Distributionally robust portfolio optimization with second-order stochastic dominance based on wasserstein metric

• Published in: Information sciences Vol. 613; pp. 828 - 852
• Main Authors: Hosseini-Nodeh, Zohreh, Khanjani-Shiraz, Rashed, Pardalos, Panos M.
• Format: Journal Article
• Language: English
• Published: Elsevier Inc 01.10.2022
• Subjects: Ambiguity; Cutting surface method; Portfolio optimization; Second-order conic programming; Second-order stochastic dominance; Semi-infinite programming; Semidefinite programming; Wasserstein metric; Portfolio optimization; Semi-infinite programming; Semidefinite programming; Second-order stochastic dominance; Wasserstein metric; Second-order conic programming; Cutting surface method; Ambiguity
• ISSN: 0020-0255; 1872-6291
• DOI: 10.1016/j.ins.2022.09.039

•This study considers a distributionally robust portfolio optimization problem with an ambiguous stochastic dominance constraint by assuming the unknown distribution of asset returns.•We propose the worst-case expected return and subject to an ambiguous second- order stochastic dominance constraint.•We use a cutting plane to solve our second-order stochastic dominance constraint portfolio optimization problem with ambiguity sets based on the Wasserstein metric.•It is also shown that the Wasserstein-moment ambiguity set-based distributionally robust portfolio optimization can be reduced to a semidefinite program and second-order conic programming.•We decompose this class of distributionally robust portfolio optimization into semi-infinite programming and apply the cutting surface method to solve it. In portfolio optimization, we may be dealing with misspecification of a known distribution, that stock returns follow it. The unknown true distribution is considered in terms of a Wasserstein-neighborhood of P to examine the tractable formulations of the portfolio selection problem. This study considers a distributionally robust portfolio optimization problem with an ambiguous stochastic dominance constraint by assuming the unknown distribution of asset returns. The objective is to maximize the worst-case expected return and subject to an ambiguous second-order stochastic dominance constraint. The expected return robustly stochastically dominates the benchmark in the second order over all possible distributions within an ambiguity set. It is also shown that the Wasserstein-moment ambiguity set-based distributionally robust portfolio optimization can be reduced to a semidefinite program and second-order conic programming. We use a cutting plane to solve our second-order stochastic dominance constraint portfolio optimization problem with ambiguity sets based on the Wasserstein metric. Then we decompose this class of distributionally robust portfolio optimization into semi-infinite programming and apply the cutting surface method to solve it. The captured optimization programs are applied to real-life data for more efficient comparison. The problems are examined in depth using the optimal solutions of the optimization programs based on the different setups.