbers IR.

By a deviation measure will be meant a functional D that assigns to each random

variable X (understood to be in (Q) 1.,-- -, ,) a value D(X) in accordance with the following

axioms:

(Dl) D(X + C)= D(X); equivalently, D(X) = D(X EX) for all X,

(D2) D(0) = 0, and D(AX) = AD(X) for all X and A > 0,

(D3) D(X + X') < D(X) + D(X') for all X and X',

(D4) D(X) > 0 for nonconstant X, whereas D(X) = 0 for constant X.

These axioms come from our paper [11], where the notion of a general deviation measure

was first formulated at this level.1 The equivalence in D1 is evident from taking C to equal
-EX, and on the other hand, noting that [X + C] E[X + C] = X EX for any constant

C.
The example of standard deviation, D(X) = a(X), dominates classical portfolio theory

and is symmetric in the sense that D(-X) = D(X). Similar ii, .i--, _,1, I li: examples of

deviation measures -, li--, i_:_- the axioms include the standard semideviations D(X)

o- (X) and D(X) =- (X), where

o2(X) =E[maxEX X,0}2], 2(X) = E[max{X EX, 0}2]. (2.2)



1 Malevergne and Sornette [13] described a class of measures axiomatically in terms of
Dl, D2 (effectively), and the version of D4 requiring only weak inequality, but no D3. Such
measures lack convexity and other properties.









The first of these emphasizes the downside of X, while the second emphasizes the upside.

A very different pair of examples, likewise oriented to downside or upside, is furnished by

the lower range and the upper range,

D(X) = EX inf X, D(X) = sup X EX, (2.3)


where infX and supX denote the -- i i iI" infimum and supremum of X(w) over w E Q

(obtained by disregarding subsets of Q having probability 0). For either of these, it is

possible for some r.v.'s X that D(X) = oo, which is allowed by the axioms. Of course, both

are sure to be finite in the case of a finite, discrete p, l.1. 1 dil l- space Q.

Another class of deviation measures, of increasing interest now in applications, arises

from conditional value-at-risk, CVaR, as an alternative to value-at-risk, VaR. A brief discus-

sion of risk measures, in contrast to deviation measures, will lay the platform for introducing

this class properly.

By an expectation-bounded risk measure will be meant a functional R that assigns

values R(X) to random variables X in such a way that

(R1) R(X + C) = R(X) C for all X and constants C,

(R2) R(0) = 0, and R(AX) = 7R(X) for all X and all A > 0,

(R3) R(X + X') < R(X) + R(X') for all X and X',

(R4) R-(X) > E[-X] for all nonconstant X, whereas R(X) = E[-X] for constant X.

Axiom R4 is the property we explicitly mean by ::I I' i' i.-'-.." 'ii. II. I--I (The equation

part of R4 is already a consequence of R1, so the strict inequality for nonconstant X is the

chief assertion.)

Artzner, Delbaen, Eber and Heath in their landmark contribution to risk theory were

the first to consider risk measures from a broad perspective, but they concentrated instead

on functionals R -I i-f-, i :_- R1, R2, R3 and, instead of R4, the monotonicity axiom:

(R5) R(X) < R(X') when X > X'.

They called these coherent risk measures. (Actually, they posed R5 in a seemingly weaker

form, namely R(X) < 0 when X > 0, which is equivalent to the present R5 under the other

axioms. Also, they had somewhat different version R1, tailored to the use of an investment









instrument, but the version used here was subsequently adopted by Delbaen [19].) Property

R5 is natural and even crucial for many purposes, and we will be concerned with it as well.

However, we forgo it in the basic definition of an expectation-bounded risk measure in order

to capture a fundamental pairing between risk measures and deviation measures. The risk-

boundedness axiom R4, first spelled out in our own earlier work, is needed for the following

result, where it emerges as the counterpart to deviation axiom D4.

Theorem 1 (deviation vs. risk [11]). Deviation measures correspond one-to-one with

expectation-bounded risk measures under the relations

(a) D(X) = R(X EX),

(b) R(X) E[-X] + D(X).
Specifically, if 7R is an expectation-bounded risk measure and D is defined by (a), then D

is a deviation measure that yields back R through (b). On the other hand, if D is any

deviation measure and 7R is defined by (b), then 7R is a risk measure that yields back D

through (a). In this correspondence, 7R has the further property R5, yielding coherency, if

and only if D has the further property that

(D5) D(X) < EX inf X for all X.

In accordance with the final part of Theorem 1, we call D a coherent deviation measure

when it satisfies D5 along with Dl, D2, D3, and D4.

The deviation measure D(X) = pa(X) for any p E (0, oc) is paired, for instance, with

7R(X) = po(X) p(X), whereas the lower-range deviation measure D(X) = EX inf X is

paired with the maximum loss risk measure 7?(X) = sup[-X]. Coherency is lacking in the

first example but present in the second example.

Recall next that for any a E (0, 1) the value-at-risk of X at level a is defined by

VaRa(X) = inf{ z I P{X < z} > a}, (2.4)

and then the corresponding conditional value-at-risk is


[expectation of X in its lower a-tail distribution].


CVaR,(X)


(2.5)









The expectation in question is the same as the conditional expectation of X subject to

X < -VaR (X) when P{ X X -VaR (X)} = 0, but refers more generally to the

expectation of the r.v. whose cumulative distribution function F, is obtained from the

cumulative distribution function F for X by taking F,(z) = F(z)/a when z < -VaR,(X)

and F,(z) = 1 when z > -VaR,(X). This form of the definition of CVaR,(X) was

developed by Rockafellar and Uryasev [20], earlier Rockafellar and Uryasev [21] concentrated

only on the case of continuous distribution functions. Acerbi [22] has shown that this value

can also be obtained from the formula

CVaR (X) VaRp(X)dp. (2.6)
a o

The important thing for our purposes here is that a coherent risk-deviation pair in the

pattern of Theorem 1 is obtained by taking

R(X) = CVaR,(X), D(X) = CVaR,(X EX). (2.7)

In contrast, the functional R(X) = VaR,(X) fails in general to satisfy axioms R3, R4 and

R5, and correspondingly D(X) = VaR,(X-EX) fails to satisfy D3, D4 and D5. Rockafellar

et al. [11] provided more detail on these examples, as well as their generalization to "mixed"

CVaR having -I '. i representations.

The abundance of different deviation measures leads naturally to the question of how

to distinguish among them for application purposes. An important guideline is available in

terms of the notion of a risk envelope. By this is meant a subset Q of 2(Q), with elements

Q appropriately to be called risk monitors, which satisfies the axioms

(Ql) Q is convex, closed, and contains 1 (constant r.v.),

(Q2) EQ = 1 for every Q E Q,

(Q3) for every nonconstant X e 2(Q) there is a Q E Q such that E[QX] < EX.

A risk envelope Q is called coherent if it satisfies, in addition,

(Q4) Q > 0 for every Q e Q.

When Q is coherent, its elements Q can be interpreted as i,,.'1,,ii1,//:/;: li functions

on Q relative to the underlying probability measure P on Q (which itself corresponds to









the element 1 E Q as its density). For a density function Q, the probability of a subset

o c is foo Q(w)dP(w), whereas the expectation of a random variable X is EQ[X] =

fo X(w)Q(w)dP(w).
To explain the connection between risk envelopes Q and deviation measures D, we

need to impose on D the minor technical property of lower -. ii.,,'liniil which means

that the sets { X I D(X) < 6} are closed in 2(Q) for all 6 > 0. This holds for all of the

examples of deviation measures D mentioned above; cf. [11, Proposition 2].

Theorem 2 (risk envelope characterization of deviation [11]). The lower semicontinuous

deviation measures D ii-f \i.l_: D1, D2, D3 and D4 correspond one-to-one with risk en-

velopes Q ,ii-f\ i._:. Q1, Q2 and Q3 under the relations

(a) D(X) = supQE E[Q(EX X)],

(b) Q { Q IEQ= 1, E[Q(EX X)] < D(X) for allX},
where equivalently

E[Q(EX X)] = E[Q(-X)] E[-X] = covar(-X, Q).

Moreover, D has the additional property D5 (for coherency) if and only if Q has property

Q4.

The significance of the characterization in Theorem 2 is especially clear in the coherent

case, because EQ[-X] is then the expectation of the loss r.v. -X with respect to the

alternative probability distribution having density Q on Q. The interpretation is that

D(X) assesses how much worse that expected loss could be than the expected loss E[-X]

under the reference probability distribution P on Q, when the alternative distributions the

investor wishes to take into account are those encompassed by Q. The different elements

Q of Q, under their designation as risk monitors, perceive the potential losses in X from

different perspectives. Axiom Q3 requires Q to be rich enough that, when X has a downside,

that downside can be detected by at least one of the available risk monitors Q e Q. In

association with Q1 and Q2, it can be seen as meaning that the elements Q E Q form a

sort of neighborhood around the constant 1 relative to the all density functions in 2(Q).










Focussing on a particular choice of the deviation measure D in some application cor-

responds in this framework to deciding on a particular attitude toward risk, in the sense

of the trustworthiness of the reference probability distribution P. Rockafellar et al. [11]

discussed several issues in connection with concepts of ... pi .1 !., risk."

Descriptions of the risk envelopes Q corresponding to a number of specific deviation

measures D have been worked out by Rockafellar et al. [11, 23]. Some will be recalled toward

the end of this chapter in connection with optimality rules and CAPM-like equations.

An additional example, which we have not addressed elsewhere but deserves mention

because of its rich modeling implications, is the one in which Q is just a finite set of future

states and Q is taken to be the convex hull of a finite collection of functions Qi,..., Qm on

Q which give probability densities, i.e., satisfy


Qj(a)) > o, Q j(w) 1,
wEQ

and provide the i !. Ihi. --" property that for every nonconstant function X on Q there is at

least one index j such that EQ [EX X] > 0. Axioms Q1, Q2, Q3 and Q4 are all fulfilled

then, and the corresponding deviation measure D in Theorem 2, coming out as


D(X) max E[Q(EX X)] max {E[Q(-X)] E[-X]}, (2.8)
j 1,...,i j 1,...,m

is therefore coherent.

In this setting, each Qj can be viewed as a "mixed -,. 1 I. representing an alternative

probability distribution among the pi"".. -i. i..-' (the elements w of Q) that is different

from the reference distribution. An investor may have specified these mixed scenarios

as tests for what might reasonably be a cause for concern in appraising the future. The

deviation D(X) (2.8) identifies the worst discrepancy that could occur between the expected

losses under the specified alternatives and the expected loss E[-X].

2.3 Portfolio Framework

To proceed with our effort to extend the classical results in portfolio theory for standard

deviation to general deviation measure D, we must provide a market setting. The market

will be taken, for model purposes, to consist of instruments i= 0,1,..., n having rates of

return ri. The first of these instruments, for i = 0, is risk-free; its rate of return ro is a










constant. The other instruments, for i = 1,..., m, are risky; their rates of return ri are

r.v.'s in 2(Q). A dollar invested in instrument i brings back 1 + ri, for a gain (or profit)

of ri dollars at the end of the time period under consideration.

We will be concerned with portfolios that can be put together by investing an amount

xi in each instrument i. These amounts (in dollars) can be positive, zero or negative. (A

negative investment corresponds to a short position.) Such a portfolio has the present cost

xo + x, + + x, and the uncertain future value xo(1 + ro) + xi(1 + ri) + + x(1 + r,).

The associated gain is thus the r.v. X in 2(Q) described by


X = xoro + xiri + + xnrn. (2.9)


Here we are using "gain" in the sense that a loss is a negative gain. Costs, too, might be

negative as well as positive, or zero.

To facilitate our work with these r.v.'s X while taking into account the special role of

the risk-free instrument and keeping notation simple, we introduce


r (r, ... r,) (vector r.v.), r (r, ..., r.) for r Eri,


along with the vectors

X = (X ,..., n), ( ).

The general r.v. X is then x0ro + x r (2.9); its expected gain EX is x0ro + x r, and its

cost is Xo + xTe. We speak of x = (xl,..., xn) itself as giving the x-portfolio for which the

gain is the r.v. x r in 2(Q), the expected gain is xzr, and the cost is x e.

The following assumptions on instruments i = 1,... ,n in the model will henceforth

be in effect. The rest of this section will be devoted to elucidating their immediate conse-

quences. Basic assumptions are

(Al) No x-portfolio with x / 0 is risk-free.

(A2) The expected rates of return rl,..., r, are not all the same.

(A3) D(ri) < oo and D(-ri) < oo for all i.

Assumption Al is harmless and merely underscores our aim of letting the i = 0 instru-

ment do all the risk-free service. A notion of redundancy will help in understanding why










this is true. Let us say that an instruments i is redundant in the model if the associated r.v.

ri, which gives the gain from investing one dollar in instrument i, can exactly be replicated

by the gain r.v. of a portfolio put together from the other instruments. Note that such

replication, if possible at all, would have to be achieved at cost 1, or an arbitrage opportu-

nity would exist, thereby undermining our intent of starting from a market in which prices

are in equilibrium.

Proposition 1 (elimination of redundancy). Assumption Al is fulfilled if and only if none

of the instruments i in the model is redundant.

Proof. If some x-portfolio with x $ 0 were risk-free, we could find a value ox such that

the r.v. X = xoro + xr + ... + xzr is identically 0. One of the coefficients xl,..., x

would be nonzero; suppose for purposes of illustration that is xl. We would then have

ri = i,'o, + i'' + + x'r for xi = --Xi/x, which would mean that the i = 1 instrument

is redundant.

For the converse, suppose some instrument i is redundant. If that holds for i = 0,

then by the definition of redundancy there must be a nonzero x-portfolio that is risk-free.

Otherwise, we can suppose for simplicity of notation that i = 1 is redundant. This refers

to the existence of coefficients Xo, x2, ... xn such that rl = xoro + x2r2 + + xr,. Then

-rl + x2r2 + + nrn = -xoro, so the x-portfolio for x = (-1, x2,... x) would be

risk-free. 0

Redundant instruments offer nothing new, so we could I'.-, -, eliminate them from the

model one by one until nothing redundant was left. Then Al would hold.

Another insight into Al can be obtained through consideration of distribution func-

tions.

Proposition 2 (continuous distributions). Assumption Al is satisfied when the r.v. r is

continuously distributed (i.e., the multivariate distribution function for rl,..., rn is con-

tinuous on 1R"), thus guaranteeing that the gain x r of any x-portfolio with x $ 0 is

continuously distributed as well.









Proof. The well known fact about x r being continuously distributed in these circum-

stances precludes x r from being a constant r.v., of course. 0



Assumption A2 is needed to sidestep special circumstances which have little interest

for us here. If it did not hold, there would be a value p such that ri = p for i= 1,..., n;

then the expected gain x r of an x-portfolio would i'.-- -, be p times its cost x e.

Both Al and A2 seem to be taken for granted by many in finance, even though they

are essential to the validity of commonly made assertions.2 The desire to maintain mathe-

matical rigor in our development of portfolio theory requires us to make these assumptions,

and others, explicit.

Assumption A3 is certainly satisfied when D is a deviation measure that is finite on

all of 2(Q), and many measures with that property have already been indicated beyond

D(X) o-(X), for instance D(X) = CVaR,(X EX). But A3 may also be satisfied

for some deviation measures that are not finite on all of 2(Q). An example is D(X)

EX inf X when the rates of return ri are bounded. Note that we are obliged to require

the finiteness of D(ri) and D(-ri) separately, because D need not be symmetric.

Proposition 3 (portfolio deviations). The deviation function


fD(X) -D(x r)

is finite everywhere and convex on 1"' (hence also continuous), moreover with the properties

that

(a) fD(O) = 0, but fD(x) > 0 when x $ 0,

(b) fD(A ) = AXfD() when A > 0,

(c) fD(X + X') (d) { x f (x) < 6} is a bounded set for every 6 > 0,



2 For instance, in the text [24, p. 159], the n +2 linear equations in n +2 unknowns that
describe the weights for an efficient risky portfolio in the Markowitz model are said to have
a unique solution, but really that is only true when the coefficient matrix is nonsingular.
The matrix in question fails to be nonsingular if Al and A2 do not hold.









(e) fD() = maxQE~ E1I i(ri E[Q, 1) = maxQE Q E xi covar(Q, -ri),
where, in the final formula, Q is the risk envelope associated with the deviation measure D.

Proof. In view of axiom D4 on D, the strict inequality in (a) is equivalent to Al. Prop-

erties (b) and (c), together with the fact in (a) that fD(O) = 0, follow immediately from

axioms D2 and D3 on D. They imply in particular that fD is a convex function. The set

of x for which fD(x) < oo is then a convex subset of 1". Because of A3, that set includes

the vectors,

(1,0,...,0), (0,1,...,0), (0,0,..., 1),

which correspond to portfolios consisting of just one of the instruments i = 1,..., n, either

in unit long position or unit short position. It must also then include all positive multiples

of those vectors, through (b), as well as all sums generated from those, through (c). Thus,

it has to be all of W".

For the fact that finite convex functions "2' are continuous [18, Theorem 10.1]. On

the principle of [18, Corollary 8.7.1] and fD being convex and continuous, if any set of form

{ x fD(x) < 6} is bounded, then all sets of that form must be bounded. By (a), the set

{ x fD(x) < 0} is the singleton {0}, so (d) is correct.
Finally, the max formula in (e) comes immediately from applying the max formula in

Theorem 2(a) to X = x r = Ei1 xiri.


Proposition 4 (richness of cost-gain combinations). For every choice of (7, () E j2, there

is an x-portfolio having cost xe = r and expected gain xr = (.

