An Algorithm for Portfolio Optimization with Transaction Costs

Best, Michael J. and Hlouskova, Jaroslava (2005) An Algorithm for Portfolio Optimization with Transaction Costs. Management Science, 51 (11). pp. 1676-1688.

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Abstract or Table of Contents

We consider the problem of maximizing an expected utility function of n assets, such as the mean-variance or power-utility function. Associated with a change in an asset's holdings from its current or target value is a transaction cost. This cost must be accounted for in practical problems. A straightforward way of doing so results in a 3n-dimensional optimization problem with 3n additional constraints. This higher dimensional problem is computationally expensive to solve. We present a method for solving the 3n-dimensional problem by solving a sequence of n-dimensional optimization problems, which accounts for the transaction costs implicitly rather than explicitly. The method is based on deriving the optimality conditions for the higher-dimensional problem solely in terms of lower-dimensional quantities. The new method is compared to the barrier method implemented in Cplex in a series of numerical experiments. With small but positive transaction costs, the barrier method and the new method solve problems in roughly the same amount of execution time. As the size of the transaction cost increases, the new method outperforms the barrier method by a larger and larger factor. (author's abstract)

Item Type: Article in Academic Journal
Keywords: convex programming, portfolio optimization, transaction costs
Status: Published
Date Deposited: 22 May 2015 08:39
Last Modified: 01 Apr 2016 14:19
URI: http://irihs.ihs.ac.at/id/eprint/3387

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