Capturing Risk in Capital Budgeting

NPS NRP Technical ReportThis proposed research has the goal of proposing novel, reusable, extensible, adaptable, and comprehensive advanced analytical process and Integrated Risk Management to help the (DOD) with risk-based capital budgeting, Monte Carlo risk-simulation, predictive analytics, and stochastic optimization of acquisitions and programs portfolios with multiple competing stakeholders while subject to budgetary, risk, schedule, and strategic constraints. The research covers topics of traditional capital budgeting methodologies used in industry, including the market, cost, and income approaches, and explains how some of these traditional methods can be applied in the DOD by using DOD-centric non-economic, logistic, readiness, capabilities, and requirements variables. Stochastic portfolio optimization with dynamic simulations and investment efficient frontiers will be run for the purposes of selecting the best combination of programs and capabilities is also addressed, as are other alternative methods such as average ranking, risk metrics, lexicographic methods, PROMETHEE, ELECTRE, and others. The results include actionable intelligence developed from an analytically robust case study that senior leadership at the DOD may utilize to make optimal decisions. The main deliverables will be a detailed written research report and presentation brief on the approach of capturing risk and uncertainty in capital budgeting analysis. The report will detail the proposed methodology and applications, as well as a summary case study and examples of how the methodology can be applied.N8 - Integration of Capabilities & ResourcesThis research is supported by funding from the Naval Postgraduate School, Naval Research Program (PE 0605853N/2098). https://nps.edu/nrpChief of Naval Operations (CNO)Approved for public release. Distribution is unlimited.

Some New Thoughts on Performance Evaluation of Governments: An Application to Indian Cities

The present paper is an attempt to build up a framework which can holistically analyse the performance of governments bringing in the financial parameters as well as service delivery. We propose a three step methodology capturing different aspects of performance, integrated in the same framework. We generate the expenditure efficiency scores of governments based on expenditure and service delivery, applying non parametric Data Envelopment Analysis in the first step. This also enables us to identify the possible sources of mis-utilisation of resources on different expenditure heads. The second step consists of a detailed assessment of fiscal patterns of governments with Principal Component Analysis based on revenue, demand, cost, socio-demographic, expenditure-adequacy and service-adequacy indicators. The components generated in the second step can also explain the differences in efficiency scores in resource utilization generated in the first step. Also, each step can generate ranks for the governments. A composite rank from both the steps can act as an index of overall performance of the governments. The methodology is applied to the urban local governments of the state of Tamil Nadu to get some insightful results

ABSTRACTS, PAPERS PRESENTED, ANNUAL MEETING, SAEA, TULSA, OKLAHOMA, FEBRUARY 1993

Teaching/Communication/Extension/Profession,

Doubling Times in Finance

This dissertation proposes an alternative measure of performance, termed doubling time. Doubling time is defined as the time taken for an initial investment in an asset to double in value. This alternative performance metric has an intuitive appeal yet has received little attention in the academic literature to date. This thesis provides the foundations required for the use of doubling times in finance.The work begins by examining the problem of computing the expected doubling time from a sample of doubling times. Analytical formulae and a simulation are proposed as alternative approaches to estimating the expected doubling time. Using these methods,expected doubling times are computed for the Australian equity market, using both price and accumulation indices. Expected doubling times are also computed for bonds. The doubling time is then modelled as a first passage time problem. It is shown that if returns are normally distributed then the doubling times will be inverse Gaussian distributed. It is also shown that, regardless of the underlying distribution the returns follow, the simulated doubling time is very likely to be inverse Gaussian distributed. Following this, portfolio formation using doubling times is investigated. It is shown that minimising either the skewness, or the inverse shape parameter, of the doubling times inverse Gaussian distribution, result in points on the efficient frontier for returns that are identical to those obtained under the classical Markowitz framework. In this way a two parameter (mean and variance) portfolio optimisation problem is reduced to a one parameter problem (skewness or shape). Measurement errors can result in the ex-post performance of optimised portfolios being no better than naive equally weighted portfolios. This is sometimes referred to as the problem of error maximisation in portfolio formation. A doubling time transformation is used to reduce the problem of error maximisation, and the results indicate an improvement in the ex-post performance of the optimised portfolios

Portfolio choice and estimation risk : a comparison of Bayesian approaches to resampled efficiency