Proof. This is the main consequence of A2. The set of pairs (r, () coming from portfolios

in this way constitutes a subspace of f2, so if it were not all of f2, these pairs would would

be collinear, and we would be in the lockstep situation excluded by A2. D

2.4 Fundamental Optimization Problem

The problem of optimization that now we wish to study with respect to the gain r.v.'s

X in (2.9) is


minimize D(xoro + x r) subject to Xo + xe = 1 and xoro + x r > ro + A,


P(A)









where D(xoro + x r) is actually just the fD(x) in Proposition 3, of course. The cost

constraint x0 + x e =1 signifies that exactly one dollar is to be invested in the portfolio.

The gain constraint xoro + xTr > ro + A requires that this unit investment should result in

an expected future value of at least 1 + ro + A. The parameter A gives the risk premium

-the extra amount being demanded over the gain associated with investing at the risk-

free rate ro. The gain constraint has been written as an inequality instead of an equation

because there should not be any objection if some portfolio, without worsening the deviation

or costing more, might have an expected gain that is more than ro + A. It will come out

below, however, that any portfolio solving problem P(A) must satisfy this constraint with

equality, when A > 0.

The unit cost constraint in P(A) can be used to eliminate 0o by assigning it the value

xo = 1 x e. The problem statement comes down then to:


Po(A) minimize fD(x) subject to x [r roe] > A.

Adopting this framework in terms of x-portfolios alone, we let

do(A) optimal value (the infimum of the deviation) in 'Po(A),
(2.10)
So(A) = optimal solution set (the minimizing vectors x) in 'Po(A).

Proposition 5 (solution existence and homogeneity). An optimal solution to problem

Po(A) is sure to exist (not necessarily uniquely), no matter what the choice of A. Indeed,
the optimal solution set So(A) is ,l\ 1 -' convex, closed and bounded, in addition to being

nonempty. Moreover,

for A < 0 : do(A) = 0 and So(A) = {0} (put all in the risk-free instrument),

for A > 0 : do(A) > 0, with do(A) = Ado(1) and So(A) = { A x e So(1)}.
(2.11)

Additionally, when A > 0 the gain constraint is i-1 active in Po(A), i.e., every x e So(A)

satisfies x [r roe] = A.









Proof. In view of Proposition 4, the constraint in problem Po(A) can be satisfied regard-

less of the choice of ro and A. The sets of type


{x f(x) < 6, x [r roe] > A} for 6 > do(A) (2.12)

are nonempty by the definition of do(A) as well as compact because of the continuity of

fD and the boundedness in Proposition 3(d). Any nest of nonempty compact sets has a

nonempty intersection. In this case, moreover, the sets are convex by virtue of the convexity

of fD, so the intersection is likewise a convex set. This confirms that So(A) is nonempty,

convex and compact.

The special assertions about Po(A) in the case of A < 0 are evident from Proposition

3(a). They rely also on the constraint having been stated as an inequality rather than

an equation. In the case where A > 0, the relationships involving do(1) and So(1) are

immediate from the positive homogeneity of fD in Proposition 3(b).

The constraint in Po(A) has to be active when A > 0, because if a has x [r -roe] > A,

there is a factor 0 E (0, 1) such that the vector x' = Ox satisfies the same inequality and

yet yields a deviation amount that is smaller than the one for x by the same factor. This is

incompatible with x being optimal. Note that here we are invoking Proposition 3(a) once

more, since this argument would fall through if the deviation in question were 0. 0


Theorem 3 (generalized one-fund theorem in unsealed form). Suppose x* belongs to the

solution set So(A*) to problem Po(A*) for some A* > 0. Then, for each A > 0, an

optimal solution to problem P(A) is obtained by investing the amount (A/A*)(x* e) in

the x*-portfolio and the amount Xo = 1 (A/A*)(x*e) in the risk-free instrument.

Proof. According to solution rule in (2.11) of Proposition 5, by having x* e So(A*)

we are sure to have (A/A*)x* e So(A). We have formulated problem Po(A) in such a

manner that a solution to 'P(A) is constructed by acquiring an x e So(A), at cost x e,

and then investing the amount xo = 1 xe in the risk-free instrument. Here we have

x e = (A/A*)(*e), so the conclusion is at hand. 0

Theorem 3 is ii- ,I I" because it imposes no restriction on the cost x* e of the risky

portfolio that is being utilized in constructing a solution to problem 'P(A) for each A > 0.










In principle, the cost of the x*-portfolio should not really matter, since in passing from x*

to x = (A/A*)x* the relative proportions invested in the instruments i = 1,..., n remain

the same. The magnitudes of these amounts go up or down, but they do so by the common

factor A/A*. The unsealed result nevertheless leads right away to the following -i I,. I"

conclusions.

Theorem 3' (generalized one-fund theorem in scaled form).

(a) Suppose, for some A* > 0 and x* E So(A*), that x*e = 1, i.e., the x*-portfolio

has positive unit cost. Then, for any A > 0, an optimal solution to problem P(A) is

obtained by investing the positive amount (A/A*) in the x*-portfolio and the positive

amount xo = 1 (A/A*) in the risk-free instrument.

(b) Suppose, for some A* > 0 and x* E So(A*), that x*e = -1, i.e., the x*-portfolio

has negative unit cost. Then, for any A > 0, an optimal solution to problem P(A) is

obtained by investing the negative amount -(A/A*) in the x*-portfolio, thereby effectively

obtaining the positive amount (A/A*), and then investing the amount 1 + (A/A*) in the

risk-free instrument.

For someone versed in classical portfolio theory, this scaled form of the one-fund the-

orem may seem strange. Why did we bother with the unsealed form at all? Why not

proceed straight to the case of an x*-portfolio as in (a)? And how can it ever be necessary

to consider, or even be possible to encounter, an x*-portfolio as in (b).

The answer lies in the fact that nothing in our assumptions, so far, about ro and

the r.v.'s rl,..., r, ensures that in solving problem P(A), or equivalently, solving problem

Po(A), for a specified A > 0, the risky x-portfolio we get in optimality will have positive

cost. The possibility that the cost is negative, or zero, cannot be understood without a

deeper investigation. Indeed, we will see that it depends on the interplay between the

chosen deviation measure D and the size of the risk-free rate ro, relative to the uncertain

rates rl,. ..,rn.

Definition 1 (master funds). An x*-portfolio meeting the prescription in (a) of Theorem

3' will be said to furnish a master fund of positive /'l," whereas an x*-portfolio meeting

the prescription in (b) of Theorem 3' will be said to furnish a master fund of negative 'i"P










In the classical theory, based on D = a, only master funds of the 1p...-! ve type" in

this definition are contemplated, and they are immediately tied into the notion of "efficient

set." The familiar picture in Figure 2-1 is used to indicate that, for A > 0, the optimal

value do(A) can be obtained by interpolating along a tangent line to the efficient set that

passes through the point (0, ro). The point of tangency corresponds to an x*-portfolio of

cost 1 having expected gain (* = ro + A* for some A* > 0. This portfolio then solves

problem Po(A*) and furnishes a master fund which is able to perform the role in Theorem

3'(a).

In our situation of nonstandard deviation, there is a need to look much more closely

at this picture and recognize certain shortcomings as well as major challenges. In the first

place, the "efficient -, i corresponding analogously to a general deviation measure D $ a

may no longer be a quadratic curve like the one in Figure 2-1 (which is actually a hyperbola).

For that reason, the one-fund theorem must contend with serious complications.3

4 expected gain

tangent portfolio


------------------------ %
slope = 1/do(1) efficient set


ro +A -------------
r+A +1 ------

I I
I I
deviation

do (1) do(A)


Figure 2-1: Classical efficient set: expected gain versus standard deviation




3 Without the curve being quadratic, there is no hope at all, by the way, of generalizing
the classical I .- i-fund" theorem [4], which asserts the existence of two portfolios from which
all efficient portfolios can be constructed as linear combinations. That result is intrinsically
.11 I ,i iii" in its mathematical underpinnings.










Although the region marked out by the efficient set will continue to be convex in our

generalized setting, its boundary may incorporate corners or straight segments. For the

case of a corner, the very meaning of tangency has to be pinned down carefully. In the

presence of straight segments, the tangent line could have a whole interval in common with

the efficient set, and this might in fact be an infinite interval.

Another complication, which can also come up in the classical model, is the possibility

that, because of the asymptotic behavior of the efficient set, the efficient set has no "tangent"

line at all that passes through (0, ro). Indeed, apart from any troubles with asymptotic

behavior, there is an unspoken difficulty in the classical picture over the fact that it takes

for granted the existence of a master fund of positive type. Clearly this existence, perceived

in relation to tangencyy," depends in particular on the rate ro. It might fail if ro were too

high.

In the traditional setting with D = a, such a situation has been regarded as implausible

and i, i -,- 111 i pI1' i 'l1. with market equilibrium." This view appears to originate in

CAPM considerations and the supposition that all investors are effectively engaged in

minimizing standard deviation. A master fund could not be of negative type, for the reason

that if all investors wanted to take a net short position as represented by a certain portfolio,

so as to obtain money to invest at the risk-free rate, something must be wrong with the

risk-free rate -an implicit market instability which fails to account for the limited supply

of money.

None of that really applies to our setting, however, because we are only exploring

portfolio optimization for a subclass of investors, those who choose the particular deviation

measure D we are focussing on. Other investors, with different measures D, can be expected

to come to different conclusions about their portfolio choices. Some may end up with net

short positions, while others may not. From that angle, there is no hint of conflict with

market equilibrium in thinking about a master fund of negative type possibly emerging

from a particular choice of D at some level of ro.

We are compelled, therefore, in our framework of a diversity of deviation measures D,

to face up to all cost possibilities for x-portfolios as potential solutions to problem Po(A).

This will lead us to study how such solutions may depend on ro as a parameter.









Before getting into that parametric .111 -, -i-. we can record a key fact about duality

in Po(A). This problem is, after all, a convex programming problem, in which the convex

function fD is minimized subject to a single linear constraint. The Lagrangian function is


LA(x, A) f() + A(A x [r ,, ), for A > 0, (2.13)

and the problem dual to Po(A) consists therefore of maximizing the function g(A)

inf, LA(x, A) subject to A > 0 (cf. the general theory is developed by Rockafellar [18, 25]).

Because of the positive homogeneity in Proposition 3(b), however, we have gD(A) = AA

when fD(x) Ax [r roe] > 0 for all x E R"f, but g(A) = -oo otherwise. The problem

dual to Po(A) therefore takes the form:


maximize AA with respect to A -I if- i-, in: fD(x) > Ax [r roe] for all x E WR. (2.14)


Of course, we really only need to understand the case of A = 1, since everything else can

be obtained from that through rescaling. By i''l1, in:- known duality results about the

relationship between a convex programming problem and its dual, we get the following

conclusion about that case.

Proposition 6 (duality). The optimal value do(1) in problem Po(1) has the dual charac-

terization of being the highest A such that


fr(x) > AX [r roe] for all x E R". (2.15)

Proof. We are dealing with a convex programming problem in which the objective func-

tion fD has bounded level sets, the property in Proposition 3(d), and on the other hand

the Slater constraint qualification holds (it is possible to satisfy inequality constraints, here

just one, with strict inequality). In that case the dual problem has an optimal solution, as

does the primal problem, and the optimal values in the two problems (the min value in the

primal problem and the max value in the dual problem) coincide; cf. [25]. 0

2.5 Efficient Sets and Frontiers

In our endeavor to understand how the classical picture in Figure 2-1 might have to

be modified and expanded, we cannot limit our attention to x-portfolios with cost x e > 0,









for reasons already explained. It is essential to look at costs x e < 0 as well. Moreover,

we have to adjust to the fact that the deviation measure D under scrutiny might not be

symmetric. If we have an x-portfolio representing a "net long position," in the sense that

x e > 0, and we wish to pass to the associated x-portfolio with x = -x, representing a "net

short p .iI. ,i.11 because ,xe = e < 0, we cannot count on having D(x r) = D(x r).

Switches between "long" and -li!. t" could have significant effects on risk perception.

Out of these considerations, we are obliged to investigate an auxiliary optimization

problem with respect to the instruments i = 1,... n. In this problem, 7r and ( are param-

eters denoting targeted cost and expected gain, and we seek to solve:


P(,, () minimize fD(X) = D( r) subject to xae = 7 and r = (.

We wish to investigate it without any preconditions on the signs of r or (.

The gain constraint in P(r, () has been written as an equation this time because of

the chiefly technical role that the ., i 1-, -i, will 1p1 -, and the simpler geometry afforded by

having an equation instead of an inequality. We let

{d(r, () optimal value (the infimum of the deviation) in P(r, (),

S(r, () =optimal solution set (the minimizing vectors x) in P(r, ().

Proposition 7 parametricc framework for cost and expected gain). An optimal solution

to problem P(r, () is sure to exist (not necessarily uniquely), no matter what the choice of

r and (. Indeed, the solution set S(r, () in 1R" is ,it 1i convex, closed and bounded, with

S(0,0) = {0} and S(AX, A0) { Ax x E S(x ()} when A > 0, (2.17)

while the function d on JR2 giving the minimum deviation is finite everywhere and convex

(hence also continuous), moreover with the properties that

(a) d(0, 0) = 0, but d(7, () > 0 when (w, () (0, 0),

(b) d(X7, A0) = Ad(7, () when A > 0,

(c) d(7Tl + T2,l ) 8 i d(7l, 1l) d(7T2, 2),

(d) { (r, () I d(7r, () < 6} is a bounded set for every 6 > 0.









Proof. Our assumption A2 guarantees through Proposition 4 that the constraints in

P(7, () can be satisfied, regardless of how t and ( are chosen. The finiteness of d(7, () and

nonemptiness of S(7, () follow then from the properties of fD in Proposition 3 (much as

in the proof of Proposition 5). As the set of solutions to a convex programming problem,

S(7, () is convex and closed. By virtue of the boundedness of the level sets of fD in

Proposition 3(d), S(7, () is bounded. Properties (a)(b)(c)(d) of the function d follow from

the corresponding properties of fD in Proposition 3. In particular, the set in (d) is the

image of the compact set in Proposition 3(d) under the (continuous) linear transformation
x v-* (X e, x r), and that guarantees it is compact as well. 0

The relevance of problem P(7, () for our goal of .111 i-,. in: the cost of a solution to

problem Po(A) comes from the following observation.

Proposition 8 (reduced optimization perspective). When A > 0, problem Po(A) is equiv-

alent to the problem


'Po(A) minimize d(r, () subject to r and ( ,iif\ i:._ ( ro7 = A,

in the sense that optimal values in both problems are the same, and the solutions to 'Po(A)

are the vectors x in R"' such that the pair (Tr, () = (Te, xTr) solves 'P(A).

Proof. This is elementary in view of the nonemptiness of the solution sets S(r, () estab-

lished in Proposition 7, but notice that the single linear constraint, which was an inequality

in Po(A), has been written now as an equation. Proposition 5 has made this possible by

establishing that, when A > 0, the inequality must be tight at optimality. O

According to Proposition 8, the pairs (x e, xTr) giving the cost and expected gain

associated with the solutions x (or solution, if unique) to problem 'Po(A) are the pairs

(Tr, () that furnish the minimum of the function d along the line in R2 described by the
equation ( = ror + A. Due to positive homogeneity in (2.11) of Proposition 5, of course,

we can concentrate on the case where A = 1. In that case, depicted in Figure 2-2, the line

in question is the one with slope ro that passes through the point (0, 1).

The ii'.. shown in Figure 2-2 are given by the equations d(r, () = 6 for various 6 >

0 and reflect the properties in Proposition 7. They are the boundaries of certain compact,










convex sets which are merely rescaled versions of each other, generated by expanding or

contracting the one for 6 = d(O, 1). In the classical case of standard deviation, the curves

would be ellipses, but in general they may have corners and straight segments.

expected gain





-- line: (= r0 +1
S(slope = r)
/(0, I)
/ I I I

I portfolio cost
(0, 0)
I -

curve d(n,')=8
\ for = d(0, 1)




Figure 2-2: Reduced optimization perspective


The issue of whether the x-portfolios for x E So(1) have cost xTe > 0, xe = 0 or

xae < 0, comes down to whether, in minimizing d along the line in Figure 2-2, the points

(w, () that are obtained at the minimum have t > 0, t = 0 or t < 0. (We have to speak in

general of "r-por I.! .!, .- and p" .iii (t, ()" because uniqueness of optimal solutions is not

assured here, in general.) It is immediately clear that this must depend largely on the size

of the risk-free rate ro and cannot be resolved merely on the basis of any of the assumptions

that have been made, so far, on the rates of return of the instruments i = 1,..., n in our

model.

For the ro that is illustrated, the slanted line in Figure 2-2 cuts into the set

{ (t, () d(r, () < d(0, 1)} toward the right, and one therefore has rt > 0 at optimality.

But for higher and higher levels of ro, a stage will eventually be reached where the line

henceforth cuts into this set instead toward the left, in which case rt < 0 at optimality.









A formal mI i -i, of these circumstances, aimed at characterizing the threshold value, or

values, of ro where the line does not cut into the set at all, will have to be undertaken.

Observe that in the case shown in Figure 2-2 there is not just one ro for which line does

not cut into the set in question, but indeed a whole interval of such values. Geometrically,

this corresponds to the boundary of the set having a "corner 1.. mi at (0, 1). Although

that can be regarded as an exceptional situation, it cannot be ruled out. Our result on

threshold behavior (Theorem 5 in the next section) must therefore, in general, allow for an

interval of ro values for which one has t = 0 at optimality.

