Homework: Linear and Integer optimization

Vishwakant Malladi

email: [email protected]

Indian School of Business

1 LP Modeling

1.1 Restaurant stang

Consider a restaurant that is open 7 days a week. Based on past experience, the number of workers needed

on a particular day is given as follows:

Day Mon Tue Wed Thu Fri Sat Sun

Number 14 13 15 16 19 18 11

Every worker works ve consecutive days and then takes o two days, repeating this pattern indenitely.

Our goal is to minimize the number of workers that sta the restaurant. Dene your variables, constraints,

and objective function clearly. Develop a Solver model and solve for the optimal stang plan.

1.2 Managing a portfolio

We are going to manage an investment portfolio over a 6-year time horizon. We begin with $1,000,000, and

at various times we can invest in one or more of the following:

(a) Savings account X, annual yield 5%,

(b) Security Y, 2-year maturity, total yield 12% if bought now, 11% thereafter,

(c) Security Z, 3-year maturity, total yield 18%, and

(d) Security W, 4-year maturity, total yield 24%.

To keep things simple we will assume that each security can be bought in any denomination. We can make

savings deposits or withdrawals anytime. We can buy Security Y any year but year 3. We can buy Security Z
anytime after the rst year. Security W, now available, is a one-time opportunity. Write down a LP model to

maximize the nal investment yield. Assume all investments must mature on or before year 6 and you cannot

sell securities in between. Dene your decision variables and constraints clearly.
1.3 Riskless prot (Does arbitrage exist?)
A European call option is a contract with the following conditions: At a prescribed time in the future, known

as the expiration date, the holder of the option has the right, but not the obligation to purchase a prescribed

asset, known as the underlying asset/security, for a prescribed amount, known as the strike price or exercise

price. For example, suppose an investor purchases a call option on stock XYZ with a $50 strike price. At

expiration, say a month from the time of purchase, the spot price of stock XYZ is $75. In this case, the owner

of the call option has the right to purchase the stock at $50 and exercises the option, making $25, or ($75

- $50), per share. However, in this scenario, if the spot price of stock XYZ is $30 at expiration, it does not

make sense to exercise the option to purchase the stock at $50 when the same stock could be purchased in the

spot market for $30. In this case, the payo is $0. Note the payo and prot are dierent. To calculate the

prot from the option, the cost of the contract must be subtracted from the payo. In this sense, the most an

investor in the option can lose is the premium price paid for the option. In general, if S is the spot price of

stock XYZ on the expiration date and K is the strike price of the European call option, then the call option

payo = max {0, (S − K)} and the prot = payo-option price.

Consider the following problem: You have $20,000 to invest. Stock XYZ sells at $20 per share today. A

European call option to buy 100 shares of stock XYZ at $15 exactly six months from today sells for $1000.

You can also raise additional funds which can be immediately invested, if desired, by selling call options with

the above characteristics. In addition, a 6-month riskless zero-coupon bond with $100 face value (the amount

you will make at the end of 6 months) sells for $90. You have decided to limit the number of call options that

you buy or sell to at most 50.

You consider three scenarios for the price of stock XYZ six months from today: the price will be the same as

today, the price will go up to $40, or drop to $12. Your best estimate is that each of these scenarios is equally

likely.

1. Formulate and solve (in Solver) a linear program to determine the portfolio of stocks, bonds, and options

that maximizes expected prot.

(a) What happens to protability if the price of XYZ goes to $40 per stock?

2. Suppose you want a prot of at least $2000 in any of the three scenarios. Write and solve (in Solver) a

linear program that will maximize your expected prot under this additional constraint.

(a) How does the solution compare to the earlier case described in (1).

3. Riskless prot is dened as the largest possible prot that a portfolio is guaranteed to earn, no mat-

ter which scenario occurs. Formulate and solve (in Solver) the model to determine the portfolio that

maximizes riskless prot for the above three scenarios?

