EfficientPortfoliosinExcelUsingthe SolverandMatrixAlgebra

ThisnoteoutlineshowtousethesolverandmatrixalgebrainExceltocomputeefficientportfolios.The exampleusedinthisnoteisinthespreadsheet3firmExample.xlsx,andisthesameexampleusedinthe lecturenotestitledPortfolioTheorywithMatrixAlgebra. Lastupdated:November24,2009

TheSolverAddIn
ThesolverisanExcelAddIncreatedbyFrontlineSystems(www.solver.com)thatcanbeusedtosolve generaloptimizationproblemsthatmaybesubjecttocertainkindsofconstraints.Inthisnoteweshow howitcanbeusedtofindportfoliosthatminimizerisksubjecttocertainconstraints. ThesolveraddinmustbeactivatedbeforeitcanbeusedwithinExcel.InExcel2007,youactivateadd insbyclickingontheofficebuttonandthenclickingontheExcelOptionsboxatthebottomofthe menu.

ThisopenstheExceloptionsdialoguebox.ClickAddIns,whichdisplaystheavailableAddInsforExcel. MakesuretheSolverAddInisanActiveApplicationAddIn.

MatrixAlgebrainExcel
Excelhasseveralbuiltinarrayformulasthatcanperformbasicmatrixalgebraoperations.Themain functionsarelistedintablebelow ArrayFunction MINVERSE MMULT TRANSPOSE ToevaluateanarrayfunctioninExcel,youmustusethemagickeystokecombination:<CTRL><SHIFT> <ENTER>(holddownallthreekeysatoncethenrelease). Description Computeinverseofmatrix Matrixmultiplication Computetransposeofmatrix

ExampleData
IntheDatatabofthespreadsheet3firmExample.xlsistheexamplemonthlyreturndataonthreeassets: Microsoft,NordstromandStarbucks.Themonthlymeansandcovariancematrixofthereturnsare computedandthesearereferencedastheinputdataontheportfoliotabasillustratedinthescreen shotbelow.

 Inthespreadsheet,cellscoloredlightbluecontaininputdata(fixeddatanotcreatedbysomeformula) andcellscoloredtancontainoutputdata(datacreatedbyapplyingsomeformula).Also,somecellsare explicitlynamed.ForexampletherangeofcellsB3:B5isnamedmuvec.Ifthesecellsarehighlighted thenmuvecwillappearintheNameBoxintheupperlefthandcornerofthespreadsheet.Similarly,the rangeofcellsE3:G5isnamedsigma.Formatrixalgebracalculations,itisconvenienttousenamed rangesinarrayformulas.

TheGlobalMinimumVariancePortfolio
Theglobalminimumvarianceportfoliosolvestheoptimizationproblem
2 min p ,m = mm s.t. m1 = 1 m

Thisoptimizationproblemcanbesolvedeasilyusingthesolverwithmatrixalgebrafunctions.The screenshotoftheportfoliotabbelowshowshowtosetupthisoptimizationprobleminExcel.

 TherangeofcellsD10:D12iscalledmvecandwillcontaintheweightsintheminimumvarianceportfolio oncethesolverisrunandthesolutiontotheoptimizationproblemisfound.Beforethesolveristobe run,thesecellsshouldcontainaninitialguessoftheminimumvarianceportfolio.Asimpleguessfor thisvectorwhoseweightssumtooneis mmsft = 0.3, mnord = 0.3, msbux = 0.4. Tousethesolver,acellcontainingthefunctiontobemaximizedorminimizedmustbespecified.Here, thiscellisF10whichcontainsthearrayformula {=MMULT(TRANSPOSE(mvec),MMULT(sigma,mvec))}
2 whichevaluatesthematrixalgebraformulaforthevarianceofaportfolio: p ,m = mm .Noticethat

theformulaissurroundedbycurlybraces{}.Thisindicatesthat<CTRL><Shift><Enter>wasusedto evaluatetheformulasothatitistobeinterpretedasanarrayformula.Ifyoudontseethecurlybraces thentheformulawillnotbeevaluatecorrectly.Wealsoneedacelltocontainaformulathatwillbe usedtoimposetheconstraintthattheportfolioweightssumtoone: m1 = mmsft + mnord + msbux = 1. ThisformulaisspecifiedincellE10as =SUM(mvec) Thesolveraddinislocatedonthedatatabofthetopmenuribbonintherighthandcorner.Torunthe solver,clickthecellcontainingtheformulayouwanttooptimize(cellF10,andnamedsig2px)andthen clickonthesolverbutton.Thiswillopenupthesolverdialogueboxasshownbelow.