For now, the essential thing to recognize is the need to study two efficient sets, if cost

behavior in the one-fund theorem is to be understood over the whole range of possible ro

values. There has to be an efficient set corresponding to x-portfolios furnishing "unit long

P1 .--. (cost = 1), but also one for x-portfolios furnishing "unit short 1 -ii .. i- (cost

S-1). Because the deviation measure D might not be symmetric, neither of these efficient

sets can be expected to be derivable in a simple way from the other.

Dictates of simplicity in dealing with the geometry of efficiency and its relationship

to the one-fund theorem and properties of the function d cause us to adopt a convention

different from the one in Figure 2-1, where deviation is on the horizontal axis and expected

gain on the vertical axis. Instead, we will have deviation on the vertical axis and expected

gain on the horizontal axis. Of course, a flip across the 450 line between the two axes can

be used to convert our convention to the classical one, when desired.

Definition 2 (efficient sets and frontiers, positive and negative). By the positive efficient

set and the negative efficient set will be meant the boundaries G+ and G-, respectively, of

the feasibility sets

F {(( 6) I x with aXe = 1, ar = fDz() < 6},
(2.18)
F { (-(, -6) 3 x with e = -1, ar (, fD(x) < 6}.

By the positive efficient frontier will be meant the part ofG+ consisting of all ((, 6) e F+ for

which there is no ((', 6) E F+ with (' > (. Likewise, by the negative efficient frontier will

be meant the part of G consisting of all (-(, -6) e F for which there is no ((', 6) e F

with (' > (.
































master fund
(negative)

- negative efficient
frontier

negative efficient set

F-


Figure 2-3: Efficient sets in coordinates standard for graphs of functions


The virtue of passing to (-(, -6) in the definition of F will emerge in the results

below as a way of getting the most out of a single geometric picture in which both of the

efficient sets, or frontiers, can be seen, namely the picture in Figure 2-3, which will be

explained in due course, after Theorem 4. Note that, through a notational switch between

x and -x, one can express F equivalently by


F { ((, -6) 3]x with x e = 1, xr = (, f(-x) < 6}. (2.19)


Thus, in cases where the deviation measure D is symmetric, so that fD(-x) = fD(x), the

set F would merely be the reflection of the set F+ across the (-axis, and there would be

less of an imperative for considering it separately.

As depicted in Figure 2-3, the positive efficient frontier is the i !i-, boundary of F+,

in contrast to G+ being the whole boundary. In the same way, the negative efficient frontier










is the "left" boundary of F in contrast to G being the whole boundary. Only these partial

boundaries will really have a role in what follows, but it is convenient mathematically to

work with G+ and G themselves. For convenience of comparisons, Figure 2-4 poses all

these sets in the reversed coordinate --, i i 1 that is customary in finance. There, the positive

efficient frontier becomes an "upper" boundary and the negative efficient frontier a !I ,

boundary.


F



negative efficient set


negative efficient
frontier

4 ^^ -- -


expected gain


positive efficient
frontier

positive efficient set


deviation


Figure 2-4: Efficient sets in coordinates traditional for finance


Proposition 9 (efficient sets as function graphs). The positive efficient set G+ is the graph

of the convex function


min deviation for cost 1 and expected gain (,


d+(() = d(l, ()


(2.20)










whereas the negative efficient set G is the graph of the concave function


d (() = -d(-1, -() = -min deviation for cost -1 and expected gain -(. (2.21)

Indeed, F+ is the closed, convex set consisting of the pairs ((,6) for which 6 > d+((),

whereas F is the closed, convex set consisting of the pairs ((,6) for which 6 < d (().

Furthermore, the asymptotic slope of G+ on the right is the same as the asymptotic slope

of G- on the left,

lim d ) lim d ( = d(0, 1) > 0. (2.22)
C-oo ( C-oo (

Proof. The convexity of d+ and concavity of d are evident from the convexity of d

in Proposition 7. Like d, these functions are finite and continuous, in particular. Those

properties, along with the fact in Proposition 7 that the minimum deviations in (2.20) and

(2.21) are sure to be attained, immediately yield the descriptions claimed for F+ and F-.

The relations in (2.22) specialize to d a well known property in convex 1 i1 -, -i- the

asymptotic slope of a finite convex function along any half-line depends only on the direction

of the half-line, not on its starting point (see [18, Theorem 8.5]). Here, we are looking at

such slopes along half-lines in the r-( space of Figure 2-2 that are parallel to the positive or

negative (-axis. On the positive (-axis itself, d is linear because of the positive homogeneity

in Proposition 7(b): we have


d(0, ()/ = d(0, 1) for all ( > 0.

This value is trivially then the limit of the ratio as ( -- oo. Therefore, d(0, 1) is also the

limit of d(1, ()/( as ( -- oo, and as well as the limit of d(-1, ()/( as ( -- oo, where, by the

definitions of d+ and d the first is the limit of d+(()/( as ( -- oo and the second is limit

of d(-()/(-() as -( -oo.

Incidentally, the asymptotic slope of G+ on the right agrees likewise with the asymptotic

slope of G on the left, but this fact will not 1.1 -, any role here. (The portions of G+ on

the left and G on the right would drop out if we wrote the ( constraint in P(7, () as an

inequality instead of an equation.)










We are in position now to answer the question of how the tangency relationship associ-

ated with the classical one-fund theorem, as in Figure 2-1, can be extended to our framework

of general deviation measures, as a complement to the one-fund results in Theorems 3 and

3'.

Theorem 4 (efficiency characterization of master funds). The optimal deviation value

do(1) in problem Po(1) is the highest of the slopes of all the lines in JR2 through (ro, 0) that lie

between the curves G+ and G (perhaps touching them, but not crossing them). In referring

to the line through (ro, 0) with slope do(1) as the ,,-h!ii", the following conclusions can

be drawn.

(a) If the ro-line touches G+ at a point ((*,6*), then any x* E S(1, *) furnishes a

master fund of positive type: it has cost x*e = 1 and belongs to the optimal solution set

So(A*) for A* = ro > 0.

(b) If the ro-line touches G at a point (-(*, -6*), then any x* E S(1, (*) furnishes a

master fund of negative type: it has cost *Te = -1 and belongs to the optimal solution

set So(A*) for A* = (* + ro > 0.

(c) The maximum value that do(l) can have with respect to different values of ro is

the common asymptotic slope value d(0, 1) for G+ on the right and G on the left.

Proof. Our strategy is to derive this from the dual characterization of do(1) in Proposition

6. That characterization translates in terms of the definition of d into having


do(1) = max{ A IA[( ror] < d(r, () for all (T, () E JRn}. (2.23)

For the inequality condition inside this description to hold, it only has to hold when 7 > 0

or 7 < 0, since it must then hold automatically for 7 = 0 by the continuity of d. Indeed,

because of the positive homogeneity of d in Proposition 7(b), it merely has to hold for 7 1

and for 7 = -1, in order for this conclusion to be reached.

In the case of = 1, the inequality A[(-ro7] < d(r, () comes down to A((-ro) < d+(C).

Having this hold for all ( E means that the line in ((, 6)-space through (ro, 0) with slope

A does not cross above the graph of d+.










In the case of r = -1, the inequality A[( ror] < d(r, () comes down to A[( + ro] <

-d(-(). With a switch of notation between ( and -(, this becomes A[( ro] > d (().

Having that hold for all ( E Rf means that the line in question does not cross below the graph

of d Thus, the characterization of do in (2.23) reduces to the graphical characterization

claimed in the theorem.

Now (a) and (b) are obvious from the representations of G+ and G in Proposition

9. On the other hand, (c) follows from the monotonicity in the curvatures of G+ and G

(i.e., of the left and right derivatives of the functions d+ and d due to their convexity

and concavity), as expressed through Proposition 8 and the claim there about asymptotic

slopes. 0

Figure 2-3 illustrates the general situation described in Theorem 4. Two possible

values of the risk-free rate ro are indicated, corresponding to alternatives (a) and (b) of the

theorem. Note the possibility of more than one point of tangencyy," and on the other hand,

the ..--1.il.1i-, of a range of ro values all yielding the same point of tangency. Alternative

(c) of Theorem 4 corresponds to ro-line having the same slope as the diagonal line shown

in dashes. Typically there might be only one such line, associated with a unique threshold

rate, but sometimes there could be a family of parallel lines corresponding to an interval of

ro rates. This will be the subject of the next section, and eventually, Figure 2-5.

The same basic relationships underlie the reversed-coordinate picture in Figure 2-4, of

course, but there they cannot be described so simply in terms of slopes. A line having slope

do(1) in Figure 2-3 turns into a line having slope l/do(1) in Figure 2-4, so for instance, the

optimal value in problem 'Po(1) emerges instead as the reciprocal of the lowest of the slopes

of all the lines through (0, ro) that lie between the two efficient sets. The awkwardness

of this kind of statement, insisting on reciprocals, is another of the reasons why we have

chosen to give priority to the presentation in Figure 2-3.

2.6 Threshold Determination for the Risk-Free Rate

The task immediately ahead of us is the mIi i-, -i- of the transitional behavior between

the cases in Theorem 4. For that, we will make use of the Lagrange multipliers associated

with the problem P(7, (), specifically in the case of (r, () = (0, 1). The Lagrangian for









P(r, () is the function


L(W)(, p, 9) = fD() + p[r ae] + ( Tr]. (2.24)

We say that (p, rl) is a Lagrange multiplier vector for P(r, () when

inf, L(W,C)(x, rl, p) = optimal value d(7, () in P(7, (). (2.25)

This definition, the standard one for a convex programming problem like P(7, () (cf. [18]),

gets around the fact that the objective function fD(x) need not be differentiable everywhere

with respect to x. We let

M(r, () = set of Lagrange multiplier vectors (p, rl) in P(r, (). (2.26)

Under our assumptions, the Lagrange multiplier set M(r, () is I.,- -, nonempty, con-

vex and bounded. This is true from the general theory of convex programming problems

because the optimal solution set to P(r, () is .,- i-, nonempty and bounded, and the opti-

mal value d(r, () is i,,v ,-, finite; cf. [25], [18]. Moreover, the multiplier vectors for P(t, ()

are known from that theory to be the -il ,I i-I, 1'"I of the (optimal-value) function d at

the point (r, (). Accordingly, they furnish the formula

d'(r, (; 7', ') max{ 7'p + (' I (p, r) e M(T, ()}, (2.27)
P,rl

where the left side denotes the one-sided directional derivative of d at (7r, () with respect

to a vector (rt', (') and is defined by


d'(7, (; T', (' lim + + (2.28)
Et->o E~


Such derivatives exist because d is convex.









Theorem 5 (rate thresholds and cost behavior).

(a) Th!, -I.i 1 values ro and re exist which satisfy re <- r0 and have the following

effect for problem Po(A) and its solution set So(A) for all A > 0:

every x E So(A) has cost x e > 0 when ro < r0,

every x E So(A) has cost x e < 0 when ro > io,

every x E So(A) has cost xe = 0 when re < ro < r,

where the third case falls away if actually re = so as to yield a single threshold rate ro.

(b) In the borderline case of ro = r, at least one x E So(A) has cost xe = 0, but there

could be other vectors x E So(A) having cost xfe > 0. Similarly, in the case of ro = io, at

least one x E So(A) has cost e = 0, but there could be other vectors x E So(A) having

cost xTe < 0.

(c) The threshold rates ro and re can be determined from the Lagrange multiplier set

M(O, 1) for problem P(0, 1). That set consists of the pairs (p, rJ) 'ii-A i:_ r = d(O, 1) and
p- < p < p+ for a certain interval [p p+], and in those terms one has

-P+ -p
o d(0,1)' o d(0,1)

Proof. Let p(7r) = d(r, ror +1), this being a finite, convex function on JR (by Proposition

7). Because of the scaling relation in (2.11) of Proposition 5, we need only look at the case

where A = 1. As seen in Proposition 9, the costs a e of the vectors x E So(1) are the values

of rt that minimize p over JR. Such values form a nonempty, closed, bounded interval in fR,

inasmuch as So(1) is a nonempty, closed, bounded, convex subset of R~ (cf. Proposition

7); this interval may well collapse to just one rt value, of course. The issue is the extent to

which the values of rt that minimize p may be positive, negative or zero.

As a finite, convex function on f, o has right and left derivatives (ir) and p'_ (r)

which are nondecreasing as functions of rt, with '_ (it) < (' (r). The minimum of O is

attained at rt if and only if p'_ (r) < 0 < + (7r).

We can test this condition at t = 0. If y' (0) < 0, the minimum of o can only be

attained at some rt > 0, whereas if '_ (0) > 0, it can only be attained at some rt < 0. If

'_ (0) < 0 < y+'(0), it can only be attained at t = 0. When / +(0) = 0, the minimum is



































(5 A deviation


I
I
I
I
+I
I
I

I

I
I
I
I
!/
I
I
I I

I
I I
I I
I I
I I
I I
I I
I I
r- / ,
*~oj /


expected gain


I I
I I



I I
I I




I /I 6- \
I I



I I

I I
II


Figure 2-5: Tl::.- i i values for the risk-free rate









attained at t = 0, but it is conceivable that p might be constant over some interval [0, e]

(with e > 0), and the minimum would also be attained then by the positive values of rt

in that interval. Likewise, when '_ (0) = 0, the minimum is attained at r = 0, but it is

conceivable that o might be constant over some interval [-, 0], and the minimum would

also be attained then by the negative values of rt in that interval.

The crucial left and right derivatives y' (0) and '_ (0) are obtainable from the one-sided

directional derivatives of d:


0' (0) d'(0, 1; 1,ro), (0) = -d'(0,1; -1, -ro).

The Lagrange multiplier characterization of the directional derivatives of d in (2.27) tells

us then that


0' (0) = max{ p + rorl (p, r) e M(0, 1), _' (0) min{ p + ror (p, r1) e M(0, 1)}.

We note next that, because d(0, A) = Ad(, 1) when A > 0 by the positive homogeneity in

Proposition 7(b), we have d(0, 1) d'(0, 1; 0, 1) and -d(0, 1) d'(0, 1; 0, -1), and conse-

quently by (2.27) that


d(0, 1) = max{ Op + l I (p, r) e M(0, 1)} min{ Op + +l I (p, r) e M(0, 1)}.

This implies that M(0, 1) lies within the horizontal line consisting of the pairs (p, rl) such

that r = d(0, 1). Because M(0, 1) is a compact, convex set, it must actually be a closed

segment of that line (possibly reduced to a single point): the corresponding p values must

comprise an interval [p p+]. Thus, M(0, 1) has the special form claimed in the theorem.

The formulas we already have for v' (0) and y' (0) tell us then that


/' (0) p+ + rod(0, 1), (0) =p + rod(0, 1).

Finally, we can put this together with the criterion already developed for the location of

the values of rt that minimize cp. Clearly 1 +(0) < 0 if and only if ro < -p+/d(O, 1), whereas

p' (O) > 0 if and only if ro > -p /d(0, 1), and the proof is thus finished. o










Corollary (optimal portfolios at transition). The values of ro for which the maximum in

part (c) of Theorem 4 is attained are those in the interval [r r]. For such ro, the optimal

solution set So(A) to Po(A), for any A > 0, contains an x having cost xTe = 0.

Theorem 5 provides important information about master funds, in particular.

Theorem 6 (existence of master funds). The threshold values ro and ro in Theorem 5

have the property that

when ro < t there is a master fund of positive type but none of negative type,

when ro > ot, there is a master fund of negative type but none of positive type,

when r0 < ro < 0, there is neither a master fund of positive type nor one

of negative type.

In the borderline case of ro = io, there might be a master fund of positive type, whereas

in the borderline case of ro = ot, there might be a master fund of negative type. (When

ro = o it is not excluded that master funds of both types exist simultaneously.)

Proof. When ro < to, there exists by Proposition 5 and Theorem 5(a) an x E So(A)

having xre > 0. By setting x* = x/x e and A* = A/X e, we get x*Te = 1 and have

x* E So(A*) (again by Proposition 5). This x* meets the prescription in Definition 1 for

furnishing a master fund of positive type.

Similarly, when ro > r,, there exists by Proposition 5 and Theorem 5(a) an x E So(A)

having xTe < 0. Then, by setting x* = x/xTel and A* = A/ Te, we get x*Te =-1 and

have x* E So(A*). This x* furnishes a master fund of negative type.

On the other hand, Theorem 5(a) makes clear that a master fund of positive type

cannot exist when ro > ro, but might exist (by the argument just given) when ro = t.

Likewise, a master fund of negative type cannot exist when ro < ri, but might exist when

ro = -r. 0

The interpretation coming from Theorems 5 and 6 is that when the risk-free rate ro

is high enough (specifically, above the threshold rate r0), it is advantageous, for investors

whose attitudes toward risk are captured by the particular deviation measure D under

investigation (and its associated risk envelope Q), to take a net -li! t p..-iii..ii in the










market (an x-portfolio with negative cost) and invest at the risk-free rate all the money

that is obtained that way.

The relation between threshold behavior and the efficient set geometry in Figure 2-3

is indicated in Figure 2-5. Ordinarily, it can be expected that r = i, in which case the

unified threshold value could be denoted simply by or. The explanation is that these values

are determined in the proof of Theorem 5 from right and left derivatives of the convex

function #p(r) = d(7r, ro + 1), and such derivatives have to coincide almost everywhere.

When r = i, there is only one line that fits between the two efficient sets.

The reason why cases with ro < ro can truly occur is seen, from this vantage point,

to be tied to the fact that the right and left derivatives of 0 may differ in some places, due

to the function d not being differentiable. But it can also be understood from the remarks

made earlier about the geometry in Figure 2-2. When the curve through (0, 1) in Figure

2-2 has a corner there, one has a range of slopes ro corresponding to cases for which the

minimum in the reduced format of Proposition 7 occurs with r = 0. This range of slopes

is marked by the two threshold values ro and r0, as shown in Figure 2-6.

