Portfolio optimisation with transaction cost

Abstract

This thesis was submitted for the degree of Doctor of Philosophy and awarded by Brunel University.Portfolio selection is an example of decision making under conditions of uncertainty. In the face of an unknown future, fund managers make complex financial choices based on the investors perceptions and preferences towards risk and return. Since the seminal work of Markowitz, many studies have been published using his mean-variance (MV) model as a basis. These mathematical models of investor attitudes and asset return dynamics aid in the portfolio selection process. In this thesis we extend the MV model to include the cardinality constraints which limit the number of assets held in the portfolio and bounds on the proportion of an asset held (if any is held). We present our formulation based on the Markowitz MV model for rebalancing an existing portfolio subject to both fixed and variable transaction cost (the fee associated with trading). We determine and demonstrate the differences that arise in the shape of the trading portfolio and efficient frontiers when subject to non-cardinality and cardinality constrained transaction cost models. We apply our flexible heuristic algorithms of genetic algorithm, tabu search and simulated annealing to both the cardinality constrained and transaction cost models to solve problems using data from seven real world market indices. We show that by incorporating optimization into the generation of valid portfolios leads to good quality solutions in acceptable computational time. We illustrate this on problems from literature as well as on our own larger data sets