 ThefieldnamedSetTargetCellmustcontaineitherthenameorthereferencetothecellcontainingthe formulatooptimize.Youhavethreechoicesforthetypeofoptimization:Max,MinandValueof.Here, wewanttominimizetheportfoliovariancesoMinshouldbeselected.Next,wemustspecifythecells containingthevariableswhicharebeingoptimized.ThesearespecifiedintheByChangingCellsfield. Here,wecantypeinthenamemvecorspecifytherangeofcellsD10:D12.Finally,wemustAddthe constraintthattheweightssumtoone.WedothisbyclickingtheAddbutton,whichopenstheAdd Constraintdialogueboxshowbelow.

TheCellReferencecontainsthecell(E10)thathastheformulafortheconstraint

m1 = mmsft + mnord + msbux = 1. Wespecifythevalueoftheconstraint,1,intheConstraintfield.Once

everythingisfilledin,clickOKtogobacktothesolverdialogue.Thecompletedialogueshouldlooklike oneshownbelow.

 Torunthesolver,clicktheSolvebutton.Thecomputationisgenerallyveryfast.Ifsuccessful,youshould seethefollowingdialoguebox

ThemessageSolverfoundasolution.Allconstraintsandoptimalityconditionsaresatisfiedmeansthat thefirstandsecondorderconditionsforaminimumaresatisfied.ClicktheKeepSolverSolutionoption buttonandthenclickOK.Yourspreadsheetshouldlookliketheonebelow.

 Theglobalminimumvarianceportfoliohas44%inMicrosoft,36%inNordstromand19%inStarbucks. TheexpectedreturnonthisportfolioisgivenincellC13(calledmupx)andiscomputedusingthe formula p ,m = m .TheExcelarrayformulais {=MMULT(TRANSPOSE(mvec),muvec)} TheportfoliostandarddeviationincellC14isthesquarerootoftheportfoliovariance,sig2px,incell F10.

MinimumVariancePortfoliosubjecttoTargetExpectedReturn
Aminimumvarianceportfoliowithtargetexpectedreturnequalto 0 solvestheoptimizationproblem
2 min p , y = y y s.t. y = 0 and y1 = 1 y

Thisoptimizationproblemcanalsobeeasilysolvedusingthesolverwithmatrixalgebrafunctions.The screenshotbelowshowshowtosetupthisoptimizationprobleminExcelwherethetargetexpected returnistheexpectedreturnonMicrosoft(4.27%).

 TherangeofcellsK10:K12iscalledyvecandwillcontaintheweightsintheefficientportfoliooncethe solverisrunandthesolutiontotheoptimizationproblemisfound.Beforethesolveristoberun,these cellsshouldcontainaninitialguessoftheminimumvarianceportfolio.Asimpleguessforthisvector whoseweightssumtooneis ymsft = 0.3, ynord = 0.3, ysbux = 0.4. Thecellcontainingtheformulafor
2 portfoliovariance, p , y = yy ,isincellO10whichcontainsthearrayformula

{=MMULT(TRANSPOSE(yvec),MMULT(sigma,yvec))} Wealsoneedtwoadditionalcellstocontainformulasthatwillbeusedtoimposetheconstraintsthat theportfolioexpectedreturnisequaltothetargetreturn, p , y = y = 0 ,andthattheportfolio weightssumtoone, y 1 = ymsft + ynord + ysbux = 1. TheseformulasarespecifiedincellsL10andN10, whichcontaintheExcelformulas=SUM(yvec)and{=MMULT(TRANSPOSE(yvec),muvec)},respectively. Torunthesolver,clickcellO10(calledsig2py)andthenclickonthesolverbutton.Makesurethesolver dialogueboxisfilledouttolookliketheonebelow.

Noticethattherearenowtwoconstraintsspecified.Thefirstoneimposes y 1 = ymsft + ynord + ysbux = 1 , andthesecondoneimposes p , y = y = 0 = msft = 0.0475 .Torunthesolver,clicktheSolve button.Youshouldseeadialogueboxthatsaysthatthesolverfoundasolutionandthatalloptimality conditionsaresatisfied.KeepthesolutionandclickOK.Yourspreadsheetshouldlookliketheone below.

Theefficientportfoliohasweights ymsft = 0.83, ynord = 0.09, ysbux = 0.26. NoticethatNordstromis soldshortinthisportfoliobecauseithasanegativeweight.Theexpectedreturnonthisportfoliois equaltothetargetexpectedreturn(seecellN10namedmupy)andtheweightssumtoone.Noticethat thestandarddeviationofthisportfolio(seecellP10)issmallerthanthestandarddeviationofMicrosoft (seecellC3).