Allowance for corner points really does have to be made, because of deviation measures

such as the one in (2.8), for instance. There we have


fD() max x (r E[Qjr]) max {E[x r] EQ [X r]}, (2.29)

so that fD is piecewise linear and the curves in Figure 2-6 are polygonal. Aside from the

modeling potential of this kind of formula, it could also come up in numerical methods in

which the risk envelope Q associated with D is approximated progressively by sets formed by

generating finitely many elements Qj e Q. Such approximation yields (29) as a substitute

for the max formula for fD in Proposition 3(e).

Insight into circumstances in which corner points are sure not to be present will be

furnished later in Proposition 11 and its corollary, and in Example 7.

It should be noted that, although Theorem 6 conveys the circumstances in which master

funds of one type or the other are sure to exist, it says nothing about when they might be

unique. That is an entirely separate issue. Uniqueness could fail on two grounds. The first

is the possibility of more than one point of tangency where the ro-line meets the frontier,










as seen in Figure 2-3. The second arises when more than one portfolio can yield the same

point on the frontier. It may be anticipated that these phenomena are i ii.," but they

cannot readily be eliminated, a priori, in the absence of a suitable strict convexity property

of D. Rockafellar et al. demonstrated [23, Example 4], however, that the required version

of strict convexity is unavailable, in general, for coherent deviation measures such as lower

semideviation, lower range, and CVaR, and the same can be seen for mixed CVaR and

mean absolute deviation.

In contrast to these observations, and the facts in Theorem 6, both the existence and

uniqueness of a master portfolio seem to be taken for granted in much of the literature

on portfolio optimization. The belief is widespread, moreover, that a master portfolio of

positive type 1.-- -, suffices, regardless of the magnitude of the risk-free rate ro. Our

hope is that the rigorous methodology pursued in this chapter will help to dispel such

misconceptions.

expected gain

Slope =
---. .

/ f, A. slope =r


p(0,1)

/ / pf c
/ / 1 p
S / I portfolio cost
^i I I r


'U

I


curve d(x,)=
for 5 = d(o, 1)


Figure 2-6: Threshold interval tied to corner behavior









2.7 Characterization of Optimal Portfolios

Our attention turns now to the challenge of identifying the distinguishing characteristics

of the x-portfolios that, for a selected deviation measure D, solve the basic problems 'Po(A)

when A > 0. In this context, we henceforth add the assumptions

(A4) D is lower semicontinuous, i.e., the sets {X I D(X) < 6} are closed in 2( ) for

every 6 > 0,

(A5) D(X) < oo for all X e 2(),

which ensure actually that D is continuous on 2(Q); cf. [11, Proposition 1]. We then have

at our disposal the dual representation of D in terms of its associated risk envelope, as

in part (a) of Theorem 2, which in particular can be expressed by covariances with risk

envelopes

D(X) = max covar(-X, Q). (2.30)
QEQ
Of special interest to us in what follows will be the subset of Q on which the maximum in

this formula is attained for a given X, namely


Qx {Q EQ I covar(-X, Q) = (X)}. (2.31)

This assists in the statement of opl-tim lit conditions for problems in which D is minimized,

through its connection to -li I I, _,ii of D.

By the standard definition in convex .111 i-, -i-. as adapted to the probability framework

of our space 2(Q), a subgradient of D at X is an element Y E 2(Q) such that D(X') >

D(X) + E[Y(X' X)] for all X' e 2. The notation is used that


OD(X) = { set of all subgradients Y of D at X }.

In our situation where D is finite and continuous on 2(Q) OD(X) is i1' .-, a nonempty,

convex subset of 2 which is closed and bounded. Rockafellar et al. showed [11, Theorem

5] that in fact

OD(X) { Y 1 Q Q Qx}, (2.32)

and furthermore that, for any Y e 0D(X) one has EY = 0 and D(X) = E[XY] =

covar(X, Y).









Subgradients of the function fD() = D(x r) can be derived from those of D by a kind

of chain rule. A subgradient of fD(x) at a point x E R"' is of course a vector ye R"f such

that fD(x') > fD(x) + (x' x)y for all x' e R". The set of such y is denoted by OfD(x).

A number of background facts from convex .111 i-, -i, [18] are worth recalling. Because

fD is convex and finite everywhere, the subgradient set OfD(x) is '.- i-, nonempty, convex

and compact. It reduces to a singleton {y} if and only if fD is differentiable at x, in which

case the unique element y = (yi,..., y.) is the gradient VfD(x), so that


Yi= x) for i 1,...,n (2.33)

(see [18, Theorem 25.1]). Indeed, the convexity and finiteness of fD guarantee that this case

of differ (ii il -,il, in which OfD(x) reduces simply to {Vfy(x)}, holds for !_..I (I.

X E fn.

But unfortunately, there is no easy way to know, in general, whether a particular x

calculated to be optimal will happen to be such a point of differentiability. Most of the

deviation measures D of interest in our general framework necessarily do lead to functions

fD for which differ idi d1 il.-, can fail at a significant class of points x. In consequence, the

simplifications accruing from differentiability cannot be taken for granted.

A possible help sometimes could be the estimate that

Of O+f
if y e Of,(x), then (x) < yi < O x) for i 1,...,n, (2.34)
Oxi Oxi

where (0- fD/xi)(x) and (0+ fD/Oxi)(x) denote the left and right (one-sided) partial deriva-

tives of fD with respect to xi at x (which exist because fD is convex). The converse impli-

cation is generally false; the estimate in (2.34) is not enough to pin down y as a subgradient

at x. When the left and right partial derivatives coincide for each i, however, one does

necessarily have fD differentiable at x with (2.33) holding.

Proposition 10 (chain rule for deviation subgradients). The vectors y E OfD(x) are the

vectors (yl,..., yn) such that, for the r.v. X = x r, there exists Y E OD(X) with


yi = covar(ri, Y) for i = 1,..., n,


(2.35)









or equivalently, there exists Q e Qx such that

yi = covar(-r, Q) for i 1,...,n, (2.36)

Furthermore,

y E Of,(x) entails xay = fD(x).

When x is a point where fD is differentiable, as is sure to hold in particular when there is

only one Y E OD(X), or equivalently, only one Q e Qx, these formulas are available to be

combined with the partial derivative relations in (2.33).

Proof. The first formula comes from a general chain rule of convex .i i1-, -i through the

fact that fD is the composition of D with the continuous linear transformation T from JR to

2(Q) defined by T(x) = x r. That chain rule [25, Theorem 19] requires, for instance, the

existence of a point in the range of T at which D is continuous, and this requirement is met

under our assumptions A4 and A5, as noted. It characterizes OfD(x) as the set of vectors

of the form T*(Y) for Y E D(X), where T* is the adjoint linear transformation from 2(Q)

to R". That adjoint transformation takes Y to the vector in ]R"' having the components

yi in (2.35). That confirms the first description of OfD(x), and the second description then

falls immediately out of (2.32). The fact that x y = fD(x) when y E OfD(x) is obvious

then from the fact that E[XY] = D(X) when Y E OD(X).

It is clear that when OD(X) reduces to a singleton {Y}, the characterization of OfD(x)

yields a singleton {y}, in which case fD is differentiable at x and (2.33) holds, as recalled

above. 0

Theorem 7 (.oltimrlit-i rule). A portfolio vector x belongs to the solution set So(A) in

problem 'Po(A) for a A > 0 if and only if T [r roe] = A and there is a value of A and a

vector y E OfD(x) (as characterized by Proposition 10) such that

)[7 ro] = i for i 1,...,n. (2.37)

Then necessarily x / 0, fD(x) > 0, and A = fD(x)/A > 0.

Proof. In problem Po(A), the finite (but not necessarily differentiable) function fD is

minimized subject to the single linear constraint a [r roe] > A. For such a problem of









convex p.i:_ iiiiiiii,:_. the condition both necessary and sufficient for the opltinii1-itv of x is

(the fulfillment of the constraint along with) the existence of a Lagrange multiplier A > 0

such that the Lagrangian expression

LAx, A) f ) + [(A [r ,,, 1)


attains its unconstrained minimum at this x, with A = 0 if x [r -roe] > A. By Proposition

5, we necessarily have x [r roe] = A in opthn1,tiitr, however. Since A > 0, that entails

x $ 0, so fD(x) > 0 by Proposition 3(a). The condition for an unconstrained minimum,

LA (', A) > LA (x, A) for all x', translates into


fX(X') > fv(x) + (x' x) [A(r roe)] for all x.

This means A(r roe) E QfD(x) and is the same as (2.37) holding for some y E QfD(x). It

implies by Proposition 10 that x [A(r roe)] = fD(x), from which it follows (even without

knowing in advance that A > 0, as we do) that A = fv(x)/x[r roe] = f(x)/A > 0. A

It must be emphasized that the optimality rule in Theorem 7 is valid regardless of the

cost of the x-portfolio. It can be applied in particular to master funds, however, by way of

Theorems 5 and 6, as will be carried out shortly in Theorem 8. For many choices of the

deviation measure D, a precise description of the vectors y E OfD(x) that enter the rule is

available through Proposition 10 and the .111 1-, i of deviation subgradients Y E OD(X) and

risk envelopes Q E Qx that we have already carried out in examples [11, 23]. The details

will not be listed here, but we will draw on then below in a series examples concerned with

master funds.

The statement of Theorem 7 has been chosen to keep close to the optimality conditions

that would be anticipated when fD is a differentiable function (away from the origin of f1',

where its differentiability is impossible). Then the yi's are the partial derivatives in (2.33),

and it may be imagined that a solution x = (xl,... ,x) could be determined from the

n+1 equations in the n + 1 unknowns Xi,..., X and A that correspond then to optini1,lit-,










namely
{ x[rl ro] +. + [rn ro] = A,
(2.38)
A[ri -ro] (ix,...,xn) for i 1,...,n.

A practical shortcoming in this approach is apparent, however, in the fact that the partial

derivatives depend nonlinearly on xl,...,x,, in general, and although this dependence

would be continuous, it would not likely be differentiable. (The twice differentiability of fD

is rarely to be expected in our setting.) Solving systems of nonlinear equations directly is a

formidable task even by numerical methods when the expressions in the equations are not

differentiable. This is true all the more when the solution is not guaranteed to be unique,

even locally -a further difficulty which, on the basis of the remarks at the end of the

preceding section, cannot be shoved aside.

Anyway, there is no need to reduce optinriilitv conditions to a -;, -. ill of equations in

order to gain insight from them. The subgradient expressions in Theorem 7 provide both

practical and theoretical information which can readily be utilized. Numerical methods of

optimization for solving problem Po(A), making use of these conditions, can be substituted

very effectively for numerical methods of solving nonlinear equations. Such optimization

techniques can take advantage of special features like the max formula for fD in Proposition

3(e) obtained from the risk envelope Q, which relates to the form of the yi's in (2.36), for

example, but this is not the place to pursue that topic.

The optimlitvi1 conditions in Theorem 7 can be restated in a different manner by

recognizing that, since A must turn out to be equal to fD(x)/A, this ratio can be substituted

for A in (2.37), moreover with A replaced by x [r roe]. The conditions we reach by that

route are


r- ro = i A for i 1,...,n, with (yi,...,yn) = y E f,(x). (2.39)

These equations moreover embody the requirement that T [r roe] = A, since that follows

from them by Proposition 10 through multiplying each equation by xi and adding up.

The criterion for optiH1,-litv in (2.39) produces important information about the port-

folios that furnish master funds.









Theorem 8 (characterization of master funds). For an x*-portfolio and its gain r.v. X*

x* r, let B(x*) stand for the set of all vectors 3 = (31,..., /3) (perhaps no more than one)

that satisfy

covar(ri, Y*)/D(X*) for some Y* E OD(X*), and
ei (2.40)
covar(-ri, Q*)/D(X*) for some Q* E Qx*,

the two descriptions in this formula being equivalent.

(a) A master fund of positive type is furnished by x* if and only ifx* has cost x*e = 1
and there is a coefficient vector 3 E B(x*) such that

ri-ro = 3i [EX* -ro] for i= 1,...,n. (2.41)

(b) A master fund of negative type is furnished by x* if and only if x* has cost x*e =

-1 and there is a coefficient vector 13 E B(x*) such that

i ro = -3i [(-EX*) ro] for i = 1,..., n. (2.42)

(c) All coefficient vectors 3 E B(x*) have the property that

x31x* + .- +3,,* = 1. (2.43)

T!, v are subject to the general estimates

1 O f 1 O+f
f(*) O (x) < < ( f) for i 1,...,n, (2.44)

which, when x* happens to be a point at which fD is differentiable, reduce to fixing 3

uniquely through

1 3i (W*) for i 1,...,n. (2.45)
fD(x*) Oxi
Proof. This combines the optimality conditions in Theorem 7, in the version posed in

(2.39), with the facts in Proposition 10 about vectors y E Of-(x*). In the light of having

* e = 1, the equations in (2.41) assert the existence of y E OfD(x*) such that

re- ro = A* for i 1,...,n, with A* x= x [r roe]. (2.46)
fj(x*)










That is equivalent to having z* in the solution set So(A*), and since the cost of z* is 1,

corresponds to x* furnishing a master fund of positive type in the sense of Definition 1.

The case of a master fund of negative type in (b) is entirely parallel, except for being

adjusted to z* having cost -1. Since -3i[(-EX*) ro] = 3ix*[r roe] in that case, they

correspond again to having (47) hold for some y E fD(ax*). The relations in (2.40), (2.43),

(2.44) and (2.45), simply translate properties in Proposition 10 from y to y/fD(x*). Oj

The switch in Theorem 8(b) from EX* to -EX* amounts to a switch from the x*-

portfolio, which constitutes a net short position, to its opposite, the H*-portfolio for x*

-x*, which constitutes a net long position. The appearance of -3i in place of 3i in (2.42),

corresponds to reversing, accordingly, the various correlations in (2.40).

Regardless of the type of master fund, the equation in (2.43) can be interpreted as pro-

viding guidance to the allocation of risk among the instruments i = 1,..., n in determining

x*.

The generality of Theorems 7 and 8 deserves emphasis. Other researchers working

with nonstandard deviation measures have dealt with special classes of measures and have

typically narrowed the scope of their results by supposing the uniqueness of the optimal

portfolio in question, or further in the case of a master fund, that it is of positive type. They

have also relied on the function fD being differentiable. Theorems 7 and 8, in contrast, do

not have these limitations.

2.8 Specialized CAPM-like Relations

The equations in the characterization of master funds in Theorem 8 bear a strong

resemblance to the CAPM relations in classical portfolio theory. They need not have the

same interpretation as in that theory, though. We explore this now with respect to a number

of different choices of the deviation measure D. The subgradients Y* and risk monitors Q*

described in these examples can be applied also beyond the master fund context to the

optimality conditions in Theorem 7. We leave the details of that aside, however.

Example 1 (master funds for standard deviation). When D = a and X* is any noncon-

stant r.v., there is a unique Y* e OD(X*), namely Y* = [X* EX*]/a(X*). The master

fund characterizations in Theorem 8, with respect to X* = x*r, therefore hold with fD










differentiable and
covar(ri, X*)
A = (2.47)
O72(X*)
Detail. The description of OD for this case comes from [11, Examples 14 and 18]. o

In this setting, as long as the risk-free rate ro is not too high (in the sense of the

threshold in Theorem 5), there is a unique master fund of positive type: x*, (* and A*

are uniquely determined subject to the x*-portfolio having unit cost. The coefficients /3i in

(48) turn the relations in (2.41) into the standard CAPM equations for the expected rate

of return of this master fund (or "market portfolio").

These classical covariance relations have been interpreted in the case of a master fund

of positive type4 as furnishing a one-factor predictive model in the form


ri ro /3i[X* ro] for i = 1,..., n. (2.48)


This is based conceptually on a supposition that all investors seek essentially to minimize

standard deviation, when putting together a portfolio at a specified level of expected gain.

It is tempting to think that the equations of Theorem 8 in (2.41) might be able to take

on such a role as in (49) more widely, for other deviation measures, but one must be careful

not to jump directly to such a conclusion. We are operating here from a distinctly different

standpoint, where the investors employing any particular deviation measure D are viewed

only as a subgroup of all the investors, perhaps just a small subgroup. There is little reason

to believe that the actions of such a subgroup ought to have a determining influence on

market behavior as a whole.



4 Little, if any, attention has been paid in the classical context to the potential nonex-
istence of such a fund. For instance, in Luenberger's derivation of a master fund in his
book [24, p. 168], he sets up a function of the .- i, !-," our xi's, and claims that by de-
termining where the partial derivatives of this function vanish, the fund in question will be
determined. The function is nonconvex, however, so this is just a necessary condition, not
a sufficient condition, and could correspond to a maximum as well as a minimum. Anyway,
he neglects the issue of whether a point where the derivatives vanish even exists. In this
way, the threshold phenomenon with the risk-free rate is missed entirely.










Another issue which must not be ignored, in general, is that the coefficients /3i in

Theorem 8 might not be uniquely determined. This could happen in (2.40) because of Y*

or Q* not being uniquely determined by the conditions at hand with respect to x*, but it

could also occur in (2.40) or (2.45) from x* not even being the only solution to problem

Po(A*). Still another .. --1i.1il-, is that x* might be the unique solution for this A*, and

yet another portfolio, corresponding to a value different from A*, might furnish a different

master fund. This could arise from a "flat spot" on the efficient frontier; it occurs in Figures

2-3 and 2-4.

Of course, it is conceivable nonetheless that, through statistical .1,! '-, -i-. the relations

(2.41) in Theorem 8 with respect to one, or maybe several alternative deviation measures

in combination, may lead to interesting predictive models of type (49) with advantages

over the classical CAPM. (The underlying assumption of the classical model is ',i, .-,- not

beyond controversy.) That is not a topic to be taken up in this chapter, however.

