Mathematical optimization is a problem that takes the following form
where is a vector containing all the variables of the problem
The function is referred to as the cost or the objective function. Moreover, the functions are referred to as constraint functions. In most cases, our goal is to find a (or the) point which is feasible (i.e. satisfies and is minimum. Rigorously stated, is optimal if
Well, we can state many applications. In finance and stock analysis, a well-known one is Markowitz portfolio optimization. This problem takes the form
Here will reflect the number of assets (or stocks) held over a period of time. For example, let’s say you decide to buy stocks in the period of time between today and 6 months from now. You are interested in the following stocks: CEVA, GOOGL, LVMH and NIO. This means you have decided on 4 assets and hence your . Furthermore, let’s denote by the amount of asset held throughout the period of investment. A long position in asset would indicate , and a short position in asset would mean . Moreover, is the change in price divided by the initial price (i.e. today’s price). Your return will simply be
Anyone investing (short or long term) would simply want to maximize . However, no constraints would simply mean that is a vector of all-, which is unrealistic. Keeping our feet on the ground, we should understand that a vector of all- is un-achievable, but we can accept a minimum return as
where is a minimum return you seek from the investment over your investing period. The above equation will then suit one of our constraints. Note that the above is a way of saying “I want maximum return”. To embed risk somewhere, volatility has to be included. A suitable measure of volatility seems to be the variance of the asset prices, which is captured in covariance matrix . The variance would then by the term . Markowitz introduced the problem of minimizing risk subject to maximum and acceptable return
Note that the constraint along with imposes a probability constraint on vector . In other words, we are interested in vectors that contains probabilities (or proportions). Markowitz portfolio optimization lies under the category of convex optimization problems of type QP (Quadratic Programming). In Electrical Engineering, convex optimization finds application in many communication and electronic manufacturing problems, such as water filling and electronic micro scale design.