QUESTIONS

  1. What are the most common constraints encountered in optimal portfolio allocation in practice?
  2. State the standard definition of tracking error and discuss why other definitions of tracking error may be used.
  3. How are transaction costs typically incorporated in portfolio allocation models?
  4. Give an example of how the presence of taxes changes the concept of risk in portfolio optimization.
  5. A limitation in the implementation of the mean-variance model for portfolio optimization is that one of the critical inputs in the model, the sample covariance matrix, is subject to considerable estimation risk. This can skew the optimizer towards suggesting extreme weights for some of the stocks in the portfolio and lead to poor performance. Explain what approaches can be used to deal with the problem.

1 See Chapter 1 in John L. Maginn and Donald L. Tuttle (eds.), Managing Investment Portfolios: A Dynamic Process, 2nd ed. (New York: Warren, Gorham & Lamont, 1990).

2 Harry M. Markowitz, “Portfolio Theory,” Journal of Finance 7, no. 1 (1952): 77–91.

3 Multiperiod portfolio optimization models are still rarely used in practice, not because the value of multiperiod modeling is questioned, but because such models are often too intractable from a computational perspective.

4 As the term intuitively implies, the ADV measures the total amount of a given asset traded in a day on average, where the average is taken over a prespecified time period.

5 R. Tyrell Rockafellar and Stanislav Uryasev, ...

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