In the examples that follow, we are content mainly to see what the relations coming

from Theorem 8 look like as master fund characterizations, and to note comparisons with

the "beta" formulas derived by other researchers under assumptions like differentiability

and uniqueness. In each case, the same coefficients work for master funds of negative type

as well as ones of positive type, in line with the alternative forms of the equations in (2.41)

and (2.42).

Example 2 (master funds for lower semideviation). When D = a and X* is any non-

constant r.v., there is a unique Y* e OD(X*), namely Y* = [X* EX*]/a (X*) for

X* = min{X* EX*,0}. The master fund characterizations in Theorem 8, with respect

to X* = x*r, therefore hold with fD differentiable and

covar(ri, X*)
2Xi *) (2.49)
(2 (X*)

Detail. Here, we rely on the formula for OD established by Rockafellar et al. [23], Example

6. 0









Lower semideviation is among the measures covered by Malevergne and Sornette [13].

Those authors, although concerned especially with ii.._ iii. -," based their results on ax-

ioms aimed at covering a wide class of measures of I,. i I .11!" type. They did not require

convexity or continuity, or invoke those properties i-, '.-_ re, so the underpinnings to their

assertions of the existence and uniqueness of optimal portfolios appears to be without foun-

dation. The same is true of their claims of having determined master funds of positive type

without making any restriction on the risk-free rate.

Example 3 (master funds for CVaR). Let D(X) = CVaR,(X EX) for any choice of

a E (0, 1). For any r.v. X*, the elements of Qx* are then the functions Q* on Q that are

densities (Q* > 0, EQ* = 1) such that

Sa-1 on { w E Q X*(w) < -VaRa(X*)},

Q* 0 on { e Q X*(w) > -VaRa(X*)}, (2.50)

E [0, a-1] on { a e Q| X*(w) = -VaR,(X*)}.

The master fund characterizations in Theorem 8, with respect to X* = x*r, hold therefore

with the coefficients 3i in (2.40) coming from such a density function Q*.

Moreover, if the set { w E Q X(w) = -VaRo(X)} has probability 0, as is true in

particular when the r.v. r = (ri,..., rn) is continuously distributed, then fD is differentiable

at x* and the coefficients 13i can be expressed by conditional expectations:

E[ r ri X* < -VaR(X*) ]
E[EX* X* IX* < -VaRa(X*)] (

Detail. This utilizes the description of Qx* coming out of [11, Example 20]. C'I. ly, Q*

is uniquely determined (up to the usual equivalence in 2(Q)) by the relations in (2.50)

for X* when there is zero probability of X* taking on the value -VaR,(X*). Then fD

is differentiable at x* by Proposition 10. Otherwise, though, Q* might not be uniquely

determined, and fD could thus fail to be differentiable at x*. Indeed, when


P{X* < -VaRa(X*)} < < P{X* < -VaRa(X*)},









the values of Q* on the set { E Q I X*(w) = -VaRo(X*)} can be selected arbitrarily from
the interval [0, a-1], subject only to arranging that P{X* < -VaRo(X*)} = a. It may

not be possible in that situation to pass from the formula for 3i in (2.40) to the formula in

(2.51). 0

The version of the CVaR opttim -litv, relations in (2.51) is interesting for the reason that

the numerators of the beta coefficients give the conditional expectation of the downside of

ri subject to X* being in its lower a-tail. As noted, however, this version is valid when r is

continuously distributed, but not necessarily when the distribution of X* has a p i! ,1, 1il li

atom at -VaRa(X*).

In previous work on CVaR master funds, Tasche [14], Bertsimas [15] and Acerbi and

Simonetti [16] have avoided the issue of discontinuities coming up in the probability dis-

tributions and has moreover required the differentiability of fD. The need for a threshold

assumption on the risk-free rate, in order to be assured of the existence of a master fund

of positive type, did not get addressed, nor did the issue of nonuniqueness of such a fund,

even when it exists.

Example 4 (master funds for mixed CVaR). Let D(X) = E ,i AkCVaR (X EX) with

Ck E (0,1), Ak > 0 and /ZE 1 Ak = 1. For any r.v. X*, the elements of Qx* are then the
functions Q* on Q of the form Q* Z= E AkQ*, where each Q* is a density (Q > 0,

EQ* = 1) such that

a a- on a) E I X*(a)) < -V.R (X*)},

Ql 0 on { E QI X*(w) > -VaR (X*)}, (2.52)

E [0,ak1] on {w) E Q X*(w)= -VI (X*)}.

In this case, therefore, the master fund characterizations in Theorem 8, with respect to

X* = x*r, hold with the coefficients 3i in (2.40) coming from such a Q*, which itself is

another I,-il v function.

If the sets {( we Q X*(w) = -V'P (X*)} for k = 1,..., m all have probability 0, as is

true in particular when r = (ri, ..., r,) is continuously distributed, then fD is differentiable









at x* and the coefficients 3i can be expressed by a weighting of conditional expectations:

E3l AkE[ r ri IX* < -VaR,(X*)]
E=, AkE[ EX* X* I X* -V. ,, (X*)]"

Detail. We have D Z Ek AkDk for Dk(X) = CVaR,(X EX). The rule for the risk

envelope of a sum of deviation measures [23, Example 2] then comes into 1p1 ,. According

to that rule, Q consists of all Q Z= E 1 AkQk with Qk belonging to the risk envelope for

Dk. Then too, since Qx*, for any r.v. X*, consists, by definition, of the elements Q that
maximize covar(-X*, Q) subject to Q E Q, we have Q* E Q if and only if Q* = J: I AkQ*

for a choice of functions Q* E (Qk)x*. It remains only to utilize for each of the CVaR

deviation measures Dk the description of (Qk)x* in the pattern of Example 3. O

Example 5 (master funds for lower range deviation). Let D(X) = EX inf X with the

state space Q being finite (so that inf X is finite for all X e 2(Q)). For any r.v. X*, the

elements of Qx* are then the functions Q* on Q that are densities concentrated in the worst

w states for X*, i.e., '! \ are the functions Q* ,ii -f i.i_

> 0 for w E Q such that X*(w) infX*,
EQ* = 1 and Q*(w) = (2.54)
0 for w e Q such that X*(w) > infX*.

In this case, the master fund characterizations in Theorem 8, with respect to X* = x*r,

therefore hold with the coefficients 3i in (2.40) coming from such a density function Q*.

When the set of states w E Q such that X*(w) = inf X* consists of a unique w* (having

nonzero prl .1 1illiv), then Q* is uniquely determined from X*, so fD is differentiable at x*

and the coefficients 13i come out as

S=- i() where X*(w*) infX*. (2.55)
EX* -X*(w*)

Detail. The description of Qx* for this choice of D corresponds to the formula for OD

obtained by Rockafellar et al. [11], Example 19. D

Example 6 (master funds for generalized mean absolute deviation). Suppose

D(X) = E[ aX EXI ] = a(w)X() EXIdP(w) (2.56)
JO









for a positive (measurable) function a of the states w E Q. For any r.v. X*, the subgradients

Y* E OD(X*) are then the functions of form Y* = V EV coming from functions V on Q

that satisfy
= a(w) on { w e IX*(wa) > EX*},

V(w) = -a(w) on { w I X*(w) < EX*}, (2.57)

E [-a(w),a(w)] on {C E Q X*(w) = EX*}.

TIh !1 ir ., the master fund characterizations in Theorem 8, with respect to X* = x*Tr,

hold with the coefficients P3i in (2.40) coming from such a Y* (in which case covar(ri, Y*) =

covar(ri, V), actually).

If the middle set in this formula has probability 0, as is true in particular when the

r.v. r = (ri,...,rn) is continuously distributed, then fD is differentiable at x* and the

coefficients 3i are determined by

E[a(ri ri) sign(X* EX*)]
E[ aX* EX* I ]

Detail. We have D(X) = J(X EX) for the convex functional J(U)

fJ (w,U(w))dP(w) in which p(w,u) = a(w)lul for (w,u) e Q x JR. Hence the subgra-
dients Y* e OD(X*) have the form Y* V EV for the subgradients V e OJ(X* -EX*).

The subgradients of an integral functional such as J are known in convex .' !!1-, -i, to

be characterized by the rule that V E OJ(U) if and only if V(w) e Ouc(w, U(w)), where

Ouc(w, U(w)) refers to the subgradient set of u(w, u) with respect to u at u = U(w). This

corresponds to V I i-f-, i :_- the relations in (2.57). O

Konno [17] has investigated mean absolute deviation with a(w) 1 under the assump-

tion that the ri's have a multivariate distribution given by a density function on 1R", and

with that he has obtained similar /3's. In his I ii:_, the uniqueness of a master fund is not

assured, though, since mean absolute deviation lacks the kind of strict convexity needed for

that. Short positions are said to be excluded, which would make comparisons difficult with

the optimization problem we treat here, but the constraints against shorting are suppressed

in the developments by assuming their Lagrange multipliers can be set equal to 0. The









optimal portfolio is assumed nevertheless to involve no shorting, so the potential need for

a master fund of negative type does not come into view.

2.9 Multiplier Derivation of Thresholds

The characterization of ro and ro at the end of Theorem 5 provides a means of cal-

culating these threshold risk-free rates through optimization. By solving problem P(0, 1),

one gets its multiplier set M(0, 1), which has the special form described and embodies all

the information needed.

It is possible now, by building on the subgradient developments in the preceding section,

to indicate in more detail what this involves. The Lagrangian function for P(0, 1) is


L(o,1)(x, p, rl) = fr(x) px e + r[ x r],

as specialized from (2.24), and M(0,1) consists of the pairs (p, r) such that

inf, L(o,1)(x, p, ) = d(0,1), as noted in (2.25). There are no sign restrictions on these

multipliers p and rl, a priori, since the constraints in P(0, 1) are equations.

Proposition 11 (threshold multipliers). In terms of an optimal x* in P(0, 1), the multiplier

pairs (p, rl) E M(0, 1) are characterized by the relation


pe + r E afD(x*), (2.59)

which corresponds to the existence of some Y* e OD(X*) such that

p =covar(ri, Y*) rri for i 1,..., n, with = VD(X*)= d(0,1). (2.60)

Proof. In P(0, 1), we are looking at a convex programming problem in which a finite

convex function on f?', namely fD, is minimized subject to two linear constraints -which

we know can i'.- '-, be satisfied (Proposition 4). In such a problem, the condition that x*

be optimal and (p, rl) be a Lagrange multiplier vector corresponds to x* il i-r-, in,:: xe = 0

and *Tr = 1, and being such that the inequality L(o,1)(a*,p, r) < L(o,1)(, p, rl) holds for

all x. This inequality has the form


fi(x) pX e + 1[1 xr] > fD(X*) px*Te + [1 XTr],










which can be written as fD(x) > fD(x*) + [x x*] [pe + rir]. Having it hold for all x E JR

is the same as saying that pe + rjr is a subgradient y E OfD(x*), as claimed in (2.59).

Applying the description of such subgradients y in (2.35) of Proposition 10, we get the

characterization claimed in (2.60). O


Corollary (single thresholds). In situations where the subgradient set OD(X*) consists of

a unique Y*, the multiplier set M(0, 1) reduces to a single pair (p, rl), and a single threshold

is then assured:

ro = = r = (2.61)

Although the numerical approach in which the possible multiplier vectors (p, rj) are

calculated as byproducts of the optimization in P(0, 1) itself may be all that can be counted

on in general, it is interesting to note that, in the classical case of standard deviation, an

analytic formula for the threshold can be derived.

Example 7 (threshold formula for standard deviation). When D = a, there is a single

threshold ro = o = t for the risk-free rate, which can be expressed in terms of the

variance-covariance matrix for the risky assets i = 1,..., n. This matrix, let it be denoted

by A, is positive definite under assumption Al, so its inverse A-1 exists. One has

r A-le
ro = (2.62)
eTA-le

Detail. In building on Example 1, we know that the unique Y* in (2.60) must be [X* -

EX*]/a(X*). Then (61) says that pe = A[x*/((X*)] rr, so Ax* = u(X*)[pe + rlr] and

consequently

x* = (X*)A-l [pe+rr].

Since x*Te = 0, we must have [pe+rr] A- e = 0, or in other words, p[e A- e]+rl[rVA-e]

0. Therefore, p is uniquely determined and the corresponding single threshold value for the

risk-free rate is the ratio in (2.62). 0







56

2.10 Conclusions

We have endeavored to complement the ground-breaking work of Artzner, Delbaen,

Eber and Heath by demonstrating that when risk measures in their sense are applied to

X EX instead of to a return r.v. X itself -in the presence of a new property of

expectation-boundedness -a parallel class of functionals, appropriately termed deviation

measures, arises. This should help bridge the gap between the theory of risk measures and

the way that risk is typically viewed by practitioners in the finance industry. To further

this aim, we have explored the distinction between risk measures and deviation measures

in a range of key examples, providing insights also in terms of risk acceptance notions and

their dualization by risk envelopes.

The replacement of standard deviation by other deviations, such as arise from condi-

tional value-at-risk and other risk notions, in accordance with current trends, by no means

causes the classical approach to optimization out-dated. Instead, it enriches that approach

by making a degree of customization available. One-fund theorems still reign as a way

of simplification, even though the designated funds, in their dependence on the deviation

measure, can be different for different classes of investors.

Utilizing tools of convex .1,-1 I-, -i-. we have furthermore developed a scheme for deter-

mining optim -il1it in problems of minimizing deviation or risk. We have shown that risk

envelopes have major significance in solving such problems and have illustrated the partic-

ulars in a number of settings. The results open the way for many applications and advances

in their numerical methodology.

Furthermore, optimality can still be characterized by covariance relations. However,

optimality with respect to net short positions in the risky instruments must be .111 '1-,. 1

in addition to optimality with respect to net long positions in order to determine how an

investor may wish to act with respect to the current risk-free rate. The covariance relations

that are obtained furnish additional information about the behavior of risky instruments in

various situations. This information could be useful in practical .11-1 '1, -i, even if no longer

associated with notions of equilibrium in which all investors are attracted to a single master

fund.
















CHAPTER 3
DRAWDOWN MEASURE IN PORTFOLIO OPTIMIZATION

3.1 Introduction

Optimal portfolio allocation is a longstanding issue in both practical portfolio manage-

ment and academic research on portfolio theory. Various methods have been proposed and

studied by Grinold [26]. All of them, as a starting point, assume some measure of portfo-

lio performance, which consists of at least two components: evaluating expected portfolio

reward; and assessing expected portfolio risk. From theoretical prospective, there are two

well-known approaches to manage portfolio performance: Expected Utility Theory and Risk

Management, which are usually considered within a framework of a one-period or multi-

period model.

If we are interested in Risk Management approach to portfolio optimization within a

long term, what are the functionals for assessing portfolio risk that account for different

sequences of portfolio losses? Let portfolio be optimized within time interval [0, T], and

let W(t) be portfolio value at time moment t E [0, T]. One of the functionals that we are

looking for is portfolio drawdown defined by max W(T) W(t) W(t), which, indeed,
r-e[o,t]
accounts for a sequence of portfolio losses. What are the advantages to formulate a portfolio

optimization problem with a constraint on portfolio drawdown? To answer to this question,

drawdown regulations in real trading strategies and drawdown theoretical aspects should

be addressed first.

3.1.1 Drawdown Regulations in Real Trading Strategies

From a standpoint of a fund manager, who trades clients' or bank's proprietary capital,

and for whom the clients' accounts are the only source of income coming in the form of

management and incentive fees, losing these accounts is equivalent to the death of his

business. This is true with no regard to whether the employed strategy is long-term valid

and has very attractive expected return characteristics. Such fund manager's primary

concern is to keep the existing accounts and to attract the new ones in order to increase










his revenues. Commodity Trading Advisor (CTA) determines the following rules regarding

magnitude and duration of their clients' accounts drawdowns

Highly unlikely to tolerate a 50% drawdown in an account with an average- or small-
risk CTA.

An account may be shut down if a 2-' drawdown is breached.

A warning is issued if an account in a 15% drawdown.

An account will be closed if it is in a drawdown, even of small magnitude, for longer
than 2 years;

Time to get out of a drawdown should not be longer than a year.

3.1.2 Drawdown Notion in Theoretical Framework

Several studies discussed portfolio optimization with drawdown constraints. Grossman

and Zhou [27] obtained an exact analytical solution to portfolio optimization with constraint

on maximal drawdown based on the following model

Continuous setup

One-dimensional case -allocating current capital between one risky and one risk-free
assets

An assumption of log-normality of the risky asset

Use of dynamic programming approach -finding a time-dependent fraction of the
current capital invested into the risky asset

Cvitanic and Karatzas [28] generalized this model [27] to multi-dimension case (several

risky assets). In contrast to Grossman and Zhou [27] and Cvitanic and Karatzas [28],

Chekhlov et al. [29] defined portfolio drawdown to be the drop of the current portfolio value

comparing to its maximum achieved in the past up to current moment t, i.e. max W(7) -
rE[O,t]
W(t), and introduced one-parameter family of drawdown functionals, entitled Conditional

Drawdown (CDD). Moreover, Chekhlov et al. [29] considered portfolio optimization with a

constraint on drawdown functionals in a setup similar to the index tracking problem [30],

where an index historical performance is replicated by a portfolio with constant weights.

