Paper III

Back-Testing the Performance of an Actively

Managed Option Portfolio at the Swedish Stock
Market, 1990-1999

Jorgen Blomvall and Per Olov Lindberg

 Back-Testing the Performance of an Actively
Managed Option Portfolio at the Swedish Stock
Market, 1990-1999
Jorgen Blomvall Per Olov Lindberg

February 8, 2001

Abstract
We build an investment model based on Stochastic Programming. In the
model we buy at the ask price and sell at the bid price. We further include
proportional transaction fees, to make the model as realistic as possible. We
apply the model to a case where we can invest in a Swedish stock index, call
options on the index and the risk-free asset. By reoptimizing the portfolio
on a daily basis over a ten-year period, it is shown that options can be used
to create a portfolio that outperforms the index. With ex-post analysis it is
furthermore shown that we can create a portfolio that dominates the index in
terms of mean and variance, i.e. at given level of risk we could have achieved
a higher return using options.

1 Introduction
One tool that has been of large use to portfolio managers over the years is the
Markowitz Mean-Variance model (Markowitz, 1972). Even though it has some ad-
vantages because of its simplicity, the simplicity is also the reason for its weaknesses.
In the model the probability distributions of the asset returns do not change and
there is no explicit evolution of asset prices over time in the model. This makes
it hard to study the eects of market imperfections such as transaction costs and
taxes. Furthermore it is assumed in the model that the investor wishes to optimize
only the mean and variance. The model does not consider aspects such as fat tails
(Fama, 1965) and skewnesses in the returns.
One way to handle this problem is to use a Stochastic Programming model. There
are several good reviews of this multistage framework, e.g. (Mulvey, 1994b), (Mul-
vey and Ziemba, 1998) and (Mulvey, Rosenbaum, and Shetty, 1997). The multistage
1
models can be solved with Stochastic Programming algorithms (Birge and Louveaux,
1997). Some of the rst applications of Stochastic Programming in nance was the
work of Grauer and Hakansson (Grauer and Hakansson, 1985), (Grauer and Hakans-
son, 1986), (Grauer and Hakansson, 1987) and (Grauer and Hakansson, 1993). In
these papers, a rolling two-stage model was used to solve an investment problem in
stocks and bonds. There has also been other studies on portfolios consisting of xed-
income securities (Worzel, Vassiadou-Zeniou, and Zenios, 1994), (Vassiadou-Zeniou
and Zenios, 1996) and (Zenios, Holmer, McKendall, and Vassiadou-Zeniou, 1998).
Specically, portfolios consisting of mortgage-backed securities have been extensively
treated in (Cagan, Carriero, and Zenios, 1993), (Holmer, 1994), (Zenios and Kang,
1993) and (Golub, Holmer, McKendall, and Pohlman, 1995). A mortgage-backed
security is a collection of dierent mortgages.
Another application that has received much attention is asset-liability management
for pension funds. Among the models are the Towers-Perrin (Mulvey, 1996), Pa-
cic Financial Asset Management Company (Mulvey, 1994a) and the Russel-Yasuda
Kasai model (Cari~no and Ziemba, 1998), (Cari~no, Myers, and Ziemba, 1998). The
pension-fund models are used for planning over long horizons, but there are also
models for short-term investments. In (Cari~no and Turner, 1998) a linear Stochas-
tic Programming model is used to solve an investment problem whith derivative
instruments. Linear Stochastic Programming has also been used to hedge a deriva-
tive portfolio optimally when the volatility is stochastic and there are transaction
costs (Gondzio, Kouwenberg, and Vorst, 2001). Both of these papers report only
limited numerical results on the model, without testing its performance on an ex-
tensive time series.

2 Model

2.1 Model framework

A description of Stochastic Programming can be found in (Birge and Louveaux,
1997). A Stochastic Programming model is traditionally represented by a time-
staged tree (see gure 1), where each node represent a xed outcome of the random
variables up to that stage. Each node in the tree represents a state where one
outcome has been realized for the values of the random variables. The stages (the
depth from the root node) represents the evolution of time. With each node we
can associate another state. For each node i 2 I , xi denotes the state that the
decision maker can in uence (for example the number of stocks owned). In each
node i, except for the terminal nodes T (the leaf nodes in the tree), it is possible to
make a decision ui. This decision aects the state, xi+ , in the immediate successors,
i+ 2 Ii+, to node i in the following way:
xi+ = Ai+ xi + Bi+ ui; 8i+ 2 Ii+:
2
 Sets:

I
111
000
000
111
000
111 1111 f1g
0000
0000
1111
0000
1111
i+
T
111
000 000
111
000
111
i- 000
111
i
000 111
111 000 1111 I n f1; T g
0000
0000
1111
0000
1111
i+
Ii+
111
000
000
111
000
111

Figure 1: Notation for a multistage model.