Estimation risk is known to have a huge impact on mean/variance (MV) optimized portfolios, which is one of the primary reasons to make standard Markowitz optimization unfeasible in practice. Several approaches to incorporate estimation risk into portfolio selection are suggested in the earlier literature. These papers regularly discuss heuristic approaches (e.g., placing restrictions on portfolio weights) and Bayesian estimators. Among the Bayesian class of estimators, we will focus in this paper on the Bayes/Stein estimator developed by Jorion (1985, 1986), which is probably the most popular estimator. We will show that optimal portfolios based on the Bayes/Stein estimator correspond to portfolios on the original mean-variance efficient frontier with a higher risk aversion. We quantify this increase in risk aversion. Furthermore, we review a relatively new approach introduced by Michaud (1998), resampling efficiency. Michaud argues that the limitations of MV efficiency in practice generally derive from a lack of statistical understanding of MV optimization. He advocates a statistical view of MV optimization that leads to new procedures that can reduce estimation risk. Resampling efficiency has been contrasted to standard Markowitz portfolios until now, but not to other approaches which explicitly incorporate estimation risk. This paper attempts to fill this gap. Optimal portfolios based on the Bayes/Stein estimator and resampling efficiency are compared in an empirical out-of-sample study in terms of their Sharpe ratio and in terms of stochastic dominance

Portfolio optimization methods, their application and evaluation

The submitted master’s thesis focuses on practical application of quantitative portfolio optimization in various forms. The thesis is organized in two main parts, theoretical and practical. The theoretical part introduces the underpinnings of portfolio theory. It describes the optimization process, introduces a number of selected optimization methods, and provides an overview of portfolio management. As a whole, it serves as an underlying for the practical part. The practical part of the thesis is based on an experiment that put multiple quantitative portfolio optimization methods into a contest. Different optimizers were applied to portfolios composed of identical assets, which were subsequently held under different portfolio management styles over a pre-specified period of time. The performance of each portfolio was measured expost, adequately evaluated in accord with the criteria of the experiment, and confronted with the others. The questions that this master’s thesis tried to find answers to were (1) which portfolio optimizer, out of the selected ones, performs the best, and (2) whether it is beneficial to conduct rather an active, or a passive portfolio management.Esta dissertação de mestrado apresenta uma aplicação prática da otimização quantitativa de um portfólio realizada de diversas formas. A tese está organizada em duas partes principais, uma teórica e uma prática. A parte teórica introduz os fundamentos da teoria de portfólio. Descreve o processo de otimização, apresenta vários métodos de otimização selecionadas e fornece uma visão geral da gestão de portfólios. Como um todo, serve como base para a parte prática. A parte prática da tese coloca vários métodos de otimização de portfólio quantitativos em competição. Diferentes optimizadores foram aplicados a carteiras compostas por ativos idênticos que foram subsequentemente mantidos sob diferentes estilos de gestão ao longo de um período de tempo pré-especificado. O desempenho de cada carteira foi medido ex-post, adequadamente avaliado de acordo com os critérios de otimização e comparado com as demais carteiras. As perguntas para as quais esta tese de mestrado tentou encontrar respostas foram (1) qual é o optimizador de portfólio, dentre os selecionados, tem o melhor desempenho e (2) se é benéfico conduzir uma gestão de portfólio muito ativa ou passiva

Operational Research in Education

Operational Research (OR) techniques have been applied, from the early stages of the discipline, to a wide variety of issues in education. At the government level, these include questions of what resources should be allocated to education as a whole and how these should be divided amongst the individual sectors of education and the institutions within the sectors. Another pertinent issue concerns the efficient operation of institutions, how to measure it, and whether resource allocation can be used to incentivise efficiency savings. Local governments, as well as being concerned with issues of resource allocation, may also need to make decisions regarding, for example, the creation and location of new institutions or closure of existing ones, as well as the day-to-day logistics of getting pupils to schools. Issues of concern for managers within schools and colleges include allocating the budgets, scheduling lessons and the assignment of students to courses. This survey provides an overview of the diverse problems faced by government, managers and consumers of education, and the OR techniques which have typically been applied in an effort to improve operations and provide solutions

Choosing the Currency Structure of Foreign-currency Debt: a Review of Policy Approaches

Starting from the constraints and incentives that cause countries to issue debt in foreign currency, this paper provides an overview of policy approaches for choosing the optimal currency structure of sovereign foreign-currency debt. The objective of sovereign debt managers generally includes both risk and cost minimization, while constraints to foreign-currency debt allocation originate in the parameters of the domestic macroeconomy, the shocks it faces, and the initial conditions. Overall, the main parameters that drive the solutions for optimal currency allocation of foreign-currency debt are the covariances of macrovariables with exchange rates and the variances of different exchange rates. Both the covariances and the exchange rate volatility can be deceptive when a fixed exchange rate regime is maintained, however. To adequately capture the expected covariances in the context of managed exchange rate regimes, we suggest that sovereign debt managers work with equilibrium instead of actual exchange rates. For the same reason and because the estimates of relative exchange rate variances should be forward looking, we suggest using synchronization indicators in the policy analysis to better capture the underlying drivers of exchange rate volatility across currencies.Sovereign Debt Management, Foreign-Currency Debt, Exchange Rates and Exchange Rate Volatility, External Shocks, Developing Countries.