Chekhlov et al. [29] proposed the following setup


* Discrete formulation










Multi-dimensional case -several risky assets (markets and futures)

A static set of portfolio weights li -f, in- a certain risk condition over the whole
interval [0, T]

No assumption about the underlying probability distribution, which allows considering
variety of practical applications -use of the historical sample paths of assets' rates
of return over [0, T]

Use of linear programming approach -reduction of portfolio optimization to linear
programming (LP) problem

The CDD is related to Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR)

measures studied by Rockafellar and Uryasev [21, 20]. By definition, with respect to a

specified probability level a, the a-VaR of a portfolio is the lowest amount (, such that,

with probability a, the loss will not exceed (, in a specified time r, whereas the a-CVaR

is the conditional expectation of losses above that amount (,. Various issues about VaR

methodology were discussed by Jorion [31]. The CDD is similar to CVaR and can be viewed

as a modification of the CVaR to the case when the loss-function is defined as a drawdown.

CDD and CVaR are conceptually related percentile-based risk performance functionals.

Optimization approaches developed for CVaR are directly extended to CDD. The CDD

includes the average drawdown and maximal drawdown as its limiting cases. It takes

into account both the magnitude and duration of the drawdowns, whereas the maximal

drawdown concentrates on a single event -maximal account's loss from its previous peak.

However, Chekhlov et al. [29] only tested the -ii:_: -. 1 approach to portfolio opti-

mization subject to constraints on drawdown functionals. The CDD [29] was not defined as

a true risk measure and the real-life portfolio optimization example was considered based

only on the historical sample paths of assets' rates of return.

This chapter is focused on

Concept of drawdown measure -possession of all properties of a deviation measure,
generalization of deviation measures to a dynamic case

Concept of risk profiling -Mixed Conditional Drawdown (generalization of CDD)

Optimization techniques for CDD computation -reduction to linear programming
(LP) problem


* Portfolio optimization with constraint on Mixed CDD










Our study develops concept of drawdown measure by generalizing the notion of the

CDD to the case of several sample paths for portfolio uncompounded rate of return. Def-

inition of drawdown measure is essentially based on the notion of CVaR [32, 21, 20] and

mixed CVaR [11] extended to a multi-scenario case. Drawdown measure uses the concept

of risk profiling introduced by Rockafellar et al. [11], namely, drawdown measure is a

iiiiili.--. ii i .. mixed CVaR applied to drawdown loss-function.

From theoretical prospective, drawdown measure satisfies the system of axioms deter-

mining deviation measures [11, 23]. Those axioms are: ,,,,,, ./:.,I .::. .-.:,, /. I./: .:/ to con-

stant shift, positive 1...i,.....,. i, .:I/ and convexity. Moreover, drawdown measure is an example

generalizing properties of deviation measures to a dynamic case. We develop optimization

techniques for efficient computation of drawdown measure in the case when instruments'

rates of return are given.

Similar to the Markowitz mean-variance approach [3], we formulate and solve an opti-

mization problem with the reward performance function and CDD constraints. The reward-

CDD optimization is a piece-wise linear convex optimization problem [18], which can be

reduced to a linear programming problem (LP) using auxiliary variables.

Linear programming allows solving large optimization problems with hundreds of thou-

sands of instruments. The algorithm is fast, numerically stable, and provides a solution dur-

ing one run (without adjusting parameters like in genetic algorithms or neural networks).

Linear programming approaches are routinely used in portfolio optimization with various

criteria, such as mean absolute deviation [33], maximum deviation [34], and mean regret

[30]. Ziemba and Mulvey [35] discussed other applications of optimization techniques in the

finance area.

3.2 Model Development

Suppose a given time interval [0, T] is partitioned into N subintervals [tk-, tk], k

1, N, by the set of points {to = 0, tl, t2, ..., tN = T}, and suppose there are m risky assets

with rates of return determined by random vector r(tk) = (rl(k), r2(tk), ..., rm(tk)) at

time moments tk for k = 1, N. We also assume that the risk-free instrument (or cash) with

the constant rate of return ro is available. The ith asset's rate of return at time moment










tk is defined by ri(tk) = itJ) 1, where pi(tk) and pi(tk-1) are the ith asset's prices per

share at moments tk and tk-1, respectively. Let C denote an initial capital at to = 0 and

let values Xi(tk) for i = 1, m and xo(tk) define the proportion of the current capital invested

in the ith risky asset and risk-free instrument at tk, respectively. Consequently, a portfolio

formed of the m risky assets and the risk-free instrument is determined by the vector of

weights x(tk) = xo(tk), xl(tk), X2(tk),..., X,(tk)). The components of x(tk) satisfy the

budget constraint

i=0
By definition, the rate of return of the portfolio at time moment tk is


r(P(xtk)) r(k) k) = f i (k) i k) (3.2)
i=0

Portfolio optimization can be considered within a framework of a one-period or multi-

period model. A one-period model in portfolio optimization assumes the ith asset's rates

of return for all tk, k = 1, N, to be independent observations of a random variable ri.

In this case, the vector of portfolio weights is constant and portfolio rate of return is a

random variable r() presented by a linear combination of random assets' rates of return ri,

i 1, m, and constant ro, i.e. r() = ri i. A traditional setup for a one-period portfolio
i=0
optimization problem from Risk Management point of view is maximizing portfolio expected

rate of return subject to the budget constraint and a constraint on the risk

max E(r(P))

s. t. lRisk(r()) < d, (3.3)

E xi = i.
i=0

Risk of the portfolio can be measured by different performance functionals, depending

on investor's risk preferences. Variance, VaR, CVaR and Mean Absolute Deviation (MAD)

are examples of risk functionals used in portfolio Risk Management [11]. Certainly, solv-

ing optimization problem (3.3) with different risk measures will lead to different optimal

portfolios. However, all of them are based on a one-period model, which does not take into

account the sequence of the asset's rates of return within time interval [0, T].









A multi-period model in portfolio optimization is intended for controlling and optimiz-

ing portfolio wealth over a long term. It is essentially based on how the asset's rates of

return evolve within the whole time interval. Moreover, in each time moment tk, k = 0, N,

there might be a capital inflow or outflow into or from the portfolio and portfolio weights

Xi(tk), i =, m, might be re-balanced. In this case, the portfolio wealth at tk for k = 1, N
is defined

Wk X(tk)) (Wk- I(X k-1)) + Y(tk-1)) (1 + rP)(x(tk))), (3.4)

where Y(tk-1) F+(tk-1) F-(tk-1) is the resulting capital flow at tk-1 (inflow F+(tk-_)

minus outflow F_(tk-_)), which can be positive or negative.

A portfolio optimization problem can also be formulated based on the Expected Utility

Theory (EUT). According to the EUT, an investor with additively separable concave utility

function U(.) chooses a consumption stream {Co, C1,..., CN-1} and portfolio to maximize

E U (C(tk), tk) + B (W(tN,(tN))) where B(.) is the concave utility of bequest.
\k=0 )
Note the EUT is focused on maximization of investor's consumption. However, a risk

manager who runs a hedge fund and wishes to increase capital inflow by attracting new

investors would be more interested in maximizing portfolio wealth at the final moment

tN = T and decreasing portfolio drops over the whole time interval [0, T]. In this case, Risk

Management approach is more adequate to formulate a portfolio optimization problem

max P(W)

s. t. R(W) < d, (3.5)

EXi(tk) 1= k =0,N,
i=0

where P(W) and R(W) are performance and risk functionals, respectively, depending on

stream W = (Wi, W2, ..., WN).

Suppose the optimization problem (3.5) is considered under the following conditions

A manager cannot affect a stream of Y(tk) (if the portfolio value increases it is likely
that capital inflow will also increase and vise-versa).

The manager can only allocate resources among different instruments (investment
strategies) in the portfolio at every moment tk, k 0 N, i.e. he/she can only optimize
portfolio rate of return by choosing portfolio weights Xi(tk).









Accounting for these conditions, how can the manager evaluate portfolio performance

over [0, T] and efficiently solve (3.5)? Before to answer to this question, the following

legitimate issues regarding problem formulation (3.5) should be addressed

How the risk is measured within [0, T]

How the assets' rates of return are modeled within [0, T]

What optimization approach is chosen to solve (3.5)

3.2.1 Dynamic Performance Functionals

Does using variance, VaR, CVaR or MAD by itself make sense in a dynamic case? The

obvious answer is no, since no one of them by itself takes into account the sequence of assets'

rates of return. Although, the aforementioned risk measures may be quite appropriate if

they are applied to a random variable or functional, which distinguishes different sequences

of Wk in a stream (Wi, W2, ..., WN). One of the functionals accounting for a sequence of

Wk is based on the notion of portfolio drawdown, which deals with the drop in portfolio

wealth at time moment tk with respect to the wealth's maximum value preceding tk. By

definition, the portfolio drawdown at tk is the ratio of the drop in portfolio wealth at tk to

the preceding wealth's maximum

Wk (k(t))
D (W, tk) 1 .kk) (3.6)
max {Wj ((tj))}

A possible problem formulation is to consider portfolio optimization with drawdown

constraints in continuous dynamics [27, 28], for instance


Pr {DD (W, t) < 7, V [0, T]} 1. (3.7)

In this case, portfolio drawdown should not exceed given value 7 E [0, 1] almost surely

for all t E [0, T]. However, instead of imposing the constraint (3.7) for all t E [0, T], we

are interested in maximizing portfolio expected rate of return while controlling an integral

characteristic of portfolio performance. We entitle such a characteristic to be a dynamic

performance functional (DPF). In this case, following Risk Management methodology, we

would be able to construct an efficient frontier establishing the dependence between the









expected rate of return of optimal portfolios and corresponding values of the DPF. Devel-

oping DPF based on the notion of portfolio drawdown and solving a real-life asset-allocation

problem with these functionals is the subject of this chapter.

3.3 Absolute Drawdown for a Single Sample Path

This section presents the notion of the Absolute Drawdown (AD) and considers three

DPF based on this notion. The AD is applied to a sample path of the uncompounded cumu-

lative portfolio rate of return. Note the AD is applied not to the compounded cumulative

portfolio rate of return Wk(x(tk)). If the values of r) (x(tk)) for k = 1, N determine a sam-

ple path (time series) of the portfolio's rate of return, then, by definition, the uncompounded

cumulative portfolio rate of return at time moment tk is

0, k = 0,
Wk(X(tk)) k (3.8)
Sr( )), k= 1,N.
1=1

To simplify notations, we use wk instead of Wk(x(tk)), assuming that wk is 1,-, a

function of vector x(tk). Further in this section, we consider only a single sample path of

wk, k = 1, N, which we denote by vector w, i.e. w = (wl, ..., WN).
Definition 1. The AD is a vectorial-functional depending on the sample path w


AD(w) = = (1, ..., N), k = max (wj} wk. (3.9)

Note that components (wl, ..., WN) and (&1, ..., wN) of vectors w and 4, are, in fact,

time series wl, ..., WN and (1, ..., AN, respectively, where the kth components of w and (

correspond to time moment tk. Since o is I1.- -, zero, we do not include it into drawdown

time series Moreover, although AD(w) and ( are the same drawdown time series, we

refer to notation AD(w) to emphasize its dependence on w and to notation ( whenever we

use drawdown time series just as vector of numbers.

Figure 3-1 illustrates an example of the absolute drawdown ( and a corresponding

sample path of uncompounded cumulative rate of return w. Starting from to = 0, uncom-

pounded cumulative rate of return w goes up and the first component of equals zero.

When w decreases, ( goes up. When time series w achieves its local minimum, absolute

drawdown achieves its local maximum. This process continues until tN = T.











S= (w, ..., WN)


t
0 t, t2 T

Figure 3-1: Time series of uncompounded cumulative rate of return w and corresponding
absolute drawdown (.


Proposition 1. Defining vectorial operations: w + const = (wi + const, ..., WN + const)

and Aw = (Awl, ..., AwN), the AD(w) satisfies the following properties

1. Nonnegativity: AD(w) > 0.

2. Insensitivity to constant shift: AD(w + const) = AD(w).

3. Positive homogeneity: AD(A w) = A AD(w), VA > 0.

4. Convexity: if wA A wa + (1 A) Wb is a linear combination of any two sample paths

of uncompounded cumulative rates of return, Wa and Wb, with A e [0, 1], then AD(w\) <

A AD(wa) + (1 A) AD(b).

Proof. Properties 1-3 are direct consequences of definition (3.9). Property 4 is proved

based on max {Aw + (1 ) wb} < A max {Wa + (1 ) max {wb}, A [0, 1]. 0
O Note DD does not satisfies the properties which AD does (advantage of AD). The

difference between the AD and DD is similar to the difference between absolute and relative

errors in a measurement. The AD and DD functionals can be used in Risk Management

and Statistics to control absolute and relative drops in a realization of a stochastic process.

However, in this chapter we are focused on applications of drawdown functionals in portfolio

optimization. Since further in this chapter, we deal only with the absolute drawdown

functional, AD, the word I .-... Iii can be omitted without confusion.









3.3.1 Maximum, Average and Conditional Drawdowns

We consider three DPF based on the notion of drawdown: (i) Maximum Drawdown

(MaxDD), (ii) Average Drawdown (AvDD), and (iii) CDD. The last risk functional is

actually a family of performance functions depending upon parameter a. It is defined

similar to CVaR [20] and, as special cases, includes the MaxDD and AvDD.

Definition 2. For given time interval [0,T], partitioned into N subintervals [tk-l,tk],

k = 1, N, with to = 0 and tN = T, AvDD and MaxDD functionals are defined, respectively


MaxDD(w) max {k} (3.10)
1

1N
AvDD(w) = k. (3.11)
k 1
To define Conditional Value-A-Risk (CV@R) and CDD, we introduce a function 7r(s)

such that

s) N (3.12)
k= 1
where I/{
to zero, if the condition is false, i.e.

1, c I{cs} = c E R.
0, c > s,

Figure 3-2 explains definition of function 7re(s). For the threshold s shown on the

figure, function 7r(s) equals j, since (k < s for 5 values of k, namely, k = 2, 3, 4, 7, 8.

The inverse function to (3.12) is defined


1() { inf{s I r(s) > a}, a (0,1],
%- 1(a) (3.13)
0, = 0.

Remark 1. Since all ,k, k =1, N, are nonnegative, we define 7r- 1(0) to be zero.

Remark 2. In fact, Va e (0,1], s = 7- 1(a) is the unique solution to two inequalities


(3.14)


7 (s 0) < _a < 7(s + 0).









Figures 3-3 and 3-4 illustrate left and right continuous step functions 7rt(s) and 7 "1(a),
respectively, which correspond to drawdown time series ( shown on Figure 3-2.


Drawdown time series
- - - - - -


0 t t t, t4 t5 t6 t7 ts =T


Figure 3-2: Drawdown time series ( and indicator function I{c

Let ((a) be a threshold such that (1 a) 100% of drawdowns exceed this threshold.
By definition,


(3.15)


If we are able to precisely count (1-a)* 100% of the worst drawdowns, then r{(((a))
7 (-(a)) = a. For such a value of the parameter a, the CV@R of (k, k = 1, N, is defined
as the mean of the worst (1-a)*100% drawdowns. For instance, if a 0, then CV@R is the
average drawdown, and if a = 0.95, then CV R is the average of the worst 5% drawdowns.
However, in a general case, 7-{((a)) 7= t --1(a)) > a, followed from definition (3.13).
It means that, in general, we are not able to precisely count (1 a) 100% of the worst
drawdowns. In this case, the CV@R becomes a weighted average of the threshold ((a) and
the mean of the worst drawdowns strictly exceeding ((a).


((a) = 71(a).












x(s)



7/8 ---------------------

3/4 ----------------------------

5/8 -------------------- ............................



3/8 -------------*--
/ 2 . . . . .8
1/4 ---------













Sa(a








Figure 3 3: Funltion i(s)
-8 ---------------------------- <





--------------------------> -









Definition 3. For a given sequence of k, k = 1, N, CV@R is formally defined by

CVI@RO() ( (()) ((c) + 1 k, (3.16)
S -la ( + (1 a)N k

where E = k ~I > C(a), Ak 1, N}.
Note the first term in the right-hand side of (3.16) appears because of inequality
tr (~ (a)) > a. If (1 a) 100% of the worst drawdowns can be counted precisely,
then 7T (7r1(Ca)) = a and the first term in the right-hand side of (3.16) disappears. Defi-
nition (3.16) follows from the framework of the CVaR methodology [21, 20]. Close relation
between the CVaR and CV@R is discussed in the following remark.
Remark 3. CV@Ro, given by (3.16), and functional CVaR, [11] (p. 7, example 4), are
linearly dependent, i.e. if X is an arbitrary random variable then

1
CV@R,(X) (E(X) + a CVaR,(X)). (3.17)

Thus, use of the CV@R or CVaR is only the matter of convenience.
Definition 4. In a single scenario case, the CDD with tolerance level a E [0, 1] is the

CV@R applied to the drawdown functional, AD(w),

A,(w) = CV@RA(AD(w)). (3.18)

Equivalently, interpreting (k, k = 1, N, to be observations of a "random variable" a-CDD
is the CV@Ro of a loss function AD(w).
3.3.2 Conditional Value-at-Risk and Conditional Drawdown Properties

CDD is an example of a functional generalizing properties of deviation measures to
a dynamic case. However, since CDD is closely related to CVaR, which properties were
studied in detail by Rockafellar and Uryasev [21, 20], it is useful to discuss CDD properties
based on properties of CVaR. Because of linear relation (3.17), we can replace CVaR by
CV@R.
Proposition 2. CV@Ro,() satisfies the following properties
1. Constant translation: CV@R,( + const) = CV@R,(0) + cost, Va E [0, 1].
2. Positive homogeneity: CV@R (A ) = A CV@R (0), VA > 0 and Va E [0, 1].