Note that the state of this successor can depend on the random variables since the
matrices Ai+ and Bi+ dier for dierent successors. In the model we also allow
additional constraints of the type:
Eixi + Fiui  mi:
Together with a concave objective function that is separable over all terminal nodes
this leads to the formulation of the multistage stochastic program,

X
max
u ;i2InT
pi U (cTi xi)
i
8 i2T
< Eixi + Fiui  mi; (1)
s.t. : xi+ = Ai+ xi + Bi+ ui;
x1 given:
In Stochastic Programming, the scalar pi usually represents the probability of node
i and U (
) is a function that re ects the decision maker's preferences for dierent
3
values of the scalar cTi xi. Observe that the objective function only depends on the
states in the terminal nodes. The value of x1 is xed; it denes the current state.
Our formulation of Multistage Stochastic Programming problems diers somewhat
from conventional formulations, since it uses predecessors and successors to dene
the tree structure. This notation is also used in (Salinger and Rockafellar, 1999).
On the one hand the sets Ii+ hide the time structure in this formulation, but on
the other hand the formulation gives a greater exibility in the model since no time
structure is imposed on the model. We shall now show how to model an asset
portfolio within the given framework.

2.2 Assets
In node i the available assets are represented by the set Ai. The assets in Ai may
dier between the nodes. For each node i and for each asset a 2 Ai we know the
amount owned, xai , of the asset in the previous node, i . Furthermore we know the
amount bought, uabi , and sold, uasi . The total amount in the current node thus is
xai = xai + uabi uasi ; a 2 Ai;
where
xai; uabi ; uasi  0:
If we allow short selling, then we remove the positivity constraint on xai. When there
are no transaction costs, we replace uabi and uasi by uai = uabi uasi . For the case
when the asset a is introduced in node i , we can write the constraint as
xai = uabi uasi ; xai; uabi ; uasi  0:
If the asset expires in the current node, then the constraint becomes
xai + uabi uasi  0; uabi ; uasi  0:
In this case we have to assume that the value of the asset always is positive and
that the utility function U is nondecreasing.

2.3 Cash
Similarly to when the asset constraints were dened, we know that in the previous
node each asset was bought at the price pabi and sold at pasi . If the cash held in the
previous node was xli , then the following holds for the cash in the current node:
X
xli = (xli + (pasi uasi pabi uabi ))erl ;
a2Ai

4
where xli  0 is required and rl is the lending rate. If the lending rate and the
borrowing rate are the same, then we can remove the positivity constraint on xli to
allow borrowing. If the rates dier, then borrowing is modeled as follows
X as as ab ab
xli = (xli + (pi ui pi ui ) +
ubi )erl ;
a2Ai

xbi = (xbi +
ubi )erb ;

where xli; xbi  0 and rb is the borrowing rate. The variable
ubi is the change in
the total amount borrowed.

2.4 Objective function

Utility theory has been extensively treated in economic theory. It is possible to show,
under some reasonable assumptions on the preferences of a rational investor, that
he will act so as to maximize his expected utility (von Neumann and Morgenstern,
1953). The objective function,
X
max
u ;i2InT
pi U (cTi xi);
i i2T
corresponds to utility maximization if cTi xi
denotes the total value of the portfolio.
According to Kelly (Kelly, 1956) there exist one special utility function which out-
performs any other utility function in the long run in terms of growth of wealth,
when some natural limiting assumptions are made. If an investor invests using the
logarithmic utility function then he will have more money with probability 1 than
if any other utility function had been used. The catch with this utility function is
that you have to invest over an innitely long time period to be certain that you will
have more money. It has also been observed that the concomitant risk is high. As
an alternative, a related approach has been proposed where only a fraction of the
capital is invested in the log-optimal portfolio (Li, 1993), (MacLean and Ziemba,
1986), (MacLean and Ziemba, 1991) and (MacLean, Ziemba, and Blazenko, 1992);
this is called a Kelly strategy. In our case we will however use the logarithmic utility
function.
From the above, it is clear that a multistage asset investment problem with discrete
outcomes of prices can be modeled by (1).

