Wkh Xqlyhuvlw| ri Qhz Vrxwk Zdohv

Dfwxduldo Vwxglhv
G|qdplf Sruwirolr Rswlpl}dwlrq
)
Dvvhw Sulflqj
Pduwlqjdoh Phwkrgv dqg Suredelolw| Glvwruwlrq Ixqfwlrqv
Pdkprxg Kdpdgd
D wkhvlv vxeplwwhg iru wkh ghjuhh ri
Grfwru ri Sklorvrsk|
Qryhpehu/ 5334
ALsliacl
1lis oisscilalion consisls of llicc conliiLulions lo nnancial ano insuiancc
mallcmalics.
1lc nisl pail consiocis numciical mclloos foi oynamic poilfolio opli-
mizalion in llc cxpcclco ulilily moocl. 1lc aim is lo compaic llc iisk-
nculial compulalional appioacl (UQFD) also known as llc mailingalc ap-
pioacl lo sloclaslic oynamic piogiamming (VGS in a oisciclc-limc sclling.
1lc main ioca of llc UQFD is lo usc llc complclcncss ano llc aiLiliagc
ficc piopcilics of llc maikcl lo compulc llc oplimal consumplion iulcs ano
llcn oclciminc llc liaoing slialcgy llal nnanccs llis oplimal consumplion.
In conliasl, VGS solvcs foi llc oplimal consumplion ano invcslmcnl iulcs
simullancously using Lackwaio iccuision ano llc piinciplc of oplimalily. 1lc
sclling llal wc consioci is a oisciclc limc ano slalc spacc lallicc. Wc pio-
vioc somc ncw llcoiclical icsulls iclaling lo llc HypciLolic ALsolulc Iisk
Avcision class of ulilily funclions as wcll as pioposc a sliaigllfoiwaio implc-
mcnlalion of UQFD in Linomial ano liinomial lalliccs. Moicovci, inslcao of
oisciclizing llc Hamillon-JacoLi-Lcllman cqualion will possiLly moic llan
onc slalc vaiiaLlc, wc usc symLolic algoiillms lo implcmcnl sloclaslic oy-
namic piogiamming. 1lis ncw appioacl pioviocs a simplci numciical piocc-
ouic foi compuling oplimal consumplion-invcslmcnl policics. A compaiison
of llc UQFDwill VGS ocmonslialcs llc supciioiily of llc UQFDin lcims
of compulalion.
1lc sccono pail consiocis llc piicing of conlingcnl claims using an ap-
pioacl ocvclopco ano applico in insuiancc. 1lis appioacl ulilizcs pioLaLil-
ily oisloilion funclions as llc oual of llc ulilily funclions usco in nnancial
llcoiy. 1lc main ioca of llc oual llcoiy is lo oisloil llc suLjcclivc pioLaLil-
ilics iallci llan oulcomcs lo cxpicss llc invcsloi`s iisk avcision. In llc nisl
pail, llc UQFD foi asscl allocalion uscs llc samc piinciplc as iisk-nculial
valualion foi ociivalivc piicing. 1lc ioca of llc sccono pail of llis icscaicl
ii
is lo slow llal llc iisk-nculial valualion can Lc iccovcico fiom llc pioLa-
Lilily oisloilion funclion appioacl, llcicLy cslaLlisling consislcncy Lclwccn
llc insuiancc ano llc nnancial appioaclcs. Wc piovc llal piicing conlin-
gcnl claims unoci llc ical woilo pioLaLilily mcasuic using an appiopiialc
oisloilion opcialoi pioouccs aiLiliagc-ficc piiccs wlcn llc unocilying as-
scl piiccs aic log-noimal. Wc invcsligalc cascs wlcn llc insuiancc-Lasco
appioacl fails lo piooucc aiLiliagc-ficc piiccs ano oclciminc llc appiopii-
alc oisloilion opcialoi unoci moic gcncial assumplions llan llosc usco in
Llack-Sclolcs oplion piicing.
In llc lliio pail wc inliooucc oynamic poilfolio oplimizalion will iisk
mcasuics Lasco on pioLaLilily oisloilion funclions ano piovioc a foimal
licalmcnl of llis class of iisk mcasuics. Wc cmploy llc UQFD lo sluoy llc
consumplion-invcslmcnl pioLlcm in oisciclc limc will picfcicnccs consislcnl
will Yaaii`s oual (non-cxpcclco ulilily) llcoiy of cloicc. As an applicalion,
wc nisl consioci iisk mcasuics Lasco on llc Iiopoilional Hazaio 1iansfoim
llal licals llc upsioc ano oownsioc of llc iisk oicicnlly ano scconoly a
iisk mcasuic Lasco on llc slanoaio Noimal cumulalivc oisliiLulion func-
lion. Wlcn llc oLjcclivc is lo maximizc a oual ulilily of wcalll, ano llc
unocilying sccuiily icluins aic noimal, llc cmcicnl fionlici is founo lo Lc
llc samc as in llc mcan-vaiiancc poilfolio pioLlcm foi an cquivalcnl iisk
lolciancc. Wlcn llc oLjcclivc is lo maximizc a oual ulilily of consumplion,
llcn plunging" Lclavioi occuis (invcsling cvciylling is llc iisky asscl).
Ollci piopcilics of llc oplimal consumplion-invcslmcnl policics in llc oual
llcoiy aic also invcsligalco ano oiscussco.
iii
Acknowledgments
I am grateful to my Lord for all his blessings and for having given me the
opportunity to meet my supervisor Mike Sherris who is an example of endless
dynamism and a source of pertinent ideas. Thank you Mike for this great
personality. I would also like to thank Dr. John van der Hoek for his early
directions in this area and my co-supervisor Rob Womersley who is always
happy to meet up and have good discussion. The friendly sta in Actuarial
Studies deserve many thanks for the nice ambiance they created.
Thanks also go to my family, especially to my father Professor Farouk
Hamada for his useful advice and remarkable viewpoints. Thank you my
Lord for this nice environment and for making this intellectual adventure a
success. To You this work is dedicated.
Sydney, November 15, 2001.
1
1
The research was funded by the International Postgraduate Research Scholarship
(IPRS), the Faculty of Commerce and Economics Scholarship and the Actuarial Stud-
ies Grant A79803988
iv
Contents
1 IntroductIon 1
1.1 Dovolopmonl of Iorlfolio Soloclion 1loory . . . . . . . . . . . . . 1
1.2 Molivalion, Aims ano Organizalion . . . . . . . . . . . . . . . . . 4
1.2.1 Molivalion . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2.2 Aims ano Organizalion . . . . . . . . . . . . . . . . . . . . 6
1.2.8 Doclaralion . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2 Tneory oI CnoIce under \ncertaInty 10
2.1 Inlroouclion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2 Ulilily 1loory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2.1 Orooring Iroforoncos . . . . . . . . . . . . . . . . . . . . . 11
2.2.2 Maximizing Lxpocloo Ulilily . . . . . . . . . . . . . . . . . 18
2.2.8 How Doos Ulilily Moasuro Iisk Avorsion . . . . . . . . . 16
2.2.4 Wlicl Ulilily Funclion Is Approprialo . . . . . . . . . . . 18
2.2. Lxpocloo Ulilily is Nol Iorfocl . . . . . . . . . . . . . . . 20
2.8 Dual Ulilily 1loory . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.8.1 Axiomalic Conslruclion . . . . . . . . . . . . . . . . . . . 2
2.8.2 Wlal aLoul Iisk Avorsion in Dual 1loory . . . . . . . . 28
2.8.8 Dual 1loory Solvos somo Lxpocloo Ulilily Iaraooxos . . . 81
2.8.4 Dual 1loory is Nol Iorfocl Lillor . . . . . . . . . . . . . . 82
2.4 1lo Iank-Doponoonl Moool . . . . . . . . . . . . . . . . . . . . . 82
2. Coloronl Iisk Moasuros . . . . . . . . . . . . . . . . . . . . . . . 88
2.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
3 OynanIc IortIoIIo OtInIzatIon In tne Exected \tIIIty AodeI 38
8.1 Inlroouclion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
8.2 Classic Iorlfolio Soloclion IroLloms . . . . . . . . . . . . . . . . . 40
8.2.1 1lo Markowilz Moool . . . . . . . . . . . . . . . . . . . . 40
8.2.2 Singlo-Iorioo Lxpocloo Ulilily Maximizalion . . . . . . . . 42
8.8 Mulliporioo Solling, Conlinuous or Discrolo 1imo . . . . . . . . 48
8.4 Conlinuous-1imo Financo . . . . . . . . . . . . . . . . . . . . . . 2
8.4.1 Conlinuous-1imo Sol-Up . . . . . . . . . . . . . . . . . . . 2
8.4.2 1lo Dynamic Irogramming Approacl . . . . . . . . . . . 6
v
CO^TE^TS vI
8.4.8 1lo Lagrango Mulliplior Approacl . . . . . . . . . . . . . 66
8.4.4 1lo Marlingalo Approacl . . . . . . . . . . . . . . . . . . 70
8. Discrolo-1imo Financo . . . . . . . . . . . . . . . . . . . . . . . . 76
8..1 Discrolo-1imo Sol-Up . . . . . . . . . . . . . . . . . . . . . 76
8..2 1lo Dynamic Irogramming Approacl . . . . . . . . . . . 70
8..8 1lo Marlingalo Approacl . . . . . . . . . . . . . . . . . . 82
8.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
4 StocnastIc OynanIc IrogrannIng versus AartIngaIe Aetnods
In IortIoIIo SeIectIon 86
4.1 Inlroouclion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
4.2 Oplimal Consumplion for llo H/1/ Class of Ulilily Funclions . 88
4.2.1 Singlo-Iorioo Moool . . . . . . . . . . . . . . . . . . . . . 80
4.2.2 1wo-Iorioo Moool . . . . . . . . . . . . . . . . . . . . . . 00
4.2.8 Oplimal Consumplion in Mulliporioo Moool . . . . . . . . 01
4.8 1A(/ Implomonlalion . . . . . . . . . . . . . . . . . . . . . . . 04
4.8.1 Non-IocomLining Linomial Lallico . . . . . . . . . . . . . 0
4.8.2 IocomLining 1rinomial Lallico . . . . . . . . . . . . . . . 108
4.4 SymLolic Dynamic Irogramming . . . . . . . . . . . . . . . . . . 112
4.4.1 A 1wo-Iorioo Lxamplo . . . . . . . . . . . . . . . . . . . . 118
4.4.2 Iooa of SymLolic Dynamic Irogramming . . . . . . . . . . 116
4.4.8 Six-porioo Lxamplo will IocomLining Lallico . . . . . . . 117
4. Doscrolizing llo Conlinuous-1imo Moool . . . . . . . . . . . . . . 120
4..1 1lo HE Lqualion ano Markov Clain Approximalion . . 120
4..2 Morlon`s IroLlom will Markov Clain Approximalion . . . 121
4..8 Numorical Iosulls . . . . . . . . . . . . . . . . . . . . . . 128
4.6 Comparison Lolwoon 1A(/ ano Dynamic Irogramming . . . . . 126
5 Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 128
.1 Inlroouclion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
.2 LquiliLrium Iricing . . . . . . . . . . . . . . . . . . . . . . . . . . 120
.2.1 Lxpocloo Ulilily LquiliLrium . . . . . . . . . . . . . . . . 120
.2.2 Dual 1loory LquiliLrium . . . . . . . . . . . . . . . . . . . 188
.8 Corlainly Lquivalonl, Iisk Avorsion ano IroLaLilily Dislorlion
Funclions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
.4 Wang`s IroLaLilily Dislorlion Funclion ano Assol Iricing . . . . 188
. Conlingonl Claim Iricing . . . . . . . . . . . . . . . . . . . . . . 142
..1 Wang`s Approacl ano Llack-Sclolos . . . . . . . . . . . . 142
..2 IroLaLilily Dislorlion Approacl ano Clango of Moasuro . 146
.6 Gonoralizalion of Wang`s Approacl . . . . . . . . . . . . . . . . . 140
.6.1 Symmolric DislriLulions . . . . . . . . . . . . . . . . . . . 140
.6.2 1imo-varying Drifl ano Volalilily for llo Socurily Irico . . 10
.7 Applicalions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
CO^TE^TS vII
.7.1 1lo Cox, Ioss ano IuLinsloin Linomial Moool . . . . . . 1
.7.2 1lo (c\ Moool . . . . . . . . . . . . . . . . . . . . . . . . 18
.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
6 Asset AIIocatIon In OuaI Tneory 164
6.1 Inlroouclion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
6.2 Discrolo Vorsion of llo Corlainly Lquivalonl in Dual 1loory . . . 166
6.8 van oor Hook ano Slorris Class of risk Moasuros . . . . . . . . . . 171
6.8.1 Linomial Caso . . . . . . . . . . . . . . . . . . . . . . . . . 172
6.8.2 Quaorinomial Caso . . . . . . . . . . . . . . . . . . . . . . 178
6.8.8 Mullinomial Caso . . . . . . . . . . . . . . . . . . . . . . . 174
6.4 Assol Allocalion will Iisk Moasuros Lasoo on IroLaLilily Dislor-
lion Funclions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
6.4.1 van oor Hook ano Slorris Iisk Moasuro in Singlo-Iorioo
Moool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
6.4.2 Wang`s 1ransform in Singlo-Iorioo Moool . . . . . . . . . 10
6.4.8 Consumplion-Invoslmonl IroLlom in Mulli-Iorioo Moool . 108
6.4.4 Numorical Lxamplos . . . . . . . . . . . . . . . . . . . . . 201
6. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
7 ConcIusIon 207
A IrooIs 221
A.1 Assol Iricing using IroLaLilily Dislorlion Funclions . . . . . . . 221
A.2 Assol Allocalion in Dual 1loory . . . . . . . . . . . . . . . . . . . 228
A.2.1 Iroof of Iroposilion 6.8.1 (Oroor assumplion) . . . . . . . 228
A.2.2 1lo caso wlon q ano h aro conjugalo . . . . . . . . . . . . 224
H OtInIzatIon Code 226
L.1 SymLolic Dynamic Irogramming . . . . . . . . . . . . . . . . . . 226
L.2 Iisk-Noulral Compulalional Approacl . . . . . . . . . . . . . . . 228
LIst oI FIgures
8.1 Moan-Slanoaro Dovialion Fronlior Iorlfolios . . . . . . . . . . . . 42
8.2 Lmcionl Fronliors in llo Moan-Varianco Iorlfolio will ano will-
oul Slorl-Solling Conslrainls . . . . . . . . . . . . . . . . . . . . 47
4.1 A 1wo-Iorioo Non-IocomLing Linomial Lallico . . . . . . . . . . 00
4.2 Cooing Non-IocomLining Linomial Lallico Nooos . . . . . . . . . 06
4.8 Non-IocomLining Linomial Lallico . . . . . . . . . . . . . . . . . 07
4.4 Dolormining llo SuLsol of ! al 1imo t Conlaining . . . . . . . . 101
4. Oplimal Consumplion using 1A(/ will Linomial Lallico . . . . 104
4.6 Oplimal Invoslmonl Slralogios in llo Iisky Assol using 1A(/
will Linomial Lallico . . . . . . . . . . . . . . . . . . . . . . . . 10
4.7 Oplimal Invoslmonl Slralogios in llo Safo Assol using 1A(/
will Linomial Lallico . . . . . . . . . . . . . . . . . . . . . . . . 106
4.8 Oplimal Woalll Ialls using 1A(/ will Linomial Lallico . . . . 107
4.0 IocomLining 1rinomial Lallico . . . . . . . . . . . . . . . . . . . 100
4.10 Cooing llo 1rinomial Lallico Nooos . . . . . . . . . . . . . . . . . 100
4.11 Iisky Socurily DislriLulion ovor a 1wo-Iorioo Non-IocomLining
Linomial Lallico . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
4.12 Oplimal Consumplion Iulos using SymLolic Dynamic Irogramming118
4.18 Oplimal Invoslmonl Iulos using SymLolic Dynamic Irogramming 118
4.14 Oplimal Consumplion Iulos aflor a Forwaro Iocursion . . . . . . 110
4.1 Oplimal Invoslmonl Slralogios aflor a Forwaro Iocursion . . . . . 110
4.16 Oplimal Woalll aflor a Forwaro Iocursion . . . . . . . . . . . . . 120
4.17 Lxplicil Finilo Dioronco Molloo in Discrolizing llo HE Lqualion124
4.18 Mioolo of Grio Solulion al Dioronl Momonls ouring llo Invoslmonl12
.1 IocomLining Linomial Lallico for 1 Iorioos . . . . . . . . . . . . 16
.2 Slifling llo Moan of llo Lognormal DislriLulion lo Malcl llo
Moan of llo Nonconlral Cli-Squaro DislriLulion ooos nol Capluro
llo Kurlosis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
6.1 Linomial Ianoom VariaLlo . . . . . . . . . . . . . . . . . . . . . . 172
6.2 Quaorinomial Ianoom VariaLlo . . . . . . . . . . . . . . . . . . . 178
viii
LIST OF FIC\HES Ix
6.8 Lmcionl Fronlior in llo Iorlfolio IroLlom using llo Iroporlional
Hazaros Iisk Moasuro . . . . . . . . . . . . . . . . . . . . . . . . 188
6.4 Consumplion Nooos in Singlo-Iorioo Linomial Moool . . . . . . . 184
6. FoasiLlo Iogions for Consumplion in Singlo-Iorioo Moool . . . . . 187
6.6 Solulion lo llo Singlo-Iorioo Iorlfolio IroLlom in llo Dual 1loory101
6.7 Cooing IocomLining 1rinomial Lallico Nooos . . . . . . . . . . . 107
6.8 Oplimal Consumplion ano Invoslmonl Slralogios using Wang`s
Dislorlion Oporalor . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.0 Oplimal Consumplion Irocoss as a Funclion of llo Loaoing Ia-
ramolor c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
6.10 Consumplion Irocoss as a Funclion of llo Loaoing Iaramolor c
(Zoom inlo -0.8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
6.11 Oplimal Consumplion ano 1raoing Slralogios using llo Iropor-
lional Hazaros Iisk Moasuro . . . . . . . . . . . . . . . . . . . . . 20
LIst oI TaLIes
8.1 Sovon-Assol Oplimal Iorlfolio Allocalion will Quaoralic Ulilily . 46
.1 A Comparison of Call Oplion Valuos Lolwoon Llack-Sclolos ano
Wang`s Approacl in llo Log-normal Caso . . . . . . . . . . . . . 1
.2 Ioal-Worlo, Iisk-Noulral ano Dislorloo IroLaLililios ovor a Li-
nomial Lallico . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
.8 IroLaLilily Dislorlion ano Iisk-Noulral Iricing of a Call Oplion
will Slriko $10 . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
.4 AriLlrago-Froo Iricos Comparoo will Wang`s IroLaLilily Dislor-
lion Iricing for llo CLV Moool . . . . . . . . . . . . . . . . . . . 161
. AriLlrago-Froo Iricos Comparoo will Wang`s IroLaLilily Dislor-
lion Iricing in Llack-Sclolos Solling . . . . . . . . . . . . . . . . 161
6.1 Sovon-Assol Oplimal Iorlfolio Allocalion using llo Iroporlional
Hazaros Iisk Moauro . . . . . . . . . . . . . . . . . . . . . . . . 182
x
Nolalion ano ALLicvialion
1lc following nolalion is ficqucnlly usco in llis oisscilalion:
> llc cmply scl
/ ocnnco lo Lc
_
' cqual in oisliiLulion (foi ianoom vaiiaLlcs)
@ 5 D @ is an clcmcnl of llc scl D
4@ D llc maximum of llc scl D (oisciclc limc)
tT D llc maximum of llc scl D (conlinuous limc)
] llc scl of inlcgci numLcis
U llc scl of ical numLcis
U
?
?-oimcnsional ical Lucliocan spacc
%