2 Interpreting the sensitivity report

Your friend's diet requires that all the food your friend eats come from one of the four basic food groups

(chocolate cake, ice cream, soda, and cheesecake). At present, the following four foods are available for

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consumption: brownies, chocolate ice cream, cola, and pineapple cheesecake. Each brownie costs $50, each

scoop of chocolate ice cream costs $20, each bottle of cola costs $30, and each piece of pineapple cheesecake

costs $80. Each day, your friend must ingest at least 500 calories, 6 oz of chocolate, 10 oz of sugar, and 8 oz

of fat. The nutritional content per unit of each food is shown in Table (1) below. The variable names are

indicated in parenthesis.

Item Calories Chocolate Sugar (oz) Fat (oz)

(oz)
Brownie (BR) 400 3 2 2
Chocolate ice 200 2 2 4
cream scoop (IX)
Cola (bottle) 150 0 4 1
(COLA)
Pineapple cheese 500 0 4 5
cake piece (PC)

Table 1: Nutritional content per unit of food item.

After solving the LP formulation the sensitivity report is given in Figure (2).

Adjustable Cells
Final Reduced Objective Allowable Allowable
Cell Name Value Cost Coefficient Increase Decrease
$B$3 BR 0 27.5 50 1E+30 27.5
$C$3 IC 3 0 20 18.33333333 5
$D$3 COLA 1 0 30 10 30
$E$3 PC 0 50 80 1E+30 50

Constraints
Final Shadow Constraint Allowable Allowable
Cell Name Value Price R.H. Side Increase Decrease
$F$6 Calories 750 0 500 250 1E+30
$F$7 Chocolate 6 2.5 6 4 2.857142857
$F$8 Sugar 10 7.5 10 1E+30 4
$F$9 Fat 13 0 8 5 1E+30

Figure 2: The sensitivity report.

Answer the following questions:

1. Formulate (need not input into Solver) a linear programming model that can be used to satisfy my daily

nutritional requirements at minimum cost. Use the same variable and constraint names as indicated in

the sensitivity report.

2. If a brownie costs $30, what would be the new optimal solution to the problem? How much will our

costs change?

3. If a bottle of cola costs $35, what would be the new optimal solution to the problem?

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 4. If a bottle of cola cost $45, would the new optimal solution be the same or dierent? Can you calculate

the new optimal solution easily just from looking at the sensitivity reports? Why or why not?

5. If at least 8 oz of chocolate were required, what would be the cost of the optimal diet?

6. If at least 600 calories were required, what would be the cost of the optimal diet?

7. If at least 9 oz of sugar were required, what would be the cost of the optimal diet?

8. What would the price of pineapple cheesecake have to be before it would be optimal to eat some cheese-

cake?

9. What would the cost of the optimal diet be if your friend had to eat at least one brownie?

10. If 10 oz of fat were required, would the optimal solution to the problem change? Why or why not?

11. Suppose your friend could also eat Cad bury chocolate eggs. Each egg costs $45 and contains 250 calories,

5 oz of chocolate, 5 oz of sugar, and 2 oz of fat. Should you add Cad bury eggs to your friend's diet?

Why or why not?

3 Modeling Business Logic

Model the following situations exactly using binary/integer variables and linear constraints:

1. Suppose a consumer derives UA units of utility from product A and UB units from product B. Further

suppose UA 6= UB and UA > 0 and UB > 0 . Model the following consumer choice constraint using

binary variables: If both products are shown (presented) to the consumer, the consumer will not choose

the product with lower utility (notice that the consumer may choose none of the products.)

2. A group of friends are browsing through the local video store, trying to decide which movies to rent. The

friends, all ISB students, would like to plan their movie-watching schedule using integer programming.

Write exactly one binary variable constraint to model the following statement: If we rent both Bahubali

II (B) and Dangal (D), then we can rent at most one of Drishyam (R), The Lunch Box (L), and Bhaag

Milkha Bhaag (M).

3. Suppose a broker must choose to invest in four investments 1, 2, 3, and 4. Let x1 , x2 , x3 , and x4 denote

the binary variables if she chooses the particular investment or not. Suppose she has the following

constraints: If she invests in 3 or 4 or both then she must invest in exactly one of 1 or 2. Otherwise, if

she invests in neither (of 3 or 4) then there are no constraints on investing in 1 or 2.

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