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Optimal portfolio and consumption policies subject to Rishel's important jump events model: computational methods

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2 Author(s)
Hanson, F.B. ; Dept. of Math., Univ. of Illinois, Chicago, IL, USA ; Westman, J.J.

At important events or announcements, there can be large changes in the value of financial portfolios. Events and their corresponding jumps can occur at random or scheduled times. However, the amplitude of the response in either case can be unpredictable or random. While the volatility of portfolios is often modeled by continuous Brownian motion processes, discontinuous jump processes are more appropriate for modeling the response to important external events that significantly affect the prices of financial assets. Discontinuous jump processes are modeled by compound Poisson processes for random events or by quasi-deterministic jump processes for scheduled events. In both cases, the responses are randomly distributed and are modeled in a stochastic differential equation formulation. The objective is the maximal, expected total discounted utility of terminal wealth and instantaneous consumption. This paper was motivated by a paper by Rishel (1999) concerning portfolio optimization when prices are dependent on external events. However, the model has been significantly generalized for more realistic computational considerations with constraints and parameter values. The problem is illustrated for a canonical risk-adverse power utility model. However, the usual explicit canonical solution is not strictly valid. Fortunately, iterations about the canonical solution result in computationally feasible approximations.

Published in:

Automatic Control, IEEE Transactions on  (Volume:49 ,  Issue: 3 )

Date of Publication:

March 2004

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