ComputingtheEfficientFrontierofRiskyAssets
Theefficientfrontierofriskyassetscanbeconstructedfromanytwoefficientportfolios.Anatural questiontoaskiswhichtwoefficientportfoliosshouldbeused?Ifindthatthefollowingtwoefficient portfoliosleadstotheeasycreationoftheefficientfrontier: 1. Efficientportfolio1:globalminimumvarianceportfolio 2. Efficientportfolio2:efficientportfoliowithtargetexpectedreturnequaltothehighestaverage returnamongtheassetsunderconsideration. Forthecurrentexample,theassetwiththehighestaveragereturnisMicrosoft(averagereturnis4.27%) andwealreadycomputedtheefficientportfoliowithtargetexpectedreturnequaltotheaveragereturn onMicrosoft. Givenanytwoefficientportfolioswithweightvectorsmandytheconvexcombination

z = m + (1 ) y

foranyconstant isalsoanefficientportfolio.Theexpectedreturnandvarianceofthisportfolioare

p , z = p ,m + (1 ) p , y
2 2 2 p , z = 2 p ,m + (1 ) 2 p , y + 2 (1 ) my

wherethecovariancebetweenthereturnsonportfoliosmandyiscomputedusing my = my .To createtheefficientfrontier,createagridof valuesstartingat1anddecreaseinincrementsof0.1. Useasmanyvaluesinthegridasnecessarytomakeaniceplot. Ascreenshotofthepartofthespreadsheettocreatetheseportfoliosisshownbelow.

Considerthefirstconvexcombinationwith = 1 .Thisportfolioistheglobalminimumvariance portfolio.ThecellP20containstheformula=N20*mupx+O20*mupyfortheexpectedportfolioreturn, andthecellQ20containstheformula=N20^2*sig2px+O20^2*sig2py+2*N20*O20*sigmaxyforthe portfoliovariance.ThecovariancetermsigmaxyiscomputedinthecellR9(notshown)whichcontains thearrayformula{=MMULT(MMULT(TRANSPOSE(mvec),sigma),yvec)}.ThecellsS20:U20givethe weightsintheconvexcombinationcomputedusingthearrayformula {=TRANSPOSE(N20*D10:D12+O20*K10:K12)}.

Theefficientfrontiercanbeplottedbymakingascatterplotwiththeexpectedreturnvalues(cells P20:P50)ontheyaxisandthestandarddeviationvalues(cellsR20:R50)onthehorizontalaxis.

ComputingtheTangencyPortfolio
ThetangencyportfolioistheportfolioofriskyassetsthathasthehighestSharpesslope.Thisportfolio canbefoundbysolvingtheoptimizationproblem

max
t

t rf

( tt )

1/2

s.t. t1 = 1

Thisoptimizationproblemcanalsobeeasilysolvedusingthesolverwithmatrixalgebrafunctions.The screenshotbelowshowshowtosetupthisoptimizationprobleminExcel.

TherangeofcellsD33:D35iscalledtvecandwillcontaintheweightsinthetangencyportfoliooncethe solverisrunandthesolutiontotheoptimizationproblemisfound.Beforethesolveristoberun,these cellsshouldcontainaninitialguessoftheminimumvarianceportfolio.Asimpleguessforthisvector whoseweightssumtooneis tmsft = 0.3, tnord = 0.3, t sbux = 0.4. ThecomputationofSharpesslopeis brokendownintotwopieces.ThefirstpieceisthenumeratorofSharpesslope, p ,t rf = t rf , andiscomputedincellF33usingthearrayformula{=MMULT(TRANSPOSE(tvec),muvec)rf}.Thesecond
2 pieceisthesquareofthedenominatorofSharpesslope, p ,t = tt ,andiscomputedincellG33using

thearrayformula{=MMULT(TRANSPOSE(tvec),MMULT(sigma,tvec))}.Finally,Sharpesslopeis evaluatedincellH33usingtheformula=F33/SQRT(G33).Thisisthecellthatispassedtothesolver. Torunthesolver,clickcellH33andthenclickonthesolverbutton.Makesurethesolverdialogueboxis filledouttolookliketheonebelow.

 MakesurethattheMaxbuttonisselectedbecausewewanttomaximizetheSharpesslope.Torunthe solver,clicktheSolvebutton.Youshouldseeadialogueboxthatsaysthatthesolverfoundasolution andthatalloptimalityconditionsaresatisfied.KeepthesolutionandclickOK.Yourspreadsheetshould lookliketheonebelow.

Thetangencyportfoliohasweights tmsft = 1.03, tnord = 0.32, t sbux = 0.30. NoticethatNordstromissold shortinthisportfoliobecauseithasanegativeweight.Theexpectedreturnonthisportfolio, p ,t = t , isgivenincellC36(calledmut)andiscomputedusingthearrayformula {=MMULT(TRANSPOSE(tvec),muvec)}.

