Case 1: Banking on Bank

Every investor must tradeoff return versus risk in deciding how to allocate his or her
available funds. The opportunities that promise the greatest profits are almost always the
ones that present the most serious risks. Commercial banks must be especially careful in
balancing return and risk because legal and ethical obligations demand that they avoid
undo hazards, yet their goal as a business enterprise is to maximize profit. This dilemma
leads naturally to multiobjective optimization of investment that includes both profit and
risk criteria.

After working for 10 years as a finance manager in various companies, you get an offer
in City Co-op Bank who is looking for a dynamic Finance Head who needs to take call
on investments to maximize profits. City Co-op Bank has a modest Rs. 20 crores
capital, with Rs. 150 crores in demand deposits (current accounts) and Rs. 80 crores in
time deposits (savings accounts and fixed deposit). The table below displays the
categories among which the bank must divide its capital and deposited funds as per RBI
regulations. Rates of return are also provided for each category together with other
information related to risk.

City Co-op Bank Investment Opportunities
Investment Category (j)
Return Rate
(%)
Liquid
Part
(%)
Required
Capital
(%)
Risk Asset?
(%)
1. Cash 0.0 100.0 0.0 No
2. Short Term 4.0 99.5 0.5 No
3. Government: 1 to 5 years 4.5 96.0 4.0 No
4. Government: 5 to 10 years 5.5 90.0 5.0 No
5. Government: over 10 years 7.0 85.0 7.5 No
6. Personal loans 10.5 0.0 10.0 Yes
7. Housing loans 8.5 0.0 10.0 Yes
8. Commercial loans 9.2 0.0 10.0 Yes

Your predecessor was a finance head who raised to the position over thirty years after
starting his career as a cashier. He being just commerce graduate did not know OR tools.
He has been taking investment decisions based on his subjective judgment using his
experience. With this at times investments were too risky bringing the bank in cash flow
problems. Then he suddenly became too conservative resulting in low profits.

When you take over the position decide to list constraints and decide to maximize profit.
The constraints you list based on management policy and regulators guidelines as:
1. Cash reserve must be at least 14% of the demand deposits based on previous
experience of withdrawals by current account holders.
2. In addition you need to keep cash reserve of 4% to cater for withdrawals and
maturity of saving account and FDs.
3. Govt. regulation requires certain portion of the total investment must be liquid.
Accordingly the portion of investment considered liquid should be at least 47% of
demand deposits plus 36% of time deposits.
4. To ensure diversified investments, at least 5% of funds should be invested in each
of the eight categories.
5. At least 30% of funds should be invested in commercial loans, to maintain the
banks community status.

Formulate the problem as LP problem & solve it. Comment on your solutions.

Note that you can set your objectives differently as per you and your higher management
perception of the mission and market situation.
a) Profit could be one objective.
b) Capital-adequacy ratio less than 0.8 is considered sufficient to ensure smooth
working capital management (particularly when many banks are seen to get into
trouble).
c) With the global financial problems due to toxic debts, your estimate is to keep risk
asset ratio below 7.

Compare your results with various objectives. Are you satisfied with this approach?

Now having studied goal programming you decide to use all these goals for your
investment decisions. You try formulating the problem with equal weight for all goals or
un-equal weight as per your bank objectives and your 92.5% profit before tax is
considered excellent to satisfy share holders. They also wont mind little less if they feel
that their investment is safe. Also you try pre-emptive goals for formulation. What are
your results? How do they help you in decision making? Can you modify then over a
period?
The above goals may be thought of as soft constraints. Soft constraints such as the
criteria targets of goal programming specify requirements that are desirable to satisfy but
which may still be violated in feasible solutions. Once target levels have been specified
for soft constraints, we proceed to a more familiar mathematical programming
formulation by adding constraints that enforce goal achievement. However, we cannot
just impose the constraint that each objective meet its goal. There may be no solution that
simultaneously achieves the desired levels of all soft constraints. Instead we introduce
new deficiency variables. Nonnegative deficiency variables are introduced to model the
extent of violation in goal or other soft constraints that need not be rigidly enforced. With
a target, the deficiency is the under achievement. With a target, it is the excess. With
= soft constraints, deficiency variables are included for both under- and over
achievement.

In the three-objective Bank Three example, we enforce goal levels with deficiency
variables:
d1
-
=amount profit falls short of its goal
d2
+
=amount capital-adequacy ratio exceeds its goal
d3
+
=amount risk-asset ratio exceeds its goal




















Case 2: Solar Energy Installation Model
An experimental solar energy system for residential heating consists of three major
components; a solar collector made up of plate glass that is oriented toward the sun; a
water tank for storing thermal energy and a piping control system for regulating flows,
pressure and temperature.
Suppose that three surface areas for the collector are under consideration: 500, 600, and
700 sq ft. Engineering tests show that the area of collector directly affects its ability to
increase average ambient (outdoor) temperatures. The 500 sq ft collector increases
ambient temperature by a factor of 6; the 600 sq ft collector by a factor of 7; and 700 sq ft
collector, by a factor of 8. For example, given an average ambient temperature of 30
0
F,
the 600 sq ft collector has the capacity of sending water into the storage tank, which is
heated to 210
0
F (i.e. 30*7). Over the life of a typical home (estimated at 40 yrs), the
amortized cost of the collector is $0.50 per sq ft per yr.
Two choices are available for the size of the storage tank: 800 gallons and 1000 gallons.
Generally, the tanks have a greater ability to store thermal energy for use during the night
time or during cloudy weather. The effective heat retention of the smaller tank is 0.7 , and
that of the larger tank is 0.8. For example, the larger tank is capable of effectively
maintaining the water at 168
0
F, when the collector delivers water at 210
0
F (210*0.8).
The amortized cost of the storage facility is $0.15 per gallon per yr.
Two choices also are available for the piping and control system. These are amortized at
$50 per yr and $100 per yr. The efficiency factor for the cheaper alternative is 0.4 and
that for the more expensive alternative is 0.5. For example, if the effective temp of water
in a tank is 168
0
F, then an efficiency factor of 0.5 means that the effective temp that can
be delivered to the residence is 84
0
F (168*0.5).
The effective delivery temp is important because it determines the average cost of
supplying conventional heat to supplement the solar system. For a 2000 sq ft residence
heated to 70
0
F, the average annual cost of the conventional heating system has been
estimated by the following relationship:
h =150 +10 (70 Effective delivery temperature).
Note that effective delivery temperatures above 70
0
F reduce h below $150 per year.
Moreover, if a calculation yields h<0, then h should be set to zero.
Identify the DP structure for this problem. Determine the optimal design by DP. ( to
simplify the problem round off the effective temperature to the nearest 10
0
F)

