Inter-Temporal Portfolio Analysis Based on Simulation of Joint Returns

Kalman J. Cohen · Edwin J. Elton

43 citations0/0 files storedManagement Science

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Risk and Portfolio Optimization Stochastic processes and financial applications Capital Investment and Risk Analysis

Abstract

An inter-temporal quadratic programming model for selecting portfolios of risky assets is formulated. The model's application to capital budgeting is discussed in considerable detail. This is followed by briefer discussions of its application in other areas. The paper develops a new and more efficient way of using simulation to calculate the variance-covariance elements required as input to Markowitz-type models; this new procedure makes no further demands on the decision maker than do other simulation models that have been suggested. The paper also shows how such models can be made inter-temporal. Finally, the paper analyzes the potentials for extending such models to include other theoretical considerations that have been proposed in the literature.

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References

1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1959Theory of Value 1973The Role of Securities in the Optimal Allocation of Risk-bearing 1966Market and Industry Factors in Stock Price Behavior 1965Investment Decision Under Uncertainty: Choice-Theoretic Approaches 1966Capital Budgeting of Interrelated Projects: Survey and Synthesis 1965Optimal financing decisions

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