Portfolio optimization with relaxation of stochastic second order dominance constraints via conditional value at risk

Abstract

A portfolio optimization model with relaxed second order stochastic dominance (SSD) constraints is presented. The proposed model uses Conditional Value at Risk (CVaR) constraints at probability level \begin{document}$ \beta\in(0,1) $\end{document} to relax SSD constraints. The relaxation is justified by theoretical convergence results based on sample average approximation (SAA) method when sample size \begin{document}$ N\to\infty $\end{document} and CVaR probability level \begin{document}$ \beta $\end{document} tends to 1. SAA method is used to reduce infinite number of inequalities of SSD constraints to finite ones and also to calculate the expectation value. The proposed relaxation on the SSD constraints in portfolio optimization problem is achieved when the probability level \begin{document}$ \beta $\end{document} of CVaR takes value less than but close to 1, and the model can then be solved by cutting plane method. The performance and characteristics of the portfolios constructed by solving the proposed model are tested empirically on three sets of market data, and the experimental results are analyzed and discussed. Furthermore, it is shown that with appropriate choices of CVaR probability level \begin{document}$ \beta $\end{document} , the constructed portfolios are sparse and outperform the portfolios constructed by solving portfolio optimization problems with SSD constraints, with either index portfolios or mean-variance (MV) portfolios as benchmarks.