Case 3: Investment Banking
A trust officer for a major banking institution is planning the investment of $1 million
family trust for the coming year. The trust officer has identified a portfolio of stocks and
another group of bonds that might be selected for investment. The family trust can be
invested in stocks or bonds exclusively, or a mix of the two. This trust officer prefers to
divide the funds in the increments of 10 percent; that is the family trust may be split as
100% stock& 0% bonds, 90% stocks and 10% bonds, 80% stocks and 20% bonds and so
on.
The trust officer has evaluated the relationship between the yields on the different
investment and general economic conditions. Her judgment is as follows:
(1) If the next year is characterized by solid growth in the economy then bonds will
yield 12% and stock will yield 20%.
(2) If the next year is characterized by inflation, then bonds will yield 18% and stock
will yield 10%.
(3) If the next year is characterized by stagnation, then bonds will yield 12% and
stock will yield 8%.

a. Formulate a payoff table where payoffs represent the annual yield, in dollars,
associated with the different investment strategies and the occurrence of various
economic conditions.
b. Determine the optimal strategy using the maxmax, maxmin, Hurwicz(=0.40),
equally likely and regret criteria.
c. Suppose that, p (solid growth) =0.4, p (inflation) =0.25 and p (stagnation) =0.35
then use the expected value criterion to select the appropriate strategy.
d. What is the expected value of perfect information?
e. If the forecasting firm projects following conditional probabilities of the forecast
of economy, revise the decision with posterior probabilities
States of
nature
Conditional probabilities
X1 X2 X3
Solid
growth
0.7 0.2 0.1
Inflation 0.1 0.8 0.1
Stagnancy 0.05 0.05 0.9
Where
X1: Forecast of solid growth.
X2: Forecast of inflation.
X3: Forecast of stagnancy.
Case 4: Pipeline Construction Model
The installation of an oil pipeline which runs from an oil field to a refinery requires the
welding of 1000 seams. Two alternatives have been specified for conducting the welding.
1. Strictly use a team of ordinary and apprentice welders (B-Team)
2. Use a team of master welders (A-Team) who check and rework (as necessary) the
works of the B team.
If the B team is strictly used, it is estimated from past experience that 5% of the seams
will be defective with probability 0.30, or 10% will be defective with probability 0.50, or
20% will be defective with probability 0.20. However if the B team is followed by A
team, a defective rate of 1% is almost certain.
Material and labour costs are estimated at $400,000 when the B-Team is used strictly,
whereas these costs rise to $530,000 when the A-Team is also brought in. Defective
seams result in leaks, which must be reworked at a cost of $1,200 per seam, which
includes the cost of labour and spilled oil but ignores the cost of environmental damage.
a. Determine the optimal decision and its expected cost. How might environmental
damage be taken into account?
b. A worker on the pipeline with a Baysian inclination (from long years of wagering
on sporting events) has proposed that management consider X-ray inspections of
five randomly selected seams following the work of the B-Team. Such an
inspection would identify defective seams, which would provide the management
with more information for the decision on whether or not to bring the A-Team,. It
costs $5000 to inspect the five seams.
Finally is it worthwhile to carry out the inspection? If so, what decision should be
made for each possible result of the inspection?



Case5: Vehicle Insurance. 'Profit from Accidents'.
In most of Europe and Asia annual automobile insurance premiums are determined by
use of a Bonus Malus (Latin for Good-Bad) system. Each policyholder is given a positive
integer valued state and the annual premium is the function of this state (along, of course,
with the type of car being insured and the level of insurance). A policyholder's state
changes from year to year in response to the number of claims made by that policyholder.
Because lower numbered states correspond to lower annual premiums, a policyholder's
state will usually decrease if he or she had no claims in the preceding year, and will
generally increase if he or she had at least one claim. (Thus, no claims is good and
typically results in a decreased premium, while claims are bad and typically result in a
higher premium.)
If we suppose that the number of yearly claims made by a particular policyholder is a
Poisson random variable with parameter >-, then the successive states of this policyholder
will constitute a Markov chain with transition probabilities
P
i,j
= e
-
(k / k! ) j >= 0
k: s
j
(k) =j
State Annual
premium ($)
Next state if
0 claims 1 claim 2 claims >=3 claims
1 200 1 2 3 4
2 250 1 3 4 4
3 400 2 4 4 4
4 600 3 4 4 4

Write a transition matrix for Markov Chain.
If average number of accident claims is 1.2 per year, is this rate of premium ok for the
company? If not what premium would you propose for your company? Can you suggest
any variation in the method to make your policy more attractive?