3. Monotonicity: if (k < rk, Vkl,k, then CV@Rs(0) < CVA@Rs(r), Va E [0,1].
4. Convexity: if A X a + (1 A) 4b is a linear combination of any two drawdown sam-

ple paths a and b with A E [0, 1], then CV@Ra(6 ) < A CV@Ra(~) + (1 A) CV@Ra(b).

Proof. Based on linear relation between CV@R, and CVaRo, given by (3.17), properties

1-4 are direct consequence of CVaR, properties [11]. O

Proposition 3. The CDD = A,(w) satisfies the properties of deviation measures, i.e.

1. Nonnegativity: Aa(w) > 0, Va E [0, 1].

2. Insensitivity to constant shift: A,(w + const) = A,(w), Va E [0,1].

3. Positive homogeneity: A,(A w) AA,(w), VA > 0 and Va E [0,1].
4. Convexity: if w = A w, + (1 A) Wb is a linear combination of any two sample paths

of uncompounded cumulative rate of returns Wa and Wb with A E [0, 1], then A,(wA) <

A A (Wa) + (1 A) A (Wb)

Proof. Properties 1 4 follow from Propositions 1 and 2. Indeed, based on the relation

between the CDD and CV@R, i.e. A,(w) = CV@Rs(AD(w)), the first property is a direct

consequence of AD(w) nonnegativity. Properties 2 4 are proved, respectively,

A,(w + c) = CV@R(AD(w + c)) = CVeR, (AD(w)) = A,(w),

A,(A w) = CV@R,(AD(A w)) = CV@R,(AAD(w)) = A CV@R, (AD(w)) = AA,(w),

A,(wA) = CVAR,(AD(A wa + (1 A)Wb)) < CVAR, (A AD(w,) + (1 A)AD(wb))
< A CV@R, (AD(Wa)) + (1- A)CV@R, (AD(Wb))

Aa(W) )+(1 -A)Aa(Wb).
Note the monotonicity property of CV@R is used in the first line of the proof of CDD

convexity. O
Proposition 4. MaDD (3.10) and AvDD (3.11) are the special cases of the a-CDD func-

tional (this notation is used to emphasize CDD dependence on a), namely,

MaxDD(w) = Ai(w), AvDD(w) = Ao(w). (3.19)


Proof. To prove the first formula of (3.19), we assume that ((1) < oo. Based on this

assumption, in the case of a = 1, we have ((1-) = r (1-) = rl(1) = ((1), i.e. function










((a) is constant in the left vicinity of 1. Hence, r(((1-)) = r(((1)) = 1, E1 = 0 and


Ai(w) = (1) lim = ((1) --lim )= (() MaxDD(w).
Al->1- r a->1- 1 r


When a

consequently


0, according to the definition (3.13), ((0)


0, 0o fJk 1,N\ and,


Ao(w) Nk =E AvDD(w).
tkEO0 k=1


Theorem 1. CVRo,() can be presented in the alternative form


1
CV@Ra() = 1r- 1(q) dq,
o


which is mathematically equivalent to (3.16).

Proof. Let s j j = 1, J be the set of the ordered values of sk, k = 1, N,

number of different values of (k, k = 1, N, such that si < S2 < ... < SJ
N J
the multiplicity of sj, i.e. nj = E I{ k=S } and E nj = N. Defining qj
k=1 j=1
functions rrt and 1 are determined by the set of (sj, qj), j 1, J, i.e.


7"(j) qj, 7" (qj) = sj.


where J is the

and n~j > 1 is

: E nzi, step
1(3.21)



(3.21)


J J
Let so 0 and qo = 0, then since n (qj-1, qj] 0 and U (qj-1, qj] (0, 1], for any
j=1 j=1
value of a E (0, 1], there exists j* from 1, J such that a E (qj _1, qj ]. Using (3.21) and

condition a E (qj*_ qj ], we obtain


C((c) sj, 7r(((a)) j*,


and, consequently,


1 J
N : sj nj
I=3*+l


J
E ~1(qj) (qj j-1)
j=j*+1


(3.20)


tk E
tkhE


1
(q) dq.
qj*


Y,










Taking the last relations into account, for any a E (0, 1), the integral in the right-hand

side of (3.20) is presented

1 1
J -(q) dq (qj a) sj* + J (q) dq = (T(((a)) a) ((a) + N I k,
a qj* tkE ao7


which coincides with the expression (3.16) with accuracy of multiplier (1

Only two cases are left to consider, namely, when a = 0 and a

~t l(1) < oc, we have, respectively,


1 J
Ao(w) f7Et-(q) dq = E nj sj
0 j=1

A(W) = lim l T -l(q) dq
a-l a


. Assuming
= 1. Assuming


N
- E k = AvDD(w),
k-1

7 1(1) -MaxDD(w).


Remark 4. Let X be an arbitrary random variable with the cumulative distribution

function Fx(t) = Pr{X < t}. Assuming Fx1(a) to be the inverse function of Fx(t),

functionals CV@Ro and CVaRo are expressed, respectively,


1
CV@Ra(X) 1 J Fl(q) dq, CVaRa(X)
a


0j FI(q) dq.
0


Relation (3.17) can be verified based on (3.22). CVaR methodology was thoroughly devel-

oped by Rockafellar and Uryasev [21, 20].

Example 1. To illustrate the concept of the CV@R, let us calculate CV@Ro.7() for

drawdown time series ( shown on Figure 3 2. According to Figure 3-4, ((0.7) = '1(0.7)

(6, and, consequently, from Figure 3-3, 7d(((0.7) = 7r(6) = 0.75. Using formula (3.16),
we obtain CV@Ro.7() ( 7) 6 + 1-07 1 6 + (1 + 5). To verify this

result, we can calculate CV@Ro.7() based on (3.20). Namely, following Figure 3-4, we have

CV@Ro.7() 1 = ((0.75 0.7) (6 + (0.875 0.75) 61 + (1 0.875) 5) -6 6 + 5 1 + 5 5.

Example 2. For the drawdown time series shown on Figure 3-2, MaxDD(w) = 5 and
8
AvDD(w) E (k.
k= 1


(3.22)










3.3.3 Mixed Conditional Drawdown

The notion of CDD can be generalized by considering convex combinations of the CDDs

corresponding to different confidence levels. This idea is essentially based on risk profiling,

i.e. assignment of specific weights for CDDs with predetermined confidence levels.

Definition 5. Given a risk P",,i., X(a) such that

1) dX(a) > 0;
1
2) j dx(a) 1;
0
mixed CDD, is defined
1
Ax (W) (w ) dX(a). (3.23)
0
Obviously, the mixed CDD preserves all properties of A,(w) stated in proposition 4. A

fund manager can flexibly express his or her risk preferences by shaping x(a).

Proposition 5. The mixed CDD can be presented in the alternative form
1
A (w) f'(a) p(a) da, (3.24)
0

with -i" 'rum" p(a) to be:

1) nonnegative on [0, 1];

2) nondecreasing on [0, 1];
1
3) j p(a) da =l. 1.
0
The relation between x(a) in (3.23) and p(a) in (3.24) is

1
dp(a) dX(a).


Proof. Expressing A,(w) in the form of (3.20), consider

/A(W) ( f-f -(q) dq, dx) f of -(q)Iq> dq dx(a)
0 a 0 0
f f-l(q) (f Iq>_} dx(o) dq l(q) (I J (a ) dqI
0 \0 0 0
1
0









a
where p(a) = J-' dx(q) satisfies all properties 1) -3). Indeed, p(a) is nonneg-
0
1
ative and 1iin. .1. I.-i,,:_. since dp(a) = a dX(a) > 0. Moreover, Jp(a) da
0
1 1
ff Ti 1- {a>q} dx(q) da = 1. Obviously, conditions 1) -3) are necessarily satisfied by
00
function p(a), since they are derived from the properties of function X(a). However, if

function p(a) satisfies conditions 1) -3) then it is sufficient for (3.24) to be constant trans-

lating, positively homogeneous, monotonic and convex with respect to The last fact

comes from a direct verification of those properties. O

Corollary 1. The non-decrease property of -1"' I ium," p(a), is a necessary condition for

the mixed CDD to be convex. This property has an obvious but important interpretation,

namely, the greater drawdown quantile, 1, is, the greater p" inoi/ coefficient, jp, should

be assigned. A similar conclusion regarding risk spectrum in coherent risk measures was

made by Acerbi and Tasche [32]. This conclusion is a consequence of a general ...... ,. ,,.i

principle, stating: the greater risk is, the more it should be penalized [1].

Example 3. MaxDD and AvDD are mixed CDDs with risk profiles X(a) = I{a>} and

X(a) = I{a>o}, respectively.

Discrete risk profile. An important case is when risk profile, X(a), is specified by the

discrete set of points Xi = d(ai), i = 1, L. In this case, the mixed CDD is expressed

L
A(w) = i Ai (W), (3.25)
i= 1

L
where Z Xi =1 and Xi > 0. Consequently, -"' I 'um" function is presented by
i 1


() I{a}. (3.26)
i1 ai
i= 1

Detail. Interchanging summation and integration operations in A+(w), the result follows

L 1 1L
A+ (W) iXi Aa ) Xi 7 i(q)1dq >a I(q)dq.
i 1 i a, i


Obviously, (3.26) is a positive nondecreasing function.









3.4 Optimization Techniques for Conditional Drawdown Computation

This section develops optimization techniques for CDD efficient computation. Formulas

(3.16) and (3.20) require to calculate the value of ((a) first, which doubles computational

time. However, there is an optimization procedure that obtains the values of threshold

((a) and CDD simultaneously. This procedure is especially important in a large scale
optimization.

In the case when a time series of drawdowns is given, computation of the a-CDD is

reduced to computation of CV@Ro,().

Theorem 2. Given a time series of instrument's drawdowns = (1, ..., ZN), correspond-

ing to time moments {tl, ..., tN}, the CDD functional is presented by CV@Ro,(), which

computation is reduced to the following linear programming procedure
N
CV@R,()= min y + 1 Zk
Y, Z k~= (3.27)
s. t. Zk > k Zk> 0, k = 1, N,

leading to a single optimal value of y equal to ((a) if r~((a)) > a, and to a closed interval

of optimal y with the left endpoint of ((a) if w(((a)) = a.

Proof. We introduce a piece-wise function

1 N
h(y) y + ( [ y' (3.28)
k1 )N k 1

where [k + = max (~k y, 0}, and establish the following relation

CV@Ra(() min h(y). (3.29)
y

The derivative of h(y) with respect to y is presented

t h(Y) N N (Y) aV=1-a (3.30)
(I ) 1N kI F1 -- N{< k-

Note -h(y) is continuous for all values of y, except the set of points y

k I k k 1, N}. The necessary condition for function h(y) to attain an extremum is

d- d+
dh(/) < 0 < h(y), (3.31)
dydy- y









where h-(y) = a (r (y 0) c) and %hh(y) = (1 (rr(y + 0) c) are left and right
derivatives, respectively, which coincide with each other for all y except y { I k 1, N}.
According to (3.30) and (3.31), an optimal value y* should satisfy inequalities

7(y* 0) < a < 7r(y* + 0),

which have a unique solution y* = ((a) if 7~(((a)) > a (see Remark 2), i.e. if y* f

{ k k = 1, N. However, if -C(((a)) a, then there is a closed interval of optimal values
y*, with the left endpoint of ((a), namely, y* E [((a), ((a + 0)], where r((5(a + 0)) > a.
Hence, two cases are considered:

a) y* (a) if w((a)) > a;

b) y* E [((a), (( + 0)] if ( (((a)) a.
In both cases, equality [k y*]+ (k Y*) I{)>y*} (6k Y*) {>(c(a)} holds with
respect to all ,k, k = 1, N, for any fixed y*. Thus, based on this fact, we obtain
N
min h(y) h (y*) = y* + E [k Y]
Y k-1
( N y N
i 1- a { a)} + (1-a)N f>c(a)
k=1 k-1




k=1
1-a + (1--a)N E k,

where @ (C(Q))-a ) (7(C())-) ,(())-)
-where 1- _- ((a) in the case of a), and v(7_-()) -) y* 0 in the case


N
Since expression L [k y]+ is minimized, it can equivalently be presented by the sum








CV@R(()= max E (kGk

s.. k = 1, O qk k = N.
k=. t. 1, 0 N 1,N.
k- 11-a)


The value of CV@Ro,() can be found in O(n log2 n) time.










Proof. It is enough to observe that knapsack problem (3.32) is dual to linear programming

problem (3.27). Based on duality theory, optimal values of the objective functions in (3.27)

and (3.32) should coincide.

Problem (3.32) can be solved by the standard ,,.. .I algorithm in O(n log2 n) time. The

algorithm sorts items according to their ...- I k = 1, N}. Let [a] denote the integer

part of real number a. Obviously, q-variables, corresponding to the largest [(1 a)Nj

i...- I" have optimal values equal to ( rN, and the q-variable, corresponding to the

([(1 a)Nj + 1)th .. -" in the sorted order, has optimal value equal to 1 [( N The

rest of q-variables equal 0. In this case, the complexity of the algorithm is mainly determined

by a sorting procedure, which, in this case, requires at least O(n log2 n) operations. 0

Formulation (3.32) is closely related to the presentation of CV@R based on the concept

of a risk envelope, which is a closed, convex set of probabilities containing 1. Risk envelope

theory was developed by Rockafellar et al. [11, 23].

Suppose, a sample path of instrument's rates of return (ri, ..., rN), corresponding to

time moments {tl, ..., tN}, is given. In this case, uncompounded cumulative instrument's
k
rate of return at tk is Wk = r1, and the CDD is presented in the form of A,(w).
= 1
Proposition 6. Given a sample path of instrument's rates of return (ri, ..., rN), the

CDD functional, Aa(w), is computed by the following optimization procedure

N
A(w) = min y + 1 N Zk
u, y, z k-1
s.t. Zk uk-, (3.33)

Uk Uk-1 rk, o = 0,

Zk > 0, Uk > 0, k = 1,N,

which leads to a single optimal value of y equal to ((a) if 7r(((a)) > a, and to a closed

interval of optimal y with the left endpoint of ((a) if 7r(((a)) = a.

Proof. By virtue of relation Aa(w) = CV@Ra(AD(w)) = CV@Ra(), optimization prob-

lem (3.33) is a direct consequence of (3.27). Using recursive formula k = ['k-1 rk+,

constraint Zk > k y in (3.27) is reduced to zk > uk y, where nonnegative auxiliary

variables Uk satisfy additional constraints Uk > 'k-1 rk, k = 1, N, with uo = 0. 0










Corollary 3. Given a sample path of instrument's rates of return (ri, ..., rN), the CDD

functional, A,(w), is computed by the following optimization procedure

N
A,(w) = max E rk
q' 7 k=1
N
s. t. E qk = 1, %k k+l < k < (1- (3.34
k 1
qk > O, lk > O, lN+- = 0, k = N.

Proof. Problem (3.34) is dual to linear programming program (3.32). O

Theorem 2 and all its corollaries can be easily generalized to the case of mixed CDD.

Proposition 7. Given a sample path of instrument's rates of return rk k =1, N and

discrete risk profile Xi = d(ai), i = 1, L, the mixed CDD, A+(w), is computed by

L N
A+(w) min Xi Yi + (a)N ik
U, z i 1 k=1

s. t. Zik > k Yi, (3.35)

Uk > Uk- rk, Uo = 0,

Zik > 0, Uk > 0, i 1, L, k = 1,N.

Proof. Formulation (3.35) is a direct consequence of mixed CDD definition (3.25) and

optimization problem (3.33). Notice that auxiliary variables Uk do not have index i, since

they determine the drawdown sequence same for all ai. O

3.5 Multi-scenario Conditional Value-at-Risk and Drawdown Measure

This section presents concept of the MlNl i.., i ,, CV@R and drawdown measure,

which, in fact, are the CV@R and CDD defined in the case of several sample paths for

uncompounded cumulative portfolio rate of return. We generalize results obtained for the

CDD under assumption of a single sample path to the case of several sample paths.

Let Q denote a discrete set of random events, i.e. Q { uwj j = 1,K}, and let
K
pj be the p .l. .il, i Iv of event wj (Vj : pj > 0, and E P = 1). Suppose rj(tk)
j=1
(rIj(tk), r2j(tk), ..., rj(tk)), k = 1, N, is the jth sample path for the random vector of

risky assets' rates of return, corresponding to random event wuj e and time interval [0, T]

presented by the discrete set of time moments {to = 0, fi, t2, ..., tN = T}. Consequently,

the jth sample path for the rate of return and uncompounded cumulative rate of return









of a portfolio with capital weights x(tk) = (o(tk ), 1(tk), x2(tk), ..., m(tk)) are defined,

respectively,

r) (X(tk)) = r(tk) (tk) = ri (tk) i (tk), (3.36)
i= 1


0, k = 0,
Wjk(X(tk)) = k(3.37)
Erl (x(h)), k= 1, N.
1=1
To simplify notations, we use wjk instead of wjk(x(tk)) implying that wjk is i1., a

function of x(tk). In a multi-scenario case, w denotes matrix {wjk}, j = 1, K, k = 0, N.

3.5.1 Multi-scenario Conditional Value-at-Risk

Definition 6. In a multi-scenario case, the AD(w) is a matrix-functional defined on Q x

[0, T]

AD(w) = {Jjk/}, jk = max {j} Wjk, j = 1, K, k = 1, N. (3.38)
O
All AD properties stated in Proposition 1 hold in a multi-scenario case. Indeed, based

on (3.38), properties 1 4 in Proposition 1 can be verified directly. Matrix AD(w) is

interpreted to be drawdown surface (jk, (wj, tk) E G x [0, T].

