Designing portfolios of financial products via integrated simulation and optimization models

We analyze the problem of debt issuance through the sale of innovative financial products. The problem is broken down to questions of designing the financial products, specifying the debt structure with the amount issued in each product, and determining an optimal level of financial leverage. We formulate a hierarchical optimization model to integrate these three issues and provide constructive answers. Input data for the models are obtained from Monte Carlo simulation procedures that generate scenarios of holding period returns of the designed products. The hierarchical optimization model is specialized for the problem of issuing a portfolio of callable bonds to fund mortgage assets. The upper level optimization program is multimodal, and a tabu search procedure is developed for its solution. Empirical results illustrate the efficacy of the developed models in designing the appropriate structure of the callable bonds and making optimal allocations of equity and debt among the designed products. Computational results with the implementation of tabu search – on both serial and parallel computers – are also presented.