3 Solution procedure
Problem (1) is a mathematical programming problem with nonlinear objective and
linear constraints. To solve (1) we use the interior point solver developed in (Blom-
vall and Lindberg, 2000a). As is standard in interior point methods, the inequality
5
constraints are moved to the objective via logarithmic barrier terms premultiplied
by a penalty parameter . For a given  we solve one second-order approximation
to the problem, and take one Newton step (modied to maintain feasibility). There-
after, the multiplier  is decreased. Usually approximately 20 iterations in  are
required to nd the optimum to prescribed tolerance. The advantage of the interior
point method is that the subproblem, the second-order approximation, can be solved
eciently. To solve the quadratic subproblem, we rst determine the Value function
recursively starting at the terminal nodes using Dynamic Programming. When this
has been done the optimal decisions and states can be determined recursively start-
ing from the root node. The solver can maximize (1) to desired precision if U (
) is
concave, if there exist real-valued upper or lower bounds on the variables and if the
set of interior points is nonempty (Blomvall and Lindberg, 2000b). The paper also
shows that power utility functions can be solved in polynomial time. Thus both
linear and logarithmic utility functions can be solved in polynomial time. Using a
parallel implementation of the algorithm one instance with 16,384 scenarios, 98,300
variables and 180,214 constraints was solved in 2.9 seconds on a 32-node PC cluster.

4 Scenario generation
The scenario generation technique we use is related to (Grauer and Hakansson,
1985), (Grauer and Hakansson, 1986), (Grauer and Hakansson, 1987) and (Grauer
and Hakansson, 1993). In these papers Grauer and Hakansson use historical returns,
rt, to estimate the future probability distribution.
rt = SSt 1;
t 1
where St is the stock price at time t. They use 8 years of historical quarterly returns
and assign each return equal probability. One interesting property of this model is
that it assumes that the form of the probability distribution is of the same form as
historically. Thus the extreme price movements that occur from time to time are
automatically included in the model. When the time horizon is short, the current
stock volatility plays an important part in predicting the probability distribution,
since the current volatility to a large extent aects the returns for the next few days.
In the longer run the probability distribution of the returns is less connected to the
current volatility. Thus we modify the stock price model to capture the eect of the
volatility. We do this in the following way.
It is often assumed that stock prices follow a lognormal process. This can be modeled
with the discrete version of Brownian motion,
p
dS := ln SSt = t
t + t
tdz;
t 1
where t is the mean of the stock price process, t the volatility (standard deviation),

t the time step and dz is a normally distributed stochastic process with mean 0 and
6
standard deviation 1. From the denition above of dS we can see that St = St 1edS ,
i.e. the relative change in stock price has a lognormal distribution. In the Grauer
and Hakanssons case the stock price is equal to St = St 1rt, where rt is the stochastic
process of the historical returns. In this case the lognormal distribution has been
replaced by an empirical approximation. What we will do now is to replace the
white noise dz by an approximation, dz^, from historical data. This modication
allows us to take eects like fat tails and varying volatility into account to some
extent.
For the historical data, each change in stock price can be described as:
p
dS := ln SS = 
t + 
tdz^ : (2)
 1
To determine the corresponding sampled value for dz^ we rewrite to
dz^ = dS p
t :

t
The set of historical quotes gives a sample that can be used to estimate dz^. The
stochastic variable dz^ has to be renormalized in order to get mean 0 and standard de-
viation 1. This renormalized stochastic process is used to estimate the probabilities
for the following discretized outcomes:
p
Stj = Stet
t+(j N2 )t
t; j = 1; : : : ; N (3)
where N is the number of outcomes.
 is estimated with the same method as in RiskMetrics (RiskMetrics, 1996),
^2 = (1  )(dS ^ 1)2 +  ^2 1;
where the decay factor  is the value that minimizes the error of the historically
predicted variance.
The estimates of t has large error. To get a small error requires a large set of
historical data (Chopra and Ziemba, 1993). We use the mean of the returns to
estimate t .
X 
^ = N1 dSt
t= N +1
We use approximately 8 years (N = 2000) of daily historical returns to estimate the
mean.