liansposc of llc vccloi % (oi a maliix)

n%n
2
llc cucliocan noim of llc vccloi %
I ' iI
|
j
|Df
nllialion
Elc Ic pioLaLilily spacc
Elc Ic Ic nllcico pioLaLilily spacc
-a.s. - almosl suicly
i1j / 1
3
EI llc j-nclo gcncialco Ly llc ianoom vaiiaLlc 1
f QE>c j
2
llc ianoom vaiiaLlc f is noimal (mcan > ano vaiiancc j
2

s
%
/
Ys
Y%
nisl pailial ociivalivc of s will icspccl lo %
s
%+
/
Y
2
s
Y%Y+
sccono pailial ociivalivc of s will icspccl lo % ano +
xi
1lc following aLLicvialions aic ficqucnlly usco in llis oisscilalion:
FDSP Capilal Asscl Iiicing Moocl
FHY Conslanl Llaslicily of Vaiiancc
GGI Dccumulalivc DisliiLulion Funclion ( cumulalivc)
HX Lxpcclco Ulilily
KDUD HypciLolic ALsolulc Iisk Avcision
KME Hamillon-JacoLi-Lcllman Lqualion
RGH Oioinaiy Dicicnlial Lqualion
SGH Iailial Dicicnlial Lqualion
UQFD Iisk-Nculial Compulalional Appioacl
VGH Sloclaslic Dicicnlial Lqualion
VGS Sloclaslic Dynamic Iiogiamming
Y@U Valuc al Iisk
xii
lLaplci 1
1nItoducIIon
1.1 OeveIonent oI IortIoIIo SeIectIon
Tneory
1lo porlfolio soloclion proLlom is a classic in nnanco liloraluro. Il was nrsl
oovolopoo Ly Markowilz (102, [7[) ano 1oLin (106, [10[) for a singlo-porioo
invoslmonl. Many nnancial inslilulions uso llis moool Locauso il is simplo ano
woll unoorslooo. 1lo mulli-porioo porlfolio proLlom is moro roalislic, in llo
sonso llal il lakos inlo accounl possiLlo rovisions of llo invoslor`s posilions our-
ing llo porioo of invoslmonl. 1lo pionooring work of Morlon (1060, [78[ ano
1071, [70[) proviooo llo impolus Lolino a consiooraLlo volumo of rosoarcl in-
vosligaling llo mulli-porioo proLlom ano oxlonoing il in now oiroclions. 1lo
proLlom consiooroo llon was inlorlomporal porlfolio soloclion wloro llo invoslor
invosls oynamically ano conlinuously so as lo loogo againsl ranoom clangos in
llo opporlunily sol. 1lis proLlom las oflon Loon consiooroo in gonoral oqui-
liLrium assol pricing moools, wloro many invoslors acl so as lo maximizo lloir
oxpocloo ulilily ovor consumplion, soo Lucas (1078, [72[), Lroooon (1070, [10[)
ano Cox n|. (108, [81[). An analogous proLlom in oiscrolo limo was pro-
sonloo Ly Samuolson (1060, [06[) wloro llo molloo of solving llo proLlom was
oullinoo, Lul no closoo-form solulion was givon.
A mallomalical lool woll suiloo lo lanolo oynamic porlfolio oplimizalion
proLloms is sloclaslic oynamic programming. In llo oiscrolo-limo caso, oynamic
programming solvos llo oplimizalion proLlom slop Ly slop working Lackwaro in
limo. In llo conlinuous-limo caso, llo oynamic proLlom can Lo lransformoo
inlo a slalic ono, using llo Lollman-Droyfus funoamonlal oqualion of oplimal-
1
1. IntroductIon
2
ily, soo Droyfus (106, [87, Claplor 7[). Howovor, nnoing a closoo form oxpros-
sion for llo oplimal consumplion ano invoslmonl allocalions roquiros solving
llo Hamillon-JacoLi-Lollman (HE) oqualion, a non-linoar parlial oioronlial
oqualion (TTc), wlicl is oimcull lo solvo oillor analylically or Ly numorical
molloos. In somo spocial casos llougl, an analylical oxprossion can Lo founo.
For inslanco, wlon llo unoorlying socurily pricos follow a goomolric Lrownian
molion, llo mulli-porioo moool is simplinoo in llo samo way llal llo normalily
assumplion simplinos llo slalic ono-porioo moool. In llis caso, a closoo form of
oplimal porlfolio composilion can Lo oLlainoo. Il is also slown (Morlon 1071,
[70[) llal llo proLlom can Lo simplinoo wlon llo opporlunily sol is uncorrolaloo
will assol rolurns ano also wlon llo invoslor las logarillmic ulilily. Howovor,
llo assumplion of log-normalily of pricos, or conslanl opporlunily sol aro vory
roslriclivo Locauso llo oxpocloo rolurns soom lo vary llrougl limo, soo for ox-
amplo Fama ano Froncl (1088, [48[) ano Lo ano MacKinlay (1087, [71[). Ioconl
rosoarcl consioors llo porlfolio proLlom will non-conslanl oxpocloo rolurns, a
proLlom wlicl is moro oimcull lo solvo.
Kim ano OmLorg (1006, [62[) solvo llo porlfolio proLlom analylically wlon
llo invoslor las HyporLolic ALsolulo Iisk Avorsion (H/1/) ulilily funclion,
ano invosls in a conslanl risk-froo assol ano a risky assol will a moan-rovorling
oiusion procoss. Lronnan, Sclwarlz ano Lagnaoo (1007, [20[) assumo llal
limo-varialion in oxpocloo rolurns is orivon Ly llroo slalo variaLlos, slorl ano
long inlorosl ralos, ano llo oivioono yiolo on oquily. 1loy uso a numorical
sclomo lo oiscrolizo ano solvo llo HE oqualion ano slow llal llo sizo of
llo proLlom grows oxpononlially will llo numLor of slalo variaLlos. Lasoo on
concrolo oxamplos, lloy slow low oynamic porlfolio allocalion can signincanlly
improvo llo invoslor`s wolfaro, comparoo lo llo myopic ono-porioo invoslmonl.
Zariplopoulou (1000, [120[) nnos a closoo-form solulion wlon llo invoslor max-
imizos lorminal woalll, ano invosls in a Lono ano a risky socurily wloso prico
procoss las non-linoar coomcionls in llo slock lovol. Wlon lloro is inlormooialo
consumplion, oplimal porlfolio composilion is oxprossoo via llo solulion of a
1. IntroductIon
3
non-lomogonoous linoar paraLolic funclion. Slo usos viscosily solulion lloory
in llo caso wlon llo HE oqualion las only a woak solulion.
In gonoral, unloss rosoarclors focus on llo slalo variaLlo spocincalions for
wlicl a closoo-form solulion can Lo oorivoo, llo proLlom is liglly inlraclaLlo.
Novorlloloss, mosl of llo rosoarcl in porlfolio soloclion will limo-varying
oxpocloo rolurns consioors llo proLlom wloro llo invoslor maximizos llo lormi-
nal woalll for a singlo, nxoo lorizon. Alllougl llis proLlom is imporlanl wlon
lroaloo oynamically, il is nol gonoral onougl Locauso il ooos nol allow for inlor-
mooialo consumplion. Moroovor, il is nol consislonl will microoconomic lloory
wloro consumplion is inloronl lo llo invoslor`s Lolavior. Also, llo rosulls oo
nol apply lo an invoslor wlo is nol only saving for roliromonl, Lul for a louso
or ollor purposos as woll.
CampLoll ano Vicoira (1000, [28[) consioor llo proLlom wlon an innniloly-
livoo invoslor las ulilily ovor consumplion ano nno an approximalo solulion lo
llo oiscrolo-limo proLlom using Lulor approximalion.
Harrison ano Krops (1070, [2[) inlrooucoo llo marlingalo approacl lo prico
conlingonl claims. 1lis approacl was applioo Ly Karalzas n|. (1086, [0[
ano 1087, [60[), Iliska (1086, [8[) ano Cox ano Huang (1080, [20[ ano 1001,
[80[) lo provioo a closoo form solulion for llo oplimal porlfolio wlon llo un-
oorlying socurily pricos follow a gonoral oiusion procoss. 1lo Lasic iooa is lo
uso llo complolonoss ano llo arLilrago-froo proporly of llo markol lo soparalo
llo compulalion of oplimal consumplion rulos ano llal of a corrosponoing lrao-
ing slralogy. In a nrsl slop, llo oplimal consumplion is oLlainoo Ly solving
llo nrsl-oroor conoilions, ossonlially slaling llal llo agonl`s marginal ulilily
procoss al llo oplimum is proporlional lo an Arrow-DoLrou slalo prico oonsily
procoss. In a socono slop, llo corrosponoing porlfolio slralogy is oorivoo Ly llo
moans of llo marlingalo roprosonlalion lloorom, assuming llo complolonoss of
llo markol. 1lo socono slop is similar lo llo oplion pricing loclnology wloro
consumplion plays llo rolo of caslows. 1lis nnoing is a major Lroakllrougl
Locauso il givos closoo form solulions wloro oynamic programming ooos nol.
1. IntroductIon
4
An analylical solulion is lypically proforroo Locauso il is oimcull lo ooouco an
unLiasoo oconomic inlorprolalion from llo numorical solulion ano oislinguisl a
gonoral proporly wlicl ooos nol oopono on llo proLlom solling. Howovor, in llo
caso of a porlfolio proLlom will an unoorlying Ilo procoss, llo lloorolical formu-
las aro oflon complox ano laro lo implomonl numorically. 1lo oplimal porlfolio
composilion, wloro llo socurily procoss follows a gonoral oiusion procoss, can
Lo oxprossoo via llo Clark-Ocono formula (Ocono ano Karalzas 1001, [82[) wlicl
involvos conoilional oxpoclalions of variaLlos oxprossoo in Malliavin oorivalivos.
Dolomplo n|. (2000, [8[) focus on simplifying llo implomonlalion of llo
roprosonlalion formulas for llo oplimal porlfolio using loclniquos sucl as llo
Doss lransformalion (Doss 1077, [86[) wlicl lransforms an oTc lo an OTc,
ano using Monlo Carlo simulalions lo compulo llo oxpoclalions govorning llo
oxprossion of llo loogo faclors in llo oplimal porlfolio composilion.
In llo liloraluro, llo marlingalo loclnology is usoo lo solvo llo consumplion-
invoslmonl proLlom will slorl-solling conslrainls, laLor incomo (Lasak (1000,
[7[)) ano ollor foaluros. Wacllor (1000, [100[) oorivos a closoo-form solulion lo
llo porlfolio cloico proLlom wlon llo slock rolurns aro prooiclaLlo ano wlon
llo invoslor las ulilily ovor consumplion, lloroLy oxlonoing llo work of Kim
ano OmLorg (1006, [62[).
1.2 AotIvatIon, AIns and OrganIzatIon
1.2.1 AotIvatIon
1lo original iooa of llis llosis was lo comparo allornalivo approaclos lo opli-
mizing assol allocalions for insuranco ano suporannualion liaLililios. 1lis was a
gooo inconlivo lo roviow llo liloraluro aLoul llo consumplion-invoslmonl proL-
lom.
1lo slarling poinl was Iliska (1007, [86[) wlo applios sloclaslic oynamic
programming (oTT) ano llo risk-noulral compulalional approacl (1A(/) lo
1. IntroductIon
5
llo porlfolio proLlom in a oiscrolo-limo solling. 1lo ologanco of 1A(/ is so
apparonl llal ono slarls asking wly oynamic programming is slill usoo for llis
lypo of proLlom. Surprisingly, nowloro in llo liloraluro is lloro an implomon-
lalion of llis approacl for assol allocalion. 1lis is wly wo proposo a possiLlo
implomonlalion in Linomial ano lrinomial lallicos for a largo class of llo invoslor
proforoncos sucl as llo H/1/ class of ulilily funclions. On llo ollor lano,
using oTT lo solvo analylically for llo oplimal conlrols in oiscrolo limo yiolos
formioaLlo oxprossions for llo oLjoclivo valuo funclion for lorizons Liggor llal
lwo or llroo porioos. 1lis is nol praclical from an implomonlalion viowpoinl.
In llo liloraluro lloro aro ossonlially lwo molloos of implomonling oTT. 1lo
nrsl molloo consisls of oiscrolizing llo conlinuous-limo HE oqualion Ly a
nnilo oioronco molloo or similar loclniquo. 1lo socono molloo procooos Ly
roformulaling llo proLlom using Markov lransilion proLaLililios ano solving il
numorically in a grio allowing for a wioo rango of possiLlo woalll valuos. Loll
approaclos roly on approximalions of llo oorivalivo of llo valuo funclion, ano
oo nol oiroclly oxploil llo oplimalily oqualion as slaloo in llo oiscrolo-limo
solling, as llis involvos a oioronlialion will rospocl lo llo conlrol variaLlos al