Definition 7. Similar to definitions of MaxDD and AvDD in single scenario case, MaxDD

and AvDD are defined on Q x [0, T], respectively,

MaxDD(w)= max {(jk}, (3.39)
I
NK
AvDD(w) 1 1p jk. (3.40)
k=lj=1
Definition 8. Indicator function for drawdown surface,its inverse function and threshold

plane, ((a), are defined, respectively,


7(S) E N j <, (3.41)
k=lj=1

\ inf{s I 7r(s) > a} a E (0, 1],

0, = 0,

((a) ="-(a). (3.43)










Figure 3-5 illustrates drawdown surface (jk and threshold plane ((a).

jk Drawdown surface


a threshold plane

---// i -
I/ /
/ I /






/ / j// scenarios
/ I I /



y / / Y__
. . . . -



t1 t2 t3

time

Figure 3-5: Drawdown surface and threshold plane


Definition 9. Multi-scenario CV@R may be defined similar to a single period CV@R,

namely,

CV@R(a) () M(c) + ( P jjk, (3.44)
1a (() (1 a)N I:
jkE oa

where o = (jk I jk > ((a), k 1, N}.

Proposition 8. Multi-scenario CV@R, given by (3.44), can be presented in the alternative

form

CV@R(0) l (q)dq, (3.45)
a
where r. 1(q) is the inverse function given by (3.42).

Proof. Similar to the proof of Theorem 1. 0

Remark 5. Let X be an arbitrary random variable. Suppose we are given K sample paths

X(tk, wj), k = 1, N, corresponding to random events wuj E Q with probabilities pj such that
K NK
E pj 1. Defining an indicator function for X to be 7x(s) Z Z PjI{x(tk,w) j=1 k lj=1
(where the inverse function 7rx1 is defined similar to (3.42)), multi-scenario CV@R may be
1
determined similar to a single period CV@R, namely, CV@Ro(X) = T- f 7xl(q) dq.
a









3.5.2 Drawdown Measure

In a multi-scenario case, CDD with tolerance level a is interpreted as

The average of the worst (1 a) 100% drawdowns on drawdown surface, if the worst
(1 a) 100% drawdowns can be counted precisely

The linear combination of ((a) and the average of the drawdowns strictly exceeding
threshold plane ((a), if we are unable to precisely count of (1 a) 100% drawdowns

A strict mathematical definition of the drawdown measure is given below.

Definition 10. In a multi-scenario case, the CDD, with tolerance level a E [0,1], is the

multi-scenario CV@R, applied to drawdown surface, AD(w),


A,(w) = CVR,(ADp(w)), (3.46)

and drawdown measure is the mixed CDD with risk profile X(a)
1
A (w)A) A (w) dX(ac), (3.47)
0
where A,(w) is given by (3.46).

Proposition 9. Defining matrix operations: w + const = {wjk + const} and Aw = {Awjk},

drawdown measure A (w) satisfies the following properties

1. Nonnegativity: A+(w) > 0, Va E [0, 1].

2. Insensitivity to constant shift: AZ(w + const) = A+(w), Va [0, 1].

3. Positive homogeneity: A+(A w) AA+(w), VA > 0 and Va E [0, 1].

4. Convexity: if w = A wi + (1 A) w2 is a linear combination of any wi and w2 with

A E [0,1], then A+(w/A) AA+(wi) + (1 A) A+(w2).

Proof. Properties 1-4 are direct generalization of CDD properties stated in Proposition 4.










Proposition 10. In the case of discrete risk profile, drawdown measure is computed by

L N K
A+(w) min E Xi y+ E E Pj Zijk
U, Z i= k= l 1

s. t. Zijk > Ujk yi,
(P) (3.48)

t1,A > 0, Uj = 0, Zijk > 0,
i 1,L, j 1,K, k =1,N.

Proof. Introducing intermediate optimization problems

L L ( N K
Xi CV@R,,() min X Yi + 1- S )N [~jk Y- +i
i=1 Ii -1 a k-1 ji 1- 1



SXi CV@R, (0) min E y y + 1 E z
i 1 yi, zijk i= ) k=lj= 1
s. t. Zijk > Njk yi, Zijk > 0,

i 1,L, j 1,K, k= 1,N,

the proof is conducted similar to the proof of Theorem 2. 0

3.6 Portfolio Optimization with Drawdown Measure

This section formulates a portfolio optimization problem with drawdown risk measure

and -ii:_:_- -r efficient optimization techniques for its solving. Optimal asset allocation

considers

Generation of sample paths for the assets' rates of return.

Uncompounded cumulative portfolio rate of return rather than compounded one.

In this case, optimal asset allocation maximizes the expected value of uncompounded

cumulative portfolio rate of return at the final time moment tN = T subject to a constraint

on drawdown measure
K
max E, (w(T,w,x)) = E j wjN(X)
x2X j-1 (3. i
s. t. AZ+(w(x)) <- ,

where X is the set of linear 1.1 In..!! .1!" constraints and y7 [0,1] is a proportion of the

initial capital allowed to loose.










In contrast to Grossman and Zhou [27] and Cvitanic and Karatzas [28], who considered

vector of portfolio weights to be a function of time within [0, T], we assume portfolio weights

x(tk) to be static for all tk, k = 0, N. This special strategy can be achieved by portfolio

rebalancing at every tk, k = 0, N. Justification of this assumption depends on a particular

case study. Based on the assumption made, uncompounded cumulative portfolio rate of

return w is rewritten
k m k
Wjk(x) i(j) L) Xi. (3.50)
=1 i=ll= 1

3.6.1 Reduction to Linear Programming Problem

Theorem 3. Problem (3.49) is reduced to linear programming (LP) problem

K
max E pj wjN(x)
u, xEX, y, z j=1
L N K
.t. Z (Li i+ (l N P Zik
i- 1 k 1 j- 1

zijk >_ 71,A Yi, (3.51)

Ujk > Uj(k-1)-r-jk

Ujk > 0, jo = 0, Zijk > 0,

i 1,L, j 1,K, k 1,N,

where 'i yi and zijk are auxiliary variables.

Proof. Consider piece-wise function H(x, y)



i= ( (1 a)N k= lj=

According to Proposition 10, drawdown measure may be presented by

L
A x(w( )) xi CVR,, (a(x)) = min H(x,y). (3.53)
i= 1

Consequently, problem (3.49) is reduced to

K
max E pj WN(X)
x2x j=1 (3.54)

s. t. min H(x,y) <7,
y










The key point of the proof is to show that minimum in the constraint of (3.54) may be

relaxed, i.e to show that problem (3.54) is equivalent to

K
max E pj WN(X)
xEX,y j=1 (3.55)

s. t. H(, y)< ,

The proof of this fact is conducted by relaxing constraint min H(x, y) < C; in (3.54),

namely, problem (3.54) is equivalently rewritten

( K /
mm max 1pj WjN(X) + A min H(x, y)
A>0 xEX Y


(K
mm max Zpj wjN(x) + A (7 H(x, y)) (3.56)
A 0 xEX, y

However, problem (3.56) is the Lagrange relaxation of (3.55). Hence, (3.55) is equivalent

to (3.54). According to Theorem 4 and Proposition 10, LP (3.51) is a direct consequence

of (3.55). O

Corollary 4. In the cases of MaxDD(w) and AvDD(w), corresponding to the mixed CDD

with risk profiles of x(a) = I(,>o} and x(c) = I{ai>}, LP (3.51) is simplified, respectively,

K
max pj WjN(X)
u, x2X j=1

s. t. Ujk Uj(k-1) "'(), (3.57)

7 > Ujk > 0, Ujo = 0,

j 1, K, k 1, N,

K
max pj WjN(X)
u, x2X j=1
N K
s.t. 1 E E I--
k= j=1
(3.58)
1,1i > Uj(k-1) I (X),(3.5)

Ujk > 0, jo = 0,

j 1,K, k 1, N.










3.6.2 Efficient Frontier

Efficient frontier is a central concept in Risk Management methodology. Suppose for

every value of 7 and risk profile X (7) is an optimal solution to (3.51). In this case,

efficient frontier is a curve expressing dependence of optimal portfolio expected reward
K
Z Pj wjN(X* ()) on portfolio risk 7.
j=1

Proposition 11. Efficient frontier 7, pj WjN(x (7)) is a concave curve.
j =1
K
Proof. Denoting g(x) = pj WjN(x), we show that for any 71,2 E [0,1] and 7 e [0,1]
j=1

g(x(7 7 + (1 T)72)) >7 T (7i)) + (1 T) (72)).


According to the proof of Theorem 3, we have


g( x(7))= max g(x)
XEX, y

s. t. H(x, y) <7,

and using notation GA(x, y) g(x) A H(x, y), we obtain


g(*(7)) min max (GA(x, y) + A7) min (G'A((A),y(A)) + A7).
A>0 xEX, y A>0

Since expression G,(x(A), y(A)) + A7 is linear with respect to 7, min (G,(x(A), y(A)) + AT)
A>O
is a concave function of 7. Indeed,

mm (GA(x(A),y(A)) + A(7 i1 + (1 )72))
A>0
mmin ( (G(x(A), y(A)) + A71) + (1 T) (GA(x(A), y(A)) + A72))
A>0
> T min (GA(x(A), y(A)) + A1) + (1 7) mmin (GA(x(A), y(A)) + A72).
A>0 A>O

This fact proves the proposition. O

Risk-adjusted return is an important characteristic for choosing an optimal portfolio

on an efficient frontier that evaluates the ratio of the portfolio reward to the portfolio risk

K
Px(7) = Pi jwjN(XX(7)). (3.59)
j=1

A fund manager is interested in such a value of 7 e [0,1], for which the ii-i:- il usted

return Px(7) is maximal. It is interpreted to be the best balance between the risk accepted










K
and the rate of return achieved. According to Proposition 11, E pj wjN(x* ;()) is concave,
j=1
hence, ratio Px(7) has a finite global maximum. Although Px(7) is a nonlinear function

with respect to 7, a problem for finding px(7) maximum and corresponding optimal 7 is

reduced to an LP.

Proposition 12. The optimization problem max px(7) is reduced to LP
7[0,1]

K
max E pj wiN(X)
i, v, 2EX, y, z j=1
SN K
i=. t. k=X j= 1

Zijk _> ,A i, (3.60)

Ujk >_ tj(k-1) -rk ,

tjk > 0, jo = 0, Zijk > 0,

i 1,L, j 1,K, k 1,N.

K
If x* is an optimal solution to (3.60) then px(7*) = max Px(7) = Pj WjN(x*), with
ye[0,1] j 1
Im
optimal value 7* = 1 / E and corresponding optimal portfolio xf = x I = 0, m.
/ l0
K K
Proof. Since max Px() = max 7-1 E pi wjN(X*(0)) max max y-1 pj WjN(x),
y_ [0,1] yE[0,1] j-1 yE[0,1] xEXx j=1
where Xx is the set of constraints in problem (3.51), the problem of
K
max max 7-1 E pj wgjN() is reduced to LP (3.60) by changing variables 1 x= /7,
7E[0,1] xEXx j=1
yi = yi/l, tkj = Ukj/i, 2ijk z= ijk/, I 0, m, i = 1,L, j = 1, K, k = 1, N. Set X may

include additional variable v = 1/7. For instance, a box constraint Xmin < Xl < Xmax from

the set X is transformed to Xmin V < x < Xmax v, which is an element of X. 0

3.7 Drawdown Measure in Real-life Portfolio Optimization

3.7.1 Static Asset Allocation

This section formulates and solves a real-life portfolio optimization problem with a

static set of weights using drawdown measure. A problem of dynamic weight allocation

when asset (or a set of assets) is log-Brownian under a constraint on the worst equity

drawdown was considered in several papers. First, a 1-dimensional case was solved by

Grossman and Zhou [27] as a mathematical programming problem. Then, the problem was

generalized to a multi-dimensional case by Cvitanic and Karatzas [28].










In contrast to Grossman and Zhou [27] and Cvitanic and Karatzas [28], we are inter-

ested in a constant set of weights that optimizes a certain portfolio of assets, which are not

assumed to have a log-brownian dynamics. This problem is stimulated by several important

practical financial applications, particularly related to the so-called hedge-fund business.

A Commodity Trading Advisor (CTA) company is a hedge fund that normally trades

several (sometimes, more than a 100) futures markets simultaneously using some mathe-

matical strategies that it believes have certain edge. Such a company manages substantial

assets as a part of all hedge funds, by some estimates, close to $100 BN. Most of the CTA

community trades the, so-called, long-term trend-following systems, but there are now mul-

tiple examples of short-term mean-reverting trading systems as well. These systems may

be viewed as some functions of the individual futures market price realized prior to the

present time. These strategies normally have a substantial smoothing-out effect on the

futures prices and have close to stationary properties. Every CTA, then, has to allocate a

certain portion of overall risk (or overall capital that it manages) to each and every "mar-

ket". Due to a substantial level of stationarity of the strategies, each CTA calculates the

weights according to a certain internal proprietary weight allocation procedure. Normally,

this set remains fixed and does not change unless a certain market gets added or removed

from the set, which normally happens when a new system is introduced, when a certain

market disappears (like Deutsche Mark or French Franc in 1999), or a new market is being

added. A standard practice in the CTA community is to use some version of the classical

Markowitz mean-variance approach.

Another important example of static asset allocation comes form the so-called, Fund of

Fund (FoF) business. In the recent several years this sector of hedge funds has experienced

a substantial growth. A typical FoF manager gives allocations of its clients' capital to a set

of pre-selected managers, normally between 5 and 25. It does so fairly infrequently, because

of liquidity constraints imposed by managers themselves, but this is not the only reason.

FoF views equity return streams as fairly stationary time series with some attractive return,

risk, and correlation properties, which need some time to present themselves. Unless some

unexpected event happens, the allocations are given for a substantial period of time, on

average of 2 years or more. A group of .111 i', in a typical FoF is responsible for finding










a constant set of weights, which makes a total portfolio of the FoF to be attractive to its

clients.

Both of these typical cases are faced with a problem of finding a constant set of weights,

which optimize their portfolios in a certain sense. The practical goal of this chapter is to

facilitate this process with a clear and statistically sound algorithm, which utilizes a newly

designed set of risk-measures based on a notion of an equity drawdown.

Despite their known potential drawbacks, it is a well-accepted and, moreover, recom-

mended practice [36], is to study historical back-tested strategy results of a hedge fund and,

based on these results, obtain an estimate of the inherent risk using some risk measures.

The only popular quantitative risk measure is VaR [36]. Various insufficiencies of the VaR

measure are also widely known. We believe that the results developed in our study would

facilitate understanding of how this can be achieved.

3.7.2 Historical Data and Scenario Generation

Even though scientists and engineers used certain simple versions of re-sampling pro-

cedures since 1930s, it was namely B. Efron [37] who unified the disconnected ideas; and

re-sampling emerged as a robust method of estimating confidence intervals of some measur-

able functions over a statistical sample of data. Method is particularly useful for the time

series where obtaining other realizations of the data may be difficult or even impossible.

Bootstrap is a form of re-sampling the original data set bootstrap, which "re-samples

with replacement." Sometimes, the simplest version of it is called "nonparametric boot-

strap." The method originally was applied to some sociological and biological applications,

-I i-, i :_. in the shade for statistical, engineering and financial applications up until the 1990s.

Due to their intrinsic "one realization only"-nature, the financial time series could be one

of the best applications for re-sampling methods.

Within financial applications, a strong particular interest in obtaining estimates of

certain measurable quantities (such as rate of return, or standard deviation), comes from

the development of trading systems. It is well known, that a problem of actual using over-

fitted trading systems can possibly lead to substantial financial losses. Therefore, it is hard

to underestimate the importance of a problem of discovering how over-fitted a particular

trading --, -I. -11 is. Among a few examples, one can mention a single asset trading --, -,. _11.










for example, a system which trades a 1:- djliusted continuous 10-year U.S. Government

Note futures contract, or, a more general portfolio optimization problem such as allocation

of weights between several assets in a portfolio subject to certain constraints.

Our study considers a particular example of optimal portfolio-allocation problem. This

example could be very relevant for global CTA managers, who apply certain trading sys-

tems (very frequently, long-term trend-following systems) across a wide set of global futures

markets attempting to take advantage of price movements occurring in these markets. Nor-

mally, after they are content with their trading system, they have to make a decision of

allocating their portfolio risk between various markets.

In this example, we are given a set of sample paths of certain futures trading systems

(in this particular case, some long-term trend-following system) as applied to a set of 32

different global futures markets. The --, -I. ii, includes long, short or flat markets, and I,.- ,

trades the same number of contracts with the average trade length from one to two months.

Here is a list of the markets with their corresponding exchanges that were traded by

the system. Ticker --, l.. .1-, of FutureSource are used for their abbreviation. In alphabetical

order of ticker symbol:

1. AAO The Australian All Ordinaries Index (OTC);

2. AD Australian Dollar Currency Futures (C'il-3);

3. AXB Australian 10-Year Bond Futures (SFE);

4. BD U.S. Long (30-Year) Treasury Bond Futures (CBT);

5. BP British Pound Sterling Currency Futures (C'll-');

6. CD Canadian Dollar Currency Futures (C(Il-3);

7. CP Copper Futures (COMEX);

8. DGB German 10-Year Bond (Bund) Futures (LIFFE);

9. DX U.S. Dollar Index Currency Futures (FNX);

10. ED 90-Day Euro Dollar Futures (C'NI);

11. EU Euro Currency Futures (CME);

12. FV U.S. 5-Year Treasury Note Futures (CBT);

13. FXADJY Australian Dollar vs. Japanese Yen Cross Currency Forward (OTC);

14. FXBPJY British Pound Sterling vs. Japanese Yen Cross Currency Forward (OTC);