5 Results
We make the model as realistic as possible to make it plausible that the returns
actually could have been achieved. We will use three dierent asset types in the
7
model. The rst is the OMX-index, a composite index in Sweden similar to the
S&P 500. It consists of the 30 most traded companies in Sweden. The weight in
the index is proportional to the company's capitalization. The second asset type
is call options on the OMX-index. We use only the options with the shortest time
to maturity. For each day there are 10-40 such options available during the period
1990-1999.

5.1 Data
The data we use is the end-of-day values of the OMX-index, from September 30,
1986 to June 1, 1999. The option prices we use are the end of day bid and ask
prices, from January 2, 1990 to June 1, 1999 and the risk-free interest rate during
the same period. We use the bid and ask prices in order to make certain that we
could actually have traded on the market. We buy at the ask price and sell at the
bid price. Thus we know that it would have been possible to trade at the price we
use. We do not however know how large amount we could have traded. There is
also a transaction cost proportional to the value of the traded assets, 2.0% for the
options and 0.1% for the OMX-index.

5.2 Model
We want to evaluate how well we could have invested from February 14, 1990 to
June 1, 1999. The data from 1986-1989 is used to initialize the model. To do the
evaluation we solve a stochastic two-stage optimization problem for the rst date,
buy the assets at the current market prices, we then step the model forward one
time period and evaluate the portfolio. When this is done we repeat the procedure.
Since we want to take advantage of incorrectly priced options it is essential to make
it possible to buy as many times as possible. Therefore we step the model forward
one day at a time. To evaluate the investment during the 9.5 years we solve 2328
optimization problems.
For each optimization problem, scenario trees are generated for the value of the
OMX-index. We use the estimated t, t and the stochastic process (2) to estimate
the probabilities for the outcomes (3). When we make the optimization for one
day we do not know future option prices. It is possible to estimate the prices
using the Black & Scholes formula (Black and Scholes, 1973) and implied volatility.
This approach is used to determine the value of the current portfolio, but it is not
appropriate to let the optimization believe that it can trade at prices in the future
when it in fact probably cannot. Because of the diculty of determining future
option prices, we work with only a two-stage model. We select the dates for the
second stage as the same date as the options mature, because at this date the value
of the option is given by the index price. This means that the time horizon will
8
never be longer than one month.

5.3 Computational results

The optimization problems that are solved use 80 scenarios to model the future out-
comes of the OMX-index. The 2328 optimization problems are solved as a sequence
in chronological order. In the option portfolio it is neither allowed to borrow money
nor short selling of assets. The complete simulation takes approximately 1 hour on
a 233 MHz Pentium II. During the 9.5 year period the index increased from 1 to
3.88 (scaled). The return of the growth optimal portfolio was 8:8
1027 during the
same period, see gure 2.
30
10

25
10

20
10

15
10
Return

10
10

5
10

0
10
Optimal option portfolio
−5
OMX−index
10
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year

Figure 2: The portfolio and index compounded returns.

This is an unrealistic return, which indicates that several opportunities have existed
to buy assets at advantageous prices. To facilitate a more realistic test, we add
liquidity constraints on the amount of assets we can trade. Since we are doing
back-testing of the returns, it is not possible to determine how many assets could
be traded at a given bid or ask price. The proxy we use for this is a percentage of
the volume traded on the same day. The upper limit on how much we can trade
is given by max(10; 0:5volume), where 10 is the smallest block that can be traded.
The initial capital was set to SEK 1 million (approximately USD 100,000). The
new returns can be seen in gure 3. In this gure we have included a new growth
9
optimal portfolio that only invest in the OMX-index. For this portfolio borrowing
is also allowed, with rbt = rlt + 0:02.

2
10

1
10
Return

0
10

Optimal option portfolio

OMX−index
−1
Optimal OMX portfolio
10
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year

Figure 3: Compounded return for the portfolio, the index portfolio and the index.
Liquidity constraints for options included.

