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Risk-sensitive ICAPM with application to fixed-income management

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2 Author(s)
Bielecki, T.R. ; Dept. of Appl. Math., Illinois Inst. of Technol., Chicago, IL, USA ; Pliska, S.R.

This paper presents an application of risk-sensitive control theory in financial decision making. A variation of Merton's continuous-time intertemporal capital asset pricing model is developed where the infinite horizon objective is to maximize the portfolio's risk adjusted growth rate. The resulting model is tractable and thus provides economic insight about optimal trading strategies as well as the fact that the strategy of 100% cash is not necessarily the least risky one. For fixed-income applications we utilize the concept of rolling-horizon bonds, which are stochastic process models of certain mutual funds of zero coupon bonds. We show by numerical example that the optimal proportion of one's wealth to hold in an asset is given by a simple affine function of economic factors such as interest rates of various maturities.

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