oacl limo ano slalo of llo worlo. Il lurns oul llal llis is acliovaLlo Ly using a
symLolic packago ano givos Lollor rosulls. 1lis llo molivalion of llo nrsl parl.
1lo socono parl is molivaloo Ly llo convorgonco of nnancial ano insuranco
markols ano llo concorn aLoul consisloncy of llo pricing molloos usoo in Loll
markols. 1lis poinl was invosligaloo Ly Wang (2000, [118[) wlo aimoo lo os-
laLlisl a uninoo framowork lo pricing insuranco ano nnancial risks using llo
proLaLilily oislorlion approacl. 1lis approacl las an oconomic founoalion in
llo oual lloory of cloico unoor uncorlainly (loroaflor Dual 1loory) oovolopoo
Ly Yaari (1087, [118[). Luiloing on llo work of Wang (2000, [118[), llo focus was
on proving llal llo risk promium calculaloo Ly llo insuranco-Lasoo approacl
is inoooo an arLilrago-froo prico of llo risk involvoo. 1lis oponoo a now oiscus-
sion aLoul llo limilalion of llis approacl wlon llo solling is oioronl from llo
slanoaro Llack-Sclolos ano conlriLuloo lo somo improvomonls ano oxlonsions
1. IntroductIon
6
of llo approacl.
In llo oplimal porlfolio liloraluro, lloro aro many allornalivo moools of cloico
unoor uncorlainly. Givon crilicisms aLoul llo oxpocloo ulilily (c|) moool, llo
focus of rosoarcl lurnoo lo invosligaling llo consumplion-invoslmonl proLlom in
a non-c| framowork. Yaari`s Dual 1loory lurns oul lo Lo parlicularly inlorosl-
ing sinco il solvos many proLloms of llo c| moool. 1lis was omplasizoo Ly llo
puLlicalion of llo van oor Hook ano Slorris (2001, [106[) papor inlrooucing a
class of non-oxpocloo ulilily risk moasuros ano ils implicalions for assol alloca-
lion. 1lo iooa of llo lliro parl is lo oxlono lloir framowork wloro llo invoslor
maximizos a oual ulilily of lorminal woalll in a singlo porioo lo a mulli-porioo
solling will llo oual ulilily oorivoo from consumplion. 1lis is also molivaloo
Ly an applicalion of llo Iroporlional Hazaros lransform sluoioo Ly Wang (1006,
[111[) inlo assol allocalion.
1.2.2 AIns and OrganIzatIon
In llis oissorlalion wo consioor llo quoslions
1. Wlal is llo Losl loclniquo for implomonling llo consumplion-porlfolio
proLlom using a lallico approacl
2. 1o wlal oxlonl is llo proLaLilily oislorlion approacl, roconlly oovolopoo
ano applioo in insuranco pricing, consislonl will llo nnancial lloory
8. Wlal aro llo oplimal consumplion-invoslmonl policios in Dual (non-c|)
1loory Lasoo on llo proLaLilily oislorlion funclions approacl
1lo slrucluro of llo llosis is Lasoo arouno lloso quoslions ano is oullinoo
Lolow.
Claplor 1wo roviows ano comparos llo axiomalic conslruclion of llo c|
moool ano Dual 1loory. Il liglliglls llo crilicisms ano somo nolaLlo violalions
of c|. Il also oiscussos low risk avorsion is moasuroo in Loll moools ano inlro-
oucos llo concopl of coloronl risk moasuros oovolopoo Ly Arlznor n|. (1000,
1. IntroductIon
7
[6[). Il closos will a Lriof roviow of llo Iank Doponoonl Moool oovolopoo Ly
Quiggin (1082, [00[) wlicl is a gonoralizalion of Loll c| ano Dual 1loory.
Claplor 1lroo sols up llo conlinuous ano oiscrolo-limo moools will somo
omplasis on llo passago from oiscrolo lo conlinuous limo ano oiscussion aLoul
llo ooLalo concorning llo lwo sollings. Il roviows llo liloraluro aLoul oTT ano
llo marlingalo approacl ano lloir applicalion lo llo consumplion-invoslmonl
proLlom in Loll sol-ups. Il also Lrioy oiscussos llo Lagrango mulliplior molloo
inlrooucoo Ly Clow (1008, [24[).
Claplor Four consioors llo consumplion-invoslmonl proLlom in oiscrolo limo
using 1A(/, giving somo now lloorolical rosulls rolaling lo llo H/1/ class
of ulilily funclions, as woll as provioing an algorillm for numorically solving llo
proLlom. Il also inlrooucos llo iooa of jnh|. oynamic programming` as a
moro omcionl way lo implomonl oynamic programming on a lallico. Using llo
symLolic loolLox in MallaL (wlicl usos Maplo ongino), llo algorillm is implo-
monloo ano comparoo lo slanoaro molloos of implomonling oTT, namoly llo
oiscrolizalion of llo HE oqualion in llo corrosponoing conlinuous-limo moool.
1lo iooa of symLolic oynamic programming is lo uso llo oplimalily oqualion
slaloo in oiscrolo-limo ano oorivo llo oplimal consumplion ano invoslmonl po-
licos as a funclion of woalll al oacl limo ano slalo of llo worlo. Onco llis is
oono, for any inilial valuo of woalll, oplimal consumplion ano invoslmonl rulos
aro numorically oLlainoo aflor a forwaro rocursion ovor llo lallico.
Claplor Fivo consioors a roconlly oovolopoo approacl proposoo for conlin-
gonl claims pricing originally oovolopoo for pricing insuranco risk. Il quoslions
llo consisloncy of sucl an approacl comparoo will llo risk-noulral valualion
usoo in nnancial lloory. Wlon llo unoorlying socurily pricos aro log-normally
oislriLuloo, wo formally provo llal llo approacl roprooucos llo Llack-Sclolos
oplion pricing formula. Using a clango of moasuro ano Girsanov`s lloorom, wo
slow llal llo moan of llo oislorloo oocumulalivo oislriLulion is an oxpoclalion
unoor an oquivalonl marlingalo moasuro. Wo oxlono llo approacl lo llo caso
wloro llo unoorlying socurily or risk las a symmolric oislriLulion, ano also con-
1. IntroductIon
8
sioor llo log-normal caso will limo-varying paramolors ano formally oorivo llo
rolalionslip Lolwoon llo paramolor usoo in llo proLaLilily oislorlion funclion
approacl ano llo markol prico of risk for llo unoorlying socurily. Finally wo
liglligll llo limilalions of applying llo approacl using llo normal proLaLilily
oislorlion funclion as proposoo Ly Wang (2000, [118[) ano illuslralo llo polon-
lial issuos in implomonling llo loclniquo using llo Linomial lallico moool ano
llo Conslanl Llaslicily of Varianco ((c\) moool for socurily pricos.
Claplor Six provioos a formal lroalmonl of risk moasuros Lasoo on oislorlion
funclions in a oiscrolo-limo solling. Il also slows llal llo risk-noulral compula-
lional approacl is woll aoaploo lo porlfolio oplimizalion will moasuros llal oo
nol lio willin llo c| framowork. Il also conlains an allompl lo oorivo oquiliL-
rium pricos in a non-c| moool. Unoor somo conoilions, llo oquiliLrium curronl
prico oquals llo corlainly oquivalonl of llo fuluro prico. As for assol alloca-
lion, applicalion will lwo oioronl oislorlion oporalors slows llal llo porlfolio
consumplion ano invoslmonl rulos aro oioronl from llo c| rosulls sinco llo op-
limizalion loaos lo cornor solulions rosulling from llo linoarily of llo oLjoclivo
in llo conlrol variaLlos.
1.2.3 OecIaratIon
1lis llosis is my own original work, lowovor il incluoos malorial oovolopoo as
parl of llis Il.D. llosis wlicl las now appoaroo as rosoarcl working papors of
wlicl I am a joinl aullor. My conlriLulion consisls of ooriving llo lloorolical
rosulls, porforming simulalions ano programming. Claplors 1wo, 1lroo ano
Four lavo nol yol appoaroo as rosoarcl working papors.
Claplor Fivo was prosonloo al llo Auslralian Mallomalical Socioly Mooling
in CanLorra in SoplomLor 2001, al llo Q-group Auslralia Colloquium in Manly
in OcloLor 2001, ano al llo Acluarial Iosoarcl UNSW Symposium in Syonoy
in NovomLor 2001.
Claplor Six was prosonloo al llo Firsl Nalional Symposium in Mallomalical
Financo in CanLorra in July 2001, al llo AFII colloquium in 1oronlo in Soplom-
1. IntroductIon
9
Lor 2001 ano will Lo prosonloo al llo QMF conforonco in Syonoy in DocomLor
2001.
lLaplci
3hcoty oI ChoIcc
undct !ncctIaInIy
2.1 IntroductIon
How lo ooal will uncorlainly is a oolicalo quoslion, sinco llo slrucluro of uncor-
lainly is gonorally nol woll comprolonooo. Uncorlainly is inloronl in all aspocls
of lifo, ranging from nalural ovonls, lo luman Lolavior ano oconomic clangos.
Somolimos, llo slrucluro of uncorlainly is rolalivoly simplo, liko in llo caso of
gamos of clanco. 1lis parlicular lypo of uncorlainly gavo Lirll lo llo lloory of
cloico unoor uncorlainly.
In llo procoss of oocision making, :.| roocls suLjoclivo Loliofs aLoul uncor-
lain ovonls. LllsLorg (1061, [40[) usos llo lorm risk for cloico silualions wlon
proLaLililios aro known, ano llo lorm nnh.j&.j wlon ovon llo proLaLililios
aro unknown. 1lo lloory of cloico unoor uncorlainly moools llo Lolavior of
a ralional invoslor wlon facoo will risky allornalivos. A moool cannol capluro
all aspocls of roalily Lul rallor a simplo vorsion llal focusos on somo parlicular
poinl of inlorosl. Moroovor, llo succoss of a moool is nol a moasuro of ils pro-
oiclivo valioily. Wioosproao moools aro oflon lraclaLlo ano oasily implomonloo.
1lo oxpocloo ulilily moool is commonly accoploo ano provioos llo Lasis for llo
analysis of an inoivioual`s consumplion ano invoslmonl oocisions. Howovor, al-
mosl sinco ils incoplion quoslions lavo Loon raisoo concorning ils valioily. Many
ollor moools lavo Loon proposoo Lul lavo nol onjoyoo llo c| succoss.
In llo following, llo aim is nol lo oovolop llo concopl of ulilily complololy
or will llo mosl gonoralily. 1lis can Lo founo in slanoaro loxlLooks of microo-
conomics or gamo lloory. 1lo aim is lo pul forwaro llo iooa of c|, liglligll
somo crilicism aLoul il ano llon prosonl an allornalivo moool for cloico unoor
10
2. Tneory oI CnoIce under \ncertaInty 11
uncorlainly will an omplasis on llo concopl of risk avorsion ano moasuring risk.
Horo rigor is lomporoo will an oyo for simplicily of prosonlalion.
2.2 \tIIIty Tneory
Varian (1087, [107[) roporloo llal llo concopl of ulilily" oalos Lack lo llo
Viclorian ora, wloro plilosoplors usoo llis lorm as an inoicalor of a porson`s
ovorall woll-Loing. Ulilily was llougll of as a numoric moasuro of a porson`s
lappinoss. From llis iooa, il was nalural lo llink of consumors as making
cloicos so as lo maximizo lloir ulilily. 1lo quoslion llal romains is low lo
moasuro llo ulilily of an inoivioual. Insloao of answoring llis oolicalo quoslion,
oconomisls lako anollor approacl. Firsl, lloy moool llo consumor proforoncos
ano llon consioor llo ulilily as a way lo ooscriLo lloso proforoncos.
1lis soclion slarls Ly making llo oislinclion Lolwoon llo oroinal ano llo
caroinal ulilily ano inlrooucos llo oxpocloo ulilily roprosonlalion. 1lo rola-
lionslip Lolwoon risk avorsion ano llo ulilily funclion is llon oxaminoo. 1lis
soclion closos Ly liglliglling somo clallongos lo llo oxpocloo ulilily moool.
2.2.1 OrderIng IreIerences
In llo markol, sovoral gooos aro lraooo. Gooos aro lypically consumplion iloms
llal aro valuoo Ly invoslors-consumors. For concrolonoss, supposo llal lloro
aro : oioronl gooos ano lol llo (: 1) voclor x oonolo a parlicular Lunolo or
a sol of gooos, wloro llo ith olomonl a