ComputingEfficientPortfoliosofTBillsandRiskyAssets
Fromthemutualfundseparationtheorem,theefficientportfoliosofTBillsandriskyassetsare combinationsofTBillsandthetangencyportfolio.Theexpectedreturnandstandarddeviationvalues oftheseportfoliosarecomputedusing

e = rf + xtan ( tan rf ) p e = xtan tan p

Ascreenshotofthespreadsheetwheretheseportfoliosarecomputedisgivenbelow.

Theportfoliowith xtan = 0 isshowninthecellsJ34:L34.TheexpectedreturniscomputedincellK34and isgivenbytheformula=rf+J34*(mutrf).ThestandarddeviationiscomputedincellL34andisgivenby theformula=J34*sigt.Thenamedrangesigtisthestandarddeviationofthetangencyportfolioandis givenincellC37.

EfficientPortfolioswithNoShortSalesConstraints
Inmanysituationsshortsalesofassetsarenotallowed.Recall,ashortsaleofanassetoccurswhenyou borrowtheassetandthensellit.Theproceedsoftheshortsaleareusuallyusedtofinancethepurchase ofotherassets.Becausetheassetwasborrowediteventuallyhastobereturned.Youdothisby repurchasingtheassetatsometimeinthefutureandthenreturningtheassettowhomeveryou borroweditfrom.Youmakeaprofitonashortsaleifthepriceoftheassetdropsduringtheperiodof timeyouhaveborrowedtheassetbecauseyourepurchasetheassetforapricelessthanforwhatyou originallysoldit.Inthecontextofportfoliotheory,whenyoushortsellanassetthecorresponding portfolioweightisnegative.Hence,whenshortsalesareprohibitedalloftheportfolioweightsmustbe constrainedtobepositive.Thistypeofnonnegativityconstraintiseasytoimposeinthesolver.

MinimumVariancePortfoliosubjecttoTargetExpectedReturnwithNoShort Sales Aminimumvarianceportfoliowithtargetexpectedreturnequalto 0 andnoshortsalessolvesthe

optimizationproblem
2 min p , y = y y s.t. y = 0 , y1 = 1 and yi 0 y

Thisoptimizationproblemcanalsobeeasilysolvedusingthesolverwithmatrixalgebrafunctions.The screenshotbelowshowshowtosetupthisoptimizationprobleminExcelwherethetargetexpected returnistheexpectedreturnonMicrosoft(4.27%).Previously,wesolvedthisproblemwherewe allowedforshortsales.Inthatcase,theefficientportfoliowas ymsft = 0.83, ynord = 0.09, ysbux = 0.26. NoticethatNordstromwassoldshortinthatportfolio.Nowwewanttoimposethenoshortsales restrictions.WesetuptheExcelspreadsheetexactlyhowwedidbefore.Theonlydifferenceoccursin howweusethesolver.Weaddanadditionalconstraintthatforcesalloftheportfolioweightstobe positive.Thescreenshotbelowshowstheinitialsetup.

TherangeofcellsAC5:AC7iscalledwvecandwillcontaintheweightsintheefficientportfoliooncethe solverisrunandthesolutiontotheoptimizationproblemisfound.Beforethesolveristoberun,these

cellsshouldcontainaninitialguessoftheminimumvarianceportfolio.Thecellcontainingtheformula
2 forportfoliovariance, p , w = wy ,isincellAG5whichcontainsthearrayformula

{=MMULT(TRANSPOSE(wvec),MMULT(sigma,wvec))} ThecellsAD5andAF5containtheExcelformulas=SUM(wvec)and{=MMULT(TRANSPOSE(wvec), muvec)}thatwillbeusedtoimposetherestrictionsthattheportfolioweightssumtooneandthatthe portfolioexpectedreturnisequaltothetargetreturn.Torunthesolver,clickcellAG5andthenclickon thesolverbutton.Makesurethesolverdialogueboxisfilledouttolookliketheonebelow.

Toaddthenoshortsalesconstraints,clicktheAddbuttontoopentheAddConstraintdialogue.Theno shortsalesconstraintsinequalityconstraintsontheelementsofwvec:

ClickOK.Thefinalsolverdialogueshouldlookliketheonebelow.

 Youshouldseeadialogueboxthatsaysthatthesolverfoundasolutionandthatalloptimality conditionsaresatisfied.KeepthesolutionandclickOK.Yourspreadsheetshouldlookliketheone below.

Theefficientportfoliohas100%inMicrosoftand0%intheotherassets.