A stochastic programming model for money management

Portfolio managers in the new fixed-income securities have to cope with various forms of uncertainty, in addition to the usual interest rate changes. Uncertainty in the timing and amount of cashflows, changes in the default and other risk premia and so on, complicate the portfolio manager's problem. We develop here a multi-period, dynamic portfolio optimization model to address this problem. The model specifies a sequence of investment decisions over time that maximize the expected utility of return at the end of the planning horizon. The model is a two-stage stochastic program with recourse. The dynamics of interest rates, cashflow uncertainty, and liquidity, default and other risk premia, are explicitly modeled through postulated scenarios. Simulation procedures are developed to generate these scenarios. The optimization models are then integrated with the simulation procedures. Extensive validation experiments are carried out to establish the effectiveness of the model in dealing with uncertainty. In particular the model is compared against the popular portfolio immunization strategy, and against a portfolio based on mean-absolute deviation optimization.