We see that the return of the option portfolio is higher over the ten-year period. It
is however hard to see from gure 3 if the yearly return is consistently higher. To
see if this holds, we plot the yearly return of the option portfolio minus the yearly
return of the OMX-index (gure 4). As can be seen from the gure most of the time
the yearly return has been higher than the return of the OMX-index. The decrease
in yearly return during the last two years can to some extent be explained by the
large value of the portfolio, 60 million SKR. This limits the possibilities of making
favorable investments: Most of the time we would have been better o with the
option portfolio in the short run as well.
As can be seen from the returns the risk is high in the optimal option portfolio. To
do an ex-post analysis, the arithmetic mean of the daily returns is used, but this
measure does not predict the actual performance of the portfolio when the money
is reinvested. In analogy with Markowitz (Markowitz, 1976), we instead look at the
mean of the logarithm of the daily returns,

1 XT
 = T ln rt;
t=1

10
 3.5

2.5
Yearly additional return

1.5

0.5

−0.5
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year

Figure 4: The yearly return in excess of the return of the OMX-index, for the option
portfolio. Liquidity constraints for options included.
and the corresponding standard deviation,
X T
2 = T 1 1 (ln rt )2:
t=1
This measure of the mean has the advantage that it is an increasing function of the
total return of the portfolio. The daily return is equal to the ratio between two
subsequent portfolio values, rt = Pt=Pt 1 , where Pt denotes the portfolio value at
time t. The total return is thus equal to:
PT = Y T
Pt = Y T
r
PT ln rt T
t = e t=1 =e :
P0 t=1 Pt 1 t=1

In spite of these measures, we still cannot compare two portfolios since they have
dierent risk. To make a comparison, we construct a mixed portfolio, consisting of
a linear combination of the original portfolio and the risk-free asset. The return of
this new portfolio is equal to

t + (1 )e lt 0    1
rt = r
r
rt + (1 )erbt  > 1 :

By changing  we can generate a frontier of dierent means and volatilities that

can be achieved by investing only a share of the capital in the optimal portfolio and
11
 0.45

0.4

0.35

0.3
Yearly mean, eµ − 1

0.25

0.2

0.15

0.1 Option portfolio frontier

OMX frontier
OMX portfolio frontier
0.05 Optimal option portfolio
OMX−index
Optimal OMX portfolio
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Yearly risk, σ

Figure 5: Ecient frontiers derived from the optimal portfolio and the OMX-index.
Liquidity constraints for options included.

the rest in the risk-free asset. To invest only a share in the log-optimal portfolio
is called a Kelly strategy. We can see this frontier plot in gure 5 together with
the corresponding frontier for the OMX-index. We can see from the gure that the
optimal portfolio with the index and options dominates any xed mixed strategy
for the OMX-index. For each volatility, we can achieve a higher return by using the
option portfolio than by using the OMX-index. We can also see that the same can
be done for the portfolio that invests only in the OMX-index, where borrowing is
also allowed.
This was however only a study of the rst two moments, mean and standard devia-
tion. As is well known, option portfolios give a return that do not have a lognormal
probability distribution. To make a more fair comparison we also study the higher
moments for the Kelly strategy that gives the same return,  = 0:139, as the OMX-
index. As table 1 shows, for the same return, the Kelly portfolio has lower standard
deviation and lower fourth moment than the OMX-index. The third moment is
slightly higher. If we on the other hand take a look at the skewness and kurtosis,
then we get a bit peculiar results. Both measures increase for the Kelly portfolio
compared to the option portfolio, even though the risk in the Kelly portfolio is lower.
The correlation between the OMX-index and the option portfolio is 0.64. In spite of
this high correlation the option portfolio would increase the value of a well diversi-
ed portfolio, because of it's high return. The Sharpe-ratio for the option portfolio
is 0.97, which is much higher than for an ordinary portfolio that has a Sharpe-ratio
12
 Moment OMX-index Kelly portfolio Option portfolio
Mean 14.58 % 14.58 % 46.33 %
Standard deviation 21.56 % 9.92 % 67.09 %
Third moment 2.46 % 2.63 % 497.58 %
Fourth moment 5.60 % 2.19 % 2542.99 %
Skewness 2.46 26.94 16.48
Kurtosis 22.91 222.38 122.55
Table 1: Moments, skewness and kurtosis for OMX-index, one Kelly portfolio ( =
0:139) and the option portfolio.

of 0.5. The generalized Sharpe-ratio (Hodges, 1998) is 0.95.

Thus by studying the four rst moments as well as the Sharpe-ratio measure we can
conclude that we have found a portfolio that dominates the OMX-index. But this
is an impossibility if the market is ecient. Options are by denition derivatives of
the underlying asset and thus the portfolio should not yield a higher return for a
given risk level if options were included in the portfolio (Long, 1990). Thus it can
be concluded that the Swedish option market probably has been inecient during
the examined period.

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