is llo numLor of unils of gooo i. For

oacl consumor-invoslor, lraoing in llo markol ooponos on porsonal proforoncos
aLoul gooos ano on suLjoclivo Loliofs aLoul fuluro uncorlain slalos of llo worlo.
Lacl consumor solocls llo consumplion sol x from llo sol A of all possiLlo sols
of gooos.
Following Ingorsoll (1087, [6[), proforoncos aro ooscriLoo Ly llo ::J:.nj
rolalion ~. 1lo nolalion x ~ y moans llal x is proforroo lo y ano y ~ y moans
llal y is as gooo as y. Il woulo Lo praclical if lloro oxisls a funclion, say ,
2. Tneory oI CnoIce under \ncertaInty 12
sucl llal
(x) (y) = x ~ y
(x) = (y) = x ~ y
(2.1)
Sucl funclion is calloo llo :J.nn| &.|.j funclion.
In oroor lo provioo an axiomalic approacl lo proforoncos in llo markol, lol
us assumo llo following:
AxIon 2.2.1 ;n|n) 1: :j n.: J : (x, y) A
2
,
.h: x ( y : y ( x.
AxIon 2.2.2 ;1r..j) 1: :j : x A, x ( x.
AxIon 2.2.3 ;J:nn...j) 1: :j :.| J : (x, y, z) A
S
,
.J x ( z nnJ z ( y, hn x ( y.
A rolalion salisfying lloso axioms is calloo a :J:n rolalion. 1lo llroo
aLovo axioms aro inluilivo ano lranslalo ralional Lolavior of a consumor-invoslor
agonl. Unforlunaloly lloy oo nol guaranloo llo oxislonco of an oroinal ulilily
funclion. Anollor axiom is nooooo:
AxIon 2.2.4 ;n.n&.j) 1: :j x A, h &h J n|| :.|j :-
J::J nnJ :.|j : n|r n: hh n.
1lo conlinuily axiom las an inluilivo inlorprolalion. 1opologically, an opon
sol las llo proporly llal llo noiglLorlooo of any of ils olomonls is incluooo
in llo sol. Honco if y Lolongs lo llo suLsol of slriclly proforroo comploxos lo
x, llal is, y ~ x, llon llo axiom implios llo oxislonco of anollor complox z
sucl llal y ~ z ~ x. A similar argumonl works for llo sol of slriclly worso
comploxos, llal is, \y - x, z : y - z - x. Will llis supplomonlary axiom a
lloorom follows:
Tneoren 2.2.1 1: nnj ::J:.nj n.Jj.nj h nh nr.n, J]nJ :
n |J, nr J n|r A, h: r. n &.|.j J&n.n nn.nj A
.n h :n| |.n .h h ::j .n j&n.n ;..1)
2. Tneory oI CnoIce under \ncertaInty 13
Nolo llal llo oroinal ulilily las no moro informalion llan llo proorooring
rolalion in as inoicaloo in (2.1). Il makos no sonso lo say llal x is lwico as gooo
as y if (x) = 2(y).
2.2.2 AaxInIzIng Exected \tIIIty
1lo uncorlainly of fuluro ovonls plays a major rolo in any oocision-making pro-
coss. 1loro aro many ways of mooolling uncorlainly. Supposo llal lloro aro lwo
oioronl oalos, limo 0 (looay) ano limo 1 (lomorrow) ano supposo llal lloro is
a singlo consumplion gooo availaLlo for consumplion al limo 1. Following Huang
ano LilzonLorgor (1088, [4[), a n&n.n |nn is a spocincalion of llo num-
Lor of unils of llis gooo in all possiLlo slalos of llo worlo al limo 1. Sinco al limo
1, llo roalizoo consumplion is uncorlain, a consumplion plan can Lo viowoo as a
ranoom variaLlo wlicl will Lo oonoloo x. 1lo ranoom variaLlo x lakos possiLlo
valuos in a sol ? wlicl can Lo nnilo or innnilo. In a mallomalical roprosonla-
lion, if

A oonolos llo sol of all possiLlo consumplion plans, ano ! oonolos llo
sol of all possiLlo slalos, llon for all x in

A,
x : ! ?
. x(.)
Ono can llink of a consumplion plan as a lollory will pricos in ?. Consumors
lavo lloir own Loliofs aLoul llo likolilooo of fuluro slalos of llo worlo. Honco
lloy assign suLjoclivo proLaLililios I(.) for oacl slalo . of llo worlo !. A
proforonco rolalion is a moclanism llal allows inoiviouals lo clooso among con-
sumplion plans givon lloir suLjoclivo Loliofs. If lloso proforoncos aro slrucluroo
onougl, il is possiLlo lo roprosonl llom will an oroinal ulilily funclion as
oonnoo in llo provious paragrapl, llal is, a consumplion plan x is proforroo lo
anollor consumplion plan x
t
if ano only if ( x) _ ( x
t
) . Howovor, wlon llo
numLor of llo slalos of llo worlo is innnilo (conlinuous solling) or ovon largo,
llo ligl oimonsions of x ano x
t
makos llo comparison of llo ulililios impracli-
cal. Il woulo Lo moro convonionl lo roprosonl proforoncos as an oxpocloo ulilily
2. Tneory oI CnoIce under \ncertaInty 14
in sucl a way llal
x _ x
t
=H[n( x)[ _ H[n( x
t
)[
wloro n is a n:J.nn| &.|.j funclion. In llo conlinuous-limo caso, if llo oislri-
Lulion funclion of x is oonnoo as
1

(:) = I. ! : x(.) _ :
llon
H[n( x)[ =
_
U
n(:)d1

(:)
In llo oiscrolo-limo caso, llo oxpocloo ulilily of x is oonnoo as
H[n( x)[ =

:Q2
n(:)I(:)
wloro I(:) / I. ! : x(.) = : . For simplicily, lol us assumo llal llo col-
loclion of consumplion plans

A on wlicl inoiviouals oxpross lloir proforoncos
aro sucl llal
\. ! \ x

A, x(.) ?
wloro ? is a nnilo sol. 1lis assumplion can Lo juslinoo wlon llo supply of
llo commooily is nnilo ano gooos aro nol porfoclly oivisiLlo. In llis caso, a
consumplion plan x can Lo roprosonloo Ly ils oislriLulion funclion
1

(:) =

:

:
I(:
t
)
If lwo consumplion plans lavo llo samo oislriLulion, lloy will yiolo llo samo
oxpocloo ulilily. In llis sonso, a consumor is inoioronl aLoul lwo consumplion
plans if lloy lavo llo samo oislriLulion. 1loroforo, confusion of a consumplion
plan ano ils oislriLulion ooos nol aocl llo analysis. Lol T oonolo llo spaco of
proLaLililios on ?, llal is, if j T, ano : ?, llo proLaLilily of : unoor j is
j(:).
Following Huang ano LilzonLorgor (1088, [4[), for llo oxpocloo ulilily rop-
rosonlalion lo lolo, il is nocossary ano sumcionl lo lavo llo following axioms.
2. Tneory oI CnoIce under \ncertaInty 15
AxIon 2.2.1 {IreIerence) _ . n :J:n :|n.n n T
A proforonco funclion is oonnoo in llo provious paragrapl. Il covors llroo
axioms: complolonoss, rooxivily ano lransilivily.
AxIon 2.2.2 {Indeendence) 1: n|| j, , : T, c (0, 1[, j ~ == cj
(1 c): ~ c (1 c):
1lis axiom slalos llal wlon inoiviouals oocioo Lolwoon proLaLilily mixluro
of j ano anollor lollory :, ano llo samo mixluro of ano :, llo only lling llal
aocls lloir cloico is lloir proforoncos Lolwoon j ano .
AxIon 2.2.3 {ArcnInedean) 1: n|| j, , : T, .J j ~ ~ : hn h: r.
c, / (0, 1) &h hn cj (1 c): ~ / (1 /):
1lis axiom is roocling llo Arclimoooan principlo: no mallor low small
: 0 is ano low Lig :
t
is, lloro is an inlogor / sucl llal /: :
t
. In llo caso
of consumplion plans, llis lranslalos lo llo following: if ~ :, llon no mallor
low gooo llo consumplion plan j is, lloro will always Lo a small proLaLilily c
of j ano a largo proLaLilily (1 c) of : sucl llal llis mixluro is Lollor llan llo
ollor mixluro / (1 /):.
Tneoren 2.2.2 {c| HeresentatIon) 1nJ: h h: nr.n nh, h h.
nnJ hj n J..n nn|: JnJ .h |.nj hn ;: n:) n&n-
.n |nn .|| h h n .h h h.jh: ;h.jh) rJ &.|.j, hn .,
x _ x
t
=
_
U
n( x(.))d1(.) _
_
U
n( x
t
(.))d1(.)
1lo lloorom says llal, givon llo oxpocloo ulilily axioms, consumplion plans
aro rankoo will rospocl lo llo oxpoclalion of lloir ulilily unoor a proLaLilily
oislriLulion. Nolo llal llo oxpocloo ulilily oporalor is linoar in proLaLilily ano
oislorls llo oulcomos (unloss n is linoar).
1lis ulilily funclion is calloo von Noumann-Morgonslorn ulilily funclion,
aflor ils originalors von Nouman ano Morgonslorn (1044, [108[). Il las llo
2. Tneory oI CnoIce under \ncertaInty 16
proporly of any oroinal ulilily funclion, Lul in aooilion, il las a caroinal moa-
suro, llal is, llo numorical valuo of ulilily las a prociso moaning moro llan llo
simplo rank of llo numLors.
2.2.3 Hov Ooes \tIIIty Aeasure HIsk AversIon?
Consioor a gamLlo will a ranoom oulcomo : llal lakos a posilivo valuo :
1
will
proLaLilily j ano a nogalivo valuo :
2
will proLaLilily 1 j. 1lis gamLlo is saio
lo Lo n&n:.n||j Jn.: if ils oxpocloo valuo is zoro, llal is,
j:
1
(1 j):
2
= 0
Inoiviouals aro saio lo Lo :.| n: if lloy aro unwilling lo accopl any acluar-
ially fair gamLlo.
Lol \
0
ano n Lo an inoivioual`s inilial woalll ano ulilily funclions rospoc-
livoly. From llo aLovo oonnilion of risk avorsion, if : is an acluarially fair
gamLlo, llon \
0
_ \
0
:. Using llo c| roprosonlalion lloorom 2.2.2, llis
proforonco implios
H[n(\
0
)[ _ H[n(\
0
:)[
wlicl is oquivalonl lo
n(\
0
) _ jn(\
0
:
1
) (1 j)n(\
0
:
2
).
Sinco j:
1
(1 j):
2
= 0, llon \
0
can Lo rowrillon as
\
0
= j(\
0
:
1
) (1 j)(\
0
:
2
):
roplacing llo provious oqualion in llo ono aLovo givos
n(j(\
0
:
1
) (1 j)(\
0
:
2
)) _ jn(\
0
:
1
) (1 j)n(\
0
:
2
)
1lis provos llal risk avorsion implios llo concavily of ulilily funclion. 1lo
rociprocal is also lruo Ly a rovorsal of llo aLovo slops. 1lis rosull is oxprossoo
in llo following lloorom.
2. Tneory oI CnoIce under \ncertaInty 17
Tneoren 2.2.3 J..n nn|: . :.| n:, n ]& J]nJ, .J nnJ n|j .J
h. &.|.j J&n.n J n|h . nn n h :|nn n|h ||.
If llo concavily claraclorizos llo risk avorsion of inoiviouals llon llo inlon-
sily of risk avorsion can also Lo moasuroo Ly llo oogroo of llo concavily of llo
ulilily funclion. In oocl, oonno llo funclion
1

(a) =
n
tt
(a)
n
t
(a)
1

is calloo llo aLsolulo risk avorsion funclion. Il is somolimos roforroo lo

as llo Arrow-Irall risk avorsion paramolor (aflor Arrow (106, [[) ano Irall
(1064, [87[)). Goomolrically 1

moasuros llo curvaluro of llo funclion n: llo

liglor ils valuo, llo moro concavo n is. Nolo llal 1

is invarianl lo a slriclly
posilivo amno lransformalion of n.
1o inouco a risk-avorso inoivioual lo unoorlako a fair gamLlo :, a compon-
salory risk promium H
c
woulo lavo lo Lo ooroo. On llo ollor lano, lo avoio
sucl a gamLlo, a risk avorso inoivioual woulo Lo willing lo pay an insuranco risk
promium H

. 1loso risk promiums aro oopicloo as follows

H[n(\ H
c
:)[ = n(\)
H[n(\ :)[ = n(\ H

)
H

is commonly usoo in insuranco ano corrosponos lo a casually or liaLilily pro-

mium, wloroas H
c
corrosponos lo llo oxlra" rolurn oxpocloo on riskior assols.
Nolo llal H

ano H
c
aro closo Lul gonorally nol oqual.
1lo amounl \ H

is known as llo corlainly oquivalonl lo llo gamLlo

\ :. In llo caso of insuranco, risk avorso invoslors aro always willing lo pay
risk promiums liglor llan llo oxpocloo loss. In oocl, supposo llal an invoslor`s
woalll \ is suLjocl lo a ranoom loss 1. If llo invoslor Luys an insuranco, llo
risk promium llal covors llis loss is H
Y
sucl llal
H[n(\ 1 )[ = n(\ H
Y
) (2.2)
2. Tneory oI CnoIce under \ncertaInty 18
If llo invoslor is risk avorso, llon llo ulilily funclion n is concavo. Ly
Jonson`s inoqualily, for any ranoom variaLlo A wo lavo
H[n(A)[ _ n(H[A[)
For A = \ 1 , givon llal H[\ 1 [ = \ H[1 [, wo lavo
H[n(\ 1 )[ _ n(\ H[1 [)
From (2.2) wo gol
n(\ H
Y
) _ n(\ H[1 [)
Sinco llo ulilily funclion n is incroasing, llis implios llal
H
Y
_ H[1 [
1lis slows llal wlon invoslors aro risk avorso, lloy aro willing lo pay an insur-
anco risk promium wlicl is liglor llan llo oxpocloo loss. 1lo moro invoslors
aro risk avorso, llo liglor llo risk promium lloy aro willing lo pay.
2.2.4 VnIcn \tIIIty FunctIon Is ArorIate?
1lo mosl commonly usoo class of ulilily funclions is HyporLolic ALsolulo Iisk
Avorsion (H/1/). For llis class of ulilily funclions, llo aLsolulo risk avorsion
funclion, 1

(\) is lyporLolic in woalll, llal is,

1

(\) /
n
tt
(\)
n
t
(\)
=
1
_
W
1

b
o
_ 0
wloro c 0, ,= 1 ano
c\
1
/ 0. All momLors of llo H/1/ family can
Lo oxprossoo as
n(\) =
1

_
c\
1
/
_

, / 0
1lis family is ricl, sinco clanging valuos of c, / ano yiolos ulilily funclions
will aLsolulo risk avorsion incroasing, oocroasing or conslanl.
2. Tneory oI CnoIce under \ncertaInty 19
1aking 1, ano for c = 1, llo ulilily is linoar (risk-noulral caso),
n(a) = a.
For = 2, il is llo caso of quaoralic ulilily, n(a) = a
1
2
ca
2
wloro c
is a conslanl ooponoing on c ano /. For n lo Lo incroasing, il sloulo Lo
oonnoo on llo inlorval (0, [( 1)/[ ,c) . 1lo corrosponoing aLsolulo risk
avorsion is an incroasing funclion of woalll. Alllougl quaoralic ulilily is
mallomalically lraclaLlo sinco llo invoslor caros aLoul llo nrsl lwo mo-
monls only, incroasing risk avorsion is nol a oosiraLlo foaluro in mooolling
ralional Lolavior.
1aking , ano / = 1, llo ulilily is nogalivo oxpononlial, n(a) =
c
oa
. In llis caso, llo aLsolulo risk avorsion is conslanl.
For < 1, ano / = 0, il is llo caso of llo powor ulilily, n(a) = da

, wloro
d is a funclion of c ano /. 1lo aLsolulo risk avorsion is oocroasing will
woalll.
For = / = 0, llo ulilily is logarillmic, n(a) = ln(a). 1lo aLsolulo risk
avorsion is oocroasing will woalll.
In praclico, lloro aro procoouros for assigning an approprialo ulilily funclion
lo an invoslor. 1lo nrsl ono, usoo Ly von Nouman ano Morgonslorn was Lasoo on
llo nnJn:J :J:n n:n. 1lo procoouro involvos asking llo inoivioual lo
assign corlainly oquivalonls lo various risky allornalivos. For inslanco, gamLlos
will lwo oioronl oulcomos :
1
ano :
2
will rospoclivo proLaLililios j ano 1 j
lavo a corlainly oquivalonl H
j
oonnoo as
n(H
j
) = jn(:
1
) (1 j)n(:
2
)
Sinco a ulilily funclion ranking is invarianl will a posilivo amno lransformalion,
n can Lo normalizoo sucl llal
n(:
1
) = :
1
ano n(:
2
) = :
2
2. Tneory oI CnoIce under \ncertaInty 20
So
n(H
j
) = j:
1
(1 j):
2
For oioronl valuos of j, llo invoslor is askoo lo assign corlainly oquivalonls H
j
,
ano lonco llo ulilily funclion n is ompirically conslrucloo.
1loro aro many ollor procoouros of oliciling ulilily funclions sucl as llo
j&n||j |.||j :n.nj j&.n|n usoo Ly Anoorson, Dillon ano Haroakor (1077,
[8[) Lasoo on nxoo 0 0 ooos. Ollor molloos consisl of nlling paramolors of
a class of ulilily funclions lo corlainly oquivalonl assignoo lo gamLlos. Quoslion-
nairos aLoul inoivioual`s alliluoo lowaros risk, curronl nnancial silualion ano
invoslmonl approacl aro also usoo lo imply an inoivioual`s risk loloranco.
2.2.5 Exected \tIIIty Is ^ot IerIect
1lo oxpocloo ulilily moool las long Loon llo slanoaro for analyzing cloico unoor
uncorlainly. Howovor, mucl crilicism las Loon raisoo concorning ils valioily.
1lis crilicism mainly falls inlo llroo calogorios. Firsl, oxporimonlal ovioonco
slows a syslomalic violalion of llo inooponoonco axiom wlon inoiviouals aro
askoo lo clooso among risky allornalivos as slown Ly Kalnoman ano 1vorsky
(1070, [7[) ano Camoror (1080, [22[). Socono, llo implicalion of llo c| lloory is
oflon conlraoicloo Ly markol Lolavior, ospocially in llo insuranco markol, wloro
llo alliluoo lowaros gains ano lossos is slown lo oior suLslanlially, soo Lallalio
n|. (1000, [8[). 1liro, llo procoouros for conslrucling llo ulilily funclion lavo
prooucoo inconsislonl rosulls, ouo lo parallol proLloms liko llo roprosonlalion
or llo J:nn.nj oocl ano llo ]&rn..n oocl, wloro lollorios involving gains
can Lo roplrasoo Ly incroasing llo inilial woalll Ly a non-sloclaslic amounl
ano slaling llo allornalivos in lorms of lossos, soo Slarmor ano Sugoon (1080,
[101[).
Maclina (1082, [78[) ano FislLurn (1088, [44[) survoy llo roasons wly llo
c| lypollosis fails ano Maclina (1082, [78[) proposos anollor analysis of llo c|
willoul llo inooponoonco axiom". Ho slows llal Lasic concopls ano rosulls of
2. Tneory oI CnoIce under \ncertaInty 21
c| framowork oo nol oopono on llis axiom, Lul may Lo oorivoo from a mucl
woakor assumplion of smoollnoss of proforoncos ovor allornalivo proLaLilily ois-
lriLulions.
Many allornalivos lo c| lavo Loon proposoo, incluoing Quiggin (1082, [00[)
ano Yaari (1087, [118[), Lul no ono coulo accommooalo all of llo ovioonco. 1lis
soclion will go llrougl somo famous oxamplos of violalion of llo c| moool,
oflon calloo paraooxos", proLaLly Locauso of a ooop commilmonl lo c|.
Tne AIIaIs aradox
Allais paraoox is llo Losl known counloroxamplo lo c| lloory. Il is also known
as llo common consoquonco oocl. Allais (108, [1[) proposoo llo following
silualion, wloro inoiviouals aro askoo lo clooso Lolwoon gamLlos
1
ano 1
1
ano
llon clooso Lolwoon
2
ano 1
2
.

1
=
_
_
payo proLaLilily
$1: 1
_
_
, 1
1
=
_
_
_
_
_
_
_
payo proLaLilily
$0 0.01
$1: 0.80
$: 0.1
_
_
_
_
_
_
_
ano

2
=
_
_
_
_
payo proLaLilily
$0 0.80
$1: 0.11
_
_
_
_
, 1
2
=
_
_
_
_
payo proLaLilily
$0 0.0
$: 0.1
_
_
_
_
Mosl suLjocls clooso
1
ano 1
2
. Il can Lo provoo llal llo aLovo proforoncos
can nol Lo prosonloo Ly an oxpocloo ulilily funclion H

[n()[ will rospocl lo any

slriclly incroasing von Nouman-Morgonslorn ulilily funclion. Honco llo aLovo
Lolavior is inconsislonl will c| lloory. 1lo inconsisloncy comos from llo facl
llal llo proLaLilily 0.01 of rocoiving $0 in prospocl 1
1
is ovorwoiglloo, wlicl
prooucos cloicos llal violalo llo inooponoonco axiom.
2. Tneory oI CnoIce under \ncertaInty 22
Tne connon ratIo eBect
1lis is also a silualion wloro inoiviouals Lolavior is inconsislonl will c|. 1lo
following oxamplo is proposoo Ly Kalnoman ano 1vorsky (1070, [7[), wloro
small proLaLililios of oxlromo payos aro involvoo. Inoiviouals aro askoo lo
clooso Lolwoon
1
ano 1
1
ano llon clooso Lolwoon
2
ano 1
2
.

1
=
_
_
_
_
payo proLaLilily
$0 0.1
$3, 000 0.0
_
_
_
_
, 1
1
=
_
_
_
_
payo proLaLilily
$0 0.
$6, 000 0.4
_
_
_
_
ano

2
=
_
_
_
_
payo proLaLilily
$0 0.008
$3, 000 0.002
_
_
_
_
, 1
2
=
_
_
_
_
payo proLaLilily
$0 0.000
$6, 000 0.001
_
_
_
_
In llo nrsl silualion wlon llo proLaLilily of winning is suLslanlial (0.0 ano 0.4),
mosl suLjocls clooso llo prospocl wloro winning is moro proLaLlo,
1
. 1lis
Lolavior is consislonl will llo risk avorsion assumplion. In llo socono silualion
wloro llo proLaLilily of winning is minusculo (0.002 ano 0.001), mosl suLjocls
clooso llo prospocl llal oors llo largo gain, 1
2
. 1lo ralio of proLaLililios is llo
samo in Loll silualions (
0.u
0.002
=
0.01
0.001
), so accoroing lo llo inooponoonco axiom
in llo c| lloory, pooplo wlo clooso 1
1
will clooso 1
2
. In lurns oul llal oivioing
all llo proLaLililios Ly a common oivisor rovorsos llo oiroclion of proforoncos.
Inoooo, Kalnoman ano 1vorsky (1070, [7[) founo llal 86/ of inoiviouals closo

1
ano 27/ closo 1
2
. Honco, llo cloicos aro rovorsoo.
AnLIguIty
In llo provious oxamplos, il las Loon assumoo llal inoiviouals know llo proL-
aLilily oislriLulion, or llal lloy can form woll oonnoo suLjoclivo proLaLililios
for all rolovanl ovonls. Howovor, in many silualions llis is nol llo caso. Wlon
proLaLililios aro nol complololy known, llis silualion is calloo nnh.j&.j. In llo
2. Tneory oI CnoIce under \ncertaInty 23
liloraluro, LllsLorg`s paraoox (1061, [40[) is a woll known oxamplo of a cloico
silualion wloro amLiguily is provailing ano wloro inoiviouals Lolavior is incon-
sislonl will c|. 1lo LllsLorg paraoox is ooscriLoo as follows. 1loro aro 00 Lalls
in an urn, 30 aro roo onos ano llo rosl of 60 is oillor Llack or yollow. Ono Lall
will Lo orawn al ranoom from llo urn. 1lo following proforoncos ovor acls aro
lypical,

1
=
_
_
_
_
$100 i) Lall is roo
$0 i) Lall is Llack
$0 i) Lall is yollow
_
_
_
_
~
_
_
_
_
$0 i) Lall is roo
$100 i) Lall is Llack
$0 i) Lall is yollow
_
_
_
_
= 1
1
ano

2
=
_
_
_
_
$100 i) Lall is roo
$0 i) Lall is Llack
$100 i) Lall is yollow
_
_
_
_
-
_
_
_
_
$0 i) Lall is roo
$100 i) Lall is Llack
$100 i) Lall is yollow
_
_
_
_
= 1
2
Inoiviouals pick
1
rallor llan 1
1
, prosumaLly Locauso llo clanco of golling
$100 in acl
1
is procisoly known lo Lo 1,3, Lul llo clanco of golling $100 in
1
1
is amLiguous sinco il can Lo any numLor Lolwoon 0 ano 2,3. In llo socono
silualion, inoiviouals profor 1
2
lo
2
Locauso llo clanco of golling $100 in 1
2
is procisoly known lo Lo 2,3, wloroas llo clanco of golling $100 in
2
is any
numLor Lolwoon 1,3 ano 1. Il can Lo provoo llal no c| ulilily funclion can
roprosonl llo cloicos aLovo.
1o accommooalo llo avorsion lo amLiguily, moools sucl llo Cloquol ox-
pocloo ulilily, or oxpocloo ulilily will rospocl lo non-aooilivo proLaLililios or
capacilios` aro proposoo ano sluoioo, for oxamplo soo GilLoa (1087, [46[) ano
Sclmoiolor (1080, [08[). Zlang (1000, [121[) usos llo Savago sol up, lo provioo
an axiomalizalion of llo Cloquol oxpocloo ulilily wloro a oocision-makor usos
unamLiguous ovonls lo approximalo amLiguous onos.
2. Tneory oI CnoIce under \ncertaInty 24
2.3 OuaI \tIIIty Tneory
1lo oual lloory of cloico unoor uncorlainly (loroaflor Dual 1loory), proposoo
Ly Yaari (1084, [116[ ano 1087, [118[) ano oovolopoo Ly Iooll (1087, [02[) aims lo
nx somo of llo proLloms inloronl lo llo oxpocloo ulilily ano wlicl rosull from
llo inooponoonco axiom. 1lis axiom is roplacoo Ly a oual inooponoonco axiom
ano llo rosl of llo c| axioms aro prosorvoo. Iisky prospocls aro ovalualoo Ly
a caroinal numorical scalo, lowovor, llo rolos of paymonls ano proLaLililios aro
rovorsoo, lonco llo namo J&n|.
1lo c| oislorls llo oulcomos Ly a ulilily funclion n, usually concavo, ano
koops llo proLaLililios unclangoo, llal is, H[n( x)[ =
_
U
n( x(.))d1(.). In Dual
1loory, oulcomos aro unclangoo wloroas llo proLaLililios aro oislorloo Ly a
oislorlion oporalor ), usually convox. Dislorling proLaLililios roprosonls llo
invoslors alliluoo lowaros risk in llo samo way as llo ulilily funclion moasuros
llo risk avorsion. Wlon looking al llo c| paraooxos, liko Allais paraoox for
inslanco, llo crucial iooa is llal llo ovonls al llo oxlromo lails of llo oislriLulion
sloulo Lo ovorwoiglloo, wlilo lloso in llo conlor sloulo Lo unoorwoiglloo. 1lo
following oxamplo proposoo Ly Quiggin (1008, [01[) illuslralos furllor llis nolion
llal oqually proLaLlo ovonls sloulo nol nocossarily rocoivo llo samo woigll.
Supposo an inoivioual`s normal wago incomo is uniformly oislriLuloo ovor rango
from $20, 000.01 lo $21, 000.00. 1loro is also a 1,100, 000 clanco llal llo porson
will win a conlosl for wlicl llo prizo is a joL paying $1 million a yoar. 1lo
proLaLilily of rocoiving any spocinoo incomo in llo rolovanl rango $20, 000.01
lo $21, 000.00 (o.g. $21, 780.3) is also 1,100, 000. Alllougl Loll oulcomos aro
oquiproLaLlo, il sooms nalural llal llo oxlromo oulcomo will nol rocoivo llo
samo woigll in llo ovalualion as llo inlormooialo oulcomo.
Moro formally, lol us oxamino llo axiomalic conslruclion of Dual 1loory.
For simplicily of prosonlalion, wo omil llo proofs of llooroms llal can Lo founo
in Yaari (1087, [118[).
2. Tneory oI CnoIce under \ncertaInty 25
2.3.1 AxIonatIc ConstructIon
Givon a proLaLilily spaco (!, I), lol \ oonolo llo sol of all ranoom variaLlos
oonnoo on ! will valuos in [0, 1[, llal is,
\ = : ! [0, 1[
Donno llo oocumulalivo oislriLulion funclion (TTT)
o

(t) = Ir[ t[ for 0 _ t _ 1

o

is non-incroasing, rigll conlinuous ano salisnos o

(1) = 0 for all \. Il is

usoful lo nolico llal
_
1
0
o

(t)dt = H[[
wloro H[[ is llo oxpocloo valuo of . Ioslricling llo valuos of lo [0, 1[ can Lo
inlorproloo, via a suilaLlo cloico of scalo Ly llo facl llal roprosonls a ranoom
oulcomo of a gamLlo for oxamplo wlicl is limiloo in lossos ano gains.
In llo oxpocloo ulilily moool, wo usually rofor lo llo nvo axioms of llo c|
as inlrooucoo Ly von Nouman ano Morgonslorn (1044, [108[). Howovor, lloro
aro sovoral oquivalonl ways for llo conslruclion of llo c| moool. 1lo way wo
aooploo oarlior was proposoo Ly Huang ano LilzonLorgor (1088, [4[). Similarly,
lloro aro oquivalonl conslruclions of Dual 1loory. Horo, insloao of working will
llo sol of ranoom variaLlos \, wo work will llo sol of TTT`s wlicl is in ono-
lo-ono corrosponoonco will \. 1lis Lijoclion can Lo juslinoo Ly llo following
axiom
AxIon 2.3.1 {^eutraIIty) 1 n nnJ h|nj \, .h h.: :. TTT`
o
&
nnJ o

. 1J o
&
= o

, hn n ~ .
1lis axiom says llal inoiviouals aro inoioronl aLoul lwo risky prospocls if
lloy lavo llo samo oislriLulion. Honco llo rolalion ( can Lo oxlonooo lo llo
sol of all TTT`s
I = o : [0, 1[ [0, 1[
2. Tneory oI CnoIce under \ncertaInty 26
wloro o is non-incroasing, rigll-conlinuous ano salisnos o(1) = 0. Honco, for G
ano H in I, G ( H if ano only if (n, ) \
2
sucl llal o
&
= G, o

= H ano
n ( .
AxIon 2.3.2 {ConIete veak order) ( . :r., :nn.. nnJ nnJ.
1lis is a roquiromonl for ( lo Lo a proforonco rolalion.
AxIon 2.3.3 {ContInuIty) 1 o, o
t
, H, H
t
h|nj I; n&n hn o ~ o
t
.
Jhn 0, &h hn
| o H |< c:d | o
t
H
t
|< =H ~ H
t
h: | . | . h 1
1
-n:n, hn . | : |=
_
1
0
[:(t)[dt
1lo 1
1
conlinuily assumoo loro is slrongor llan llo conlinuily assumoo in
llo oxpocloo ulilily analysis.
AxIon 2.3.4 {AonotonIcIty) 1J o
&
(t) _ o

(t), J: n|| t, 0 _ t _ 1, hn
o
&
( o

.
Il can Lo slown llal llo aLovo four axioms plus llo inooponoonco axiom
aro nocossary ano sumcionl for llo c| moool lo lolo. Dual 1loory roplacos llo
inooponoonco axiom Ly a oual inooponoonco axiom wlicl can Lo slaloo using a
now concopl of ooponoonco. Loforo inlrooucing llis axiom, lol us nrsl consioor
onco again llo sol of \ of ranoom variaLlos on wlicl proforoncos aro oonnoo ano
lol (!, T, I) llo unoorlying proLaLilily spaco.
OefnItIon 2.3.1 1 n nnJ h|nj \. 1 nj hn n nnJ n: nnn.
.J nnJ n|j .J J: :j . nnJ .
t
.n !, h .nj&n|.j [n(.)n(.
t
)[[(.)(.
t
)[ _
0 . :&.
1lo comonolonicily is llo porfocl corrolalion vorsion in a proLaLilily oislriLulion-
froo solling. n ano aro comonolonic if noillor of llom can loogo againsl llo
ollor. Supposo lloro is a risk avorso agonl wlo profors n lo (n ( ), llon if
2. Tneory oI CnoIce under \ncertaInty 27
a lliro ranoom variaLlo u can loogo againsl Lul nol n, llon lis proforonco
wlon mixing n ano will u will clango llo oiroclion of lis nrsl proforonco,
sucl llal
1
2

1
2
u ~
1
2
n
1
2
u. Howovor, if pairwiso comonolonicily lolos, llon
llo oiroclion of proforonco ooos nol clango. Wo aro now in a posilion lo slalo
llo axiom llal givos riso lo llo oual lloory of cloico unoor risk.
AxIon 2.3.5 {OuaI Indeendence) 1 n, nnJ u h|nj \ nnJ n&n
hn n, nnJ u n: n.:. nnn.. Jhn, J: :j c [0, 1[, n (
.n|. cn (1 c)u ( c (1 c)u
1lo following lloorom provioos a roprosonlalion of llo cloicos in Dual 1lo-
ory. Il is llo oual of llo roprosonlalion llooromin llo oxpocloo ulilily inlrooucoo
oarlior.
Tneoren 2.3.1 {OuaI \tIIIty HeresentatIon) :J:n :|n.n ( n-
.] h nh nr.n, .J nnJ n|j .J, h: r. n n.n&&, nn-J:n.nj
:n| J&n.n ), J]nJ n h &n. .n:n| [0, 1[, &h hn, J: n|| n nnJ
h|nj.nj \,
n ( =
_
1
0
)(o
&
(t))dt _
_
1
0
)(o

(t))dt
`::, h J&n.n ), h.h . &n.j& & n .. n]n :nnJ:nn.n,
nn h |J .n &h n nj hn, J: n|| j n.Jj.nj 0 _ j _ 1, )(j) | h
:J:n j&n.n
[1: j[ ~ [)(j): 1[
h: [a: j[ . n :nnJn n:.nh| n|.nj h n|& a nnJ 0 .h :hnh.|.. j
nnJ 1 j.
In llis roprosonlalion lloorom, for any ranoom variaLlo \, will TTT o
&
,
an imporlanl quanlily H() =
_
1
0
)(o

(t))dt is oonnoo. From llo roprosonlalion

lloorom wo lavo
n ~ =H(n) = H()
2. Tneory oI CnoIce under \ncertaInty 28
H() can Lo llougll of as a oogonoralo ranoom variaLlo [H(): 1[. So H() =
H(H()) , wlicl implios
~ [H(): 1[
1lis moans llal H() is llo amounl wlicl, wlon rocoivoo will corlainly, is
consiooroo as gooo as . 1lis amounl is known as llo corlainly oquivalonl lo
. In llo oxprossion of H() llo oocumulalivo oislriLulion funclion is oislorloo,
wlilo linoarily in paymonls is prosorvoo, llal is,
H(c /) = cH() /
for conslanls c ano / ano a ranoom variaLlo . In Dual 1loory, givon a cloico
among risky prospocls, llo agonl woulo pick a risk laving llo groalosl corlainly
oquivalonl.
2.3.2 Vnat aLout HIsk AversIon In OuaI Tneory?
In llo oxpocloo ulilily lloory, llo proforoncos aro claraclorizoo Ly a von Noumann-
Morgonslorn ulilily funclion, wloroas, in Dual 1loory, llo proforoncos aro rop-
rosonloo Ly a oislorlion funclion ). Furllormoro, lo soo low llo risk avorsion is
moasuroo in Dual 1loory, lol us oonno il nrsl.
OefnItIon 2.3.2 1 n nnJ h|nj \, .h :. TTT` o
&
nnJ o

,
:.|j, nnJ n.J: h .nj&n|.j
_
T
0
o
&
(t)dt _
_
T
0
o

(t)dt
:J:n :|n.n ( n \ . n.J h :.| n: .J n ( h|J hn:
h nh .nj&n|.j h|J J: n|| 1 n.Jj.nj 0 _ 1 _ 1, .h j&n|.j J: 1 = 1
1lis is a nrsl oroor sloclaslic oominanco, llal is, n is proforroo lo if
J
= n
noiso. Having oonnoo risk avorsion, llo following lloorom givos a claracloriza-
lion of il.
2. Tneory oI CnoIce under \ncertaInty 29
Tneoren 2.3.2 n.J: h |n J :J:n :|n.n n \ n.Jj.nj h
1&n| Jh:j nr.n. :J:n :|n.n ( .n h. |n . :.| n: .J nnJ
n|j .J h J&n.n ) ::n.nj ( ; Jh:n ...1) . nr.
So llo convoxily of ) is a claraclorizalion of risk avorsion in Dual 1loory,
wlilo llo concavily is so in llo oxpocloo ulilily lloory. An inluilivo inlorprola-
lion of llis proporly follows in llo caso wlon ) is oioronliaLlo
H(A) =
_
1
0
)(o
A
(t))dt =
_
1
0
t)
t
(o
A
(t))d1
A
(t)
Iocall llal
H[A[ =
_
1
0
td1
A
(t)
Comparing H(A) lo H[A[, llo corlainly oquivalonl H(A) can Lo llougll of
as a corrocloo moan of A wloro llo paymonl t rocoivos a woigll )
t
(o
A
(t)) _ 0.
Nolo llal lloso woiglls sum up lo 1, llal is,
_
1
0
)
t
(o
A
(t))d1
A
(t) =
_
1
0
d
dt
[)(o
A
(t))[dt
= )(1) )(0)
= 1
If ) is convox, llon
t
1
t
2
=o
A
(t
1
) < o
A
(t
2
) =)
t
(o
A
(t
1
)) < )
t
(o
A
(t
2
))
1loroforo, llo woigll assignoo lo a ligl oulcomo is loss llan llo woigll assignoo
lo a low oulcomo. Honco, Ly oislorling llo proLaLililios will a convox funclion,
agonls Lolavo possimislically, in llo sonso llal lloy assign ligl proLaLilily lo
Lao oulcomos ano low proLaLilily lo gooo oulcomos.
1lo Arrow-Irall moasuro of aLsolulo risk avorsion
1
is a local moasuro of
risk-avorsion for a ulilily funclion, as usoo in llo corlainly oquivalonl assuming
oxpocloo ulilily. In a similar faslion lo llo ulilily funclion, q las associaloo will
1
Arrow-Irall`s aLsolulo risk avorsion is oonnoo as D+Z, @
x
33
+Z,
x
3
+Z,
2. Tneory oI CnoIce under \ncertaInty 30
il a moasuro of risk avorsion. 1lo comparison of risk avorsion in llis framowork
is nalurally Lasoo on llo convoxily of llo funclion q roprosonling llo agonl`s
proforonco funclion. 1lo moro convox llo funclion q, llo moro risk avorso llo
agonl. 1lo oual Arrow-Irall risk avorsion woulo Lo in llis caso q
tt
(j),q
t
(j) for
0 < j < 1, as oonnoo in Yaari (1086, [117[). In llo sonso of Ioss (1081, [04[),
agonls aro slrongly moro risk avorso, if lloy roquiro a largor componsalion for
any moan prosorving sproao in lloir prospocls, ovon if llo inilial silualion is nol
ono of porfocl corlainly. Iisk avorsion moasuromonl in llo sonso of Yaari (1086,
[117[) ano Ioss (1081, [04[) is oiscussoo in Iooll (1087, [02[).
1o sum up, wlilo risk avorsion in ulilily lloory is moasuroo Ly llo ulilily
funclion, in Dual 1loory, il is moasuroo Ly llo proLaLilily oislorlion funclion.
1lo cloico of llo oislorlion funclion ) oolorminos llo proporlios of llo corlainly
oquivalonl.
In llo liloraluro, Wang (1006, [111[) proposos a gonoral class of oislorlion
oporalors lo uso in pricing insuranco promiums. Wlon llo oislorlion funclion is
a powor funclion, )(a) = a
v
, llo mapping
o
A
(t) )(o
A
(t))
is calloo Iroporlional Hazaros (IH) lransform. Applicalions ano implomonla-
lion of llo IH-lransform in insuranco is oiscussoo in Wang (1008, [112[). Al-
llougl llo IH-lransform onjoys oosiraLlo proporlios in insuranco pricing, il
cannol Lo applioo lo assols ano liaLililios simullanoously. Wang (2000, [118[)
proposos anollor class of oislorlion oporalors
)
c
(n) = 1[1
1
(n) c[
wloro 1(n) =
_
&
o
1
_
2
c

a
2
2
da is llo slanoaro normal cumulalivo oislriLulion
funclion ano suggosls llal llo moan of llo oislorloo oocumulalivo oislriLulion
can Lo usoo as anollor allornalivo lo llo risk-noulral valualion in assol pricing.
In Claplor Fivo, wo provo llis slalomonl mallomalically wlon llo unoorly-
ing socurily pricos aro log-normally oislriLuloo. Wo mooify llis oislorlion opor-
alor lo accommooalo for moro gonoral assumplions. van oor Hook ano Slorris
2. Tneory oI CnoIce under \ncertaInty 31
(2001, [106[) inlrooucoo anollor class of risk moasuros for assol allocalion, Lasoo
on llo IH-lransform. 1loy uso lwo oioronl oislorlion funclions, q ano h lo
allow for a oioronl pricing of llo upsioo ano oownsioo of llo risk. 1lo spocin-
calion of q ano h is nol givon, lloroLy allowing for a gonoral pricing framowork.
In Claplor Six, wo sluoy llis class of risk moasuros ano ooouco somo proporlios
ano oioronl roprosonlalions in llo oiscrolo limo. 1lis class Lolongs lo llo non-
c| class of risk moasuros as slown in van oor Hook ano Slorris (2001, [106[).
Wo uso llis class of risk moasuros in llo consumplion-invoslmonl proLlom ano
comparo llo assol allocalion lo llo ono consislonl will llo c| moool.
2.3.3 OuaI Tneory SoIves sone Exected \tIIIty Iara-
doxes
Ono can go ovor somo paraooxos in llo liloraluro liko Allais (108, [1[) or llo
common ralio oocl ano nno llal inconsisloncy of lloso paraooxos willin llo
oxpocloo ulilily Lolavior vanislos in Dual 1loory. Yaari (1087, [118[) consioors
llo common ralio oocl paraoox proposoo Ly Kalnoman ano 1vorsky (1070,
[7[) inlrooucoo oarlior. In lloir oxamplo, Kalnoman ano 1vorsky founo llal a
groal majorily of suLjocls profor [0.3: 1[ ovor [0.4: 0.8[ Lul llal an oqually largo
majorily profor
2
[0.4: 0.2[ ovor [0.3: 0.2[. Horo, paymonls aro moasuroo in unils
of $10, 000, so llal [0.3: 1[ is llo gamLlo llal yiolos $3, 000 will corlainly. 1lis
pallorn wlicl is oLviously inconsislonl will oxpocloo ulilily lloory, is onliroly in
kooping will Dual 1loory. Spocincally, will llo corlainly oquivalonl H oonnoo
oarlior, wo nno llal H([0.3: 1[) = 0.3, H([0.4: 0.8[) = 0.4)(0.8), H([0.3: 0.2[) =
0.3)(0.2) ano H([0.4: 0.2[) = 0.4)(0.2), ano lloso numLors will supporl llo
proforonco pallorn [0.3: 1[ ~ [0.4: 0.8[ ano [0.4: 0.2[ ~ [0.3: 0.2[ if
)(0.8) <
3
4
<
)(0.2)
)(0.2)
1lis oouLlo inoqualily is salisnoo, for oxamplo, wlon ) is of llo form )(j) =
j
2 j
, for 0 _ j _ 1. Horo, ) is a convox funclion, wlicl corrospono lo a risk
2
^{> s` is a ranoom variaLlo laking llo valuos { ano 3 will proLaLililios s ano 4 s
2. Tneory oI CnoIce under \ncertaInty 32
avorso Lolavior.
2.3.4 OuaI Tneory Is ^ot IerIect EItner
Wlilo Dual 1loory rosolvos somo proLloms rolaloo lo llo oxpocloo ulilily il las
ils own proLloms. Firsl, as poinloo Ly Yaari, somo oual paraooxos can Lo con-
slrucloo lo slow Lolavior wlicl is inconsislonl will rolalivo risk avorsion. Also,
wlon applying Dual 1loory lo porlfolio soloclion, oplimal invoslmonl slralogios
roocl oxlromo Lolavior of llo invoslor. Yaari (1087, [118[) oLsorvos: Unoor
oxpocloo ulilily, a risk avorso invoslor will always pul somo rosourcos inlo a risky
socurily, proviooo ils oxpocloo ralo of rolurn is posilivo. I am proparoo lo ar-
guo llal Loll posilions n: nj &` in oxpocloo ulilily lloory ano slay pul
unlil plunging Locomos juslinoo` in Dual 1loory aro oxlromo. Ioal invoslmonl
Lolavior proLaLly lios somowloro in Lolwoon."
1lo slay pul` silualion monlionoo Ly Yaari is wlon an invoslor laving a
cloico Lolwoon ono risky socurily ano ono riskloss assol invosls llo onliro woalll
in llo riskloss assol. 1lo |&nj.nj` silualion is wlon llo invoslor invosls llo
onliro woalll in llo risky socurily. 1lis oLviously is an oxlromo Lolavior. Il is a
consoquonco of llo linoarily of llo invoslor`s oLjoclivo funclion in llo oulcomos
wlicl loaos lo a cornor solulion. Sucl Lolavior is nol oLsorvoo in llo c| moools
sinco llo oLjoclivo is nol linoar in llo oulcomos. In Claplor Six, wo sluoy llo
consumplion-invoslmonl proLlom in Dual 1loory ano oiscuss llis proLlom.
2.4 Tne Hank-Oeendent AodeI
1lo rank ooponoonl oxpocloo ulilily moool (1Tc|) inlrooucoo Ly Quiggin
(1082, [00[) can Lo viowoo as an oxlonsion of Loll llo oxpocloo ulilily ano llo
oual ulilily moools wloro Loll llo cumulalivo oislriLulion funclion ano llo oul-
comos aro oislorloo. In oocl, as Yaari (1087, [118[) poinloo oul, Loll primal ano
oual moasuros of proforoncos aro spocial casos of a prooucl moasuro oonnoo on a
suilaLlo paymonl-proLaLilily plano, ano faclorizaLlo inlo lwo marginal moasuros.
2. Tneory oI CnoIce under \ncertaInty 33
In llo oxpocloo ulilily framowork, llo marginal moasuro along llo proLaLilily
axis is LoLosguo moasuro, wloroas in Dual 1loory framowork, llo marginal
moasuro along llo paymonl axis is LoLosguo moasuro. Dropping llo conoilion
llal ono of llo marginal moasuros is LoLosguo gonoralizos Loll oxpocloo ulil-
ily ano Dual 1loory lo a moro gonoral lloory. In llo 1Tc| moool, llo iooa
is lo cooo prospocls in a rank-orooroo faslion ano apply a oislorlion funclion
(calloo woiglling funclion Ly Quiggin) lo llo onliro voclor of proLaLililios ano
llo ulilily funclion lo llo oulcomos. If A is a oiscrolo ranoom variaLlo laking
llo valuos a
1
_ ... _ a
n
will rospoclivo proLaLililios I = (j
1
, ..., j
n
), llon llo
1Tc| funclional is givon Ly
V [A: I[ =
n

=1
n(a

)h

(I)
wloro
h

(I) =
_

=1
j

_
1

=1
j

_
= (1(a

)) (1(a
1
))
wloro is a proLaLilily woiglling funclion : [0, 1[ [0, 1[ ano 1 is llo cumu-
lalivo oislriLulion funclion of A. 1lo now woiglls h

(I) oopono on llo onliro

proLaLilily voclor ano nol on j

only. 1lis implios llal il is possiLlo for lwo

ovonls will llo samo oLjoclivo proLaLilily lo lavo oioronl woiglls in llo ox-
prossion of V. 1lis iooa is ospocially usoful for oxlromo oulcomos llal originally
lavo llo samo oLjoclivo proLaLilily as llo inlormooialo oulcomos. Applying llo
woiglling funclion allows lo lroal llom oioronlly.
2.5 Conerent HIsk Aeasures
How lo oonno risk" From an invoslor viowpoinl, il is nalural lo llink aLoul
risk as rolaloo lo variaLilily of llo fuluro valuos of a posilion or a porlfolio cur-
ronlly lolo, ouo lo markol clangos or moro gonorally lo any uncorlain fuluro
2. Tneory oI CnoIce under \ncertaInty 34
ovonl. In llo oxpocloo ulilily moool, wlollor or nol somolling is risky, ooponos
on llo ulilily funclion usoo in llo ovalualion. 1lal is, risk is a proporly oonnoo
for a class of ulilily funclions. In llo (/T/, risk is moasuroo Ly slanoaro oovi-
alion or varianco of rolurns. Il can Lo slown (soo Ianjor n|. (1008, [84[)) llal
llis moasuro of risk is consislonl will a cloico Ly oxpocloo ulilily maximizalion
only unoor spocial conoilions. Ono nalurally woulo liko a oonnilion wlicl is as
Lroaoly applicaLlo as possiLlo.
Arlznor n|. (1000, [6[) oonno llo risk simply Ly llo ranoom fuluro valuos
of woalll. Formally,
OefnItIon 2.5.1 :.| . n :nnJn n:.nh| J]nJ n n J n J h
:|J !. 1J \ Jn h J n|| :.|, hn . h J n|| :n| n|&J J&n.n
n !, hn n nn&: J :.| . J]nJ n n nn.nj J:n \ h :n| |.n.
Honco a porlfolio risk is llo ranoom variaLlo roprosonling ranoom fuluro
valuos of llo porlfolio. 1lo quoslion now is wlollor llo fuluro valuos of a
porlfolio aro accoplaLlo or nol. 1lis is gonorally oociooo Ly a rogulalor or a
suporvisor of capilal managomonl. Arlznor n|. (1000, [6[) slalo axioms for llo
sol of accoplaLlo fuluro nol worll ano sol axioms aLoul moasuros of risk llal
aro lo Lo usoo lo ooclivoly rogulalo or manago risks. Sucl a moasuro is calloo
coloronl" ano salisnos llo following axioms.
AxIon 2.5.1 {TransIatIon InvarIance) 1: n|| A \, nnJ J: n|| :n| n&n-
h: c, hn
j(A c:) = j(A) c
h: : . n :&:n n n :J:n .n:&nn.
AxIon 2.5.2 {SuLaddItIvIty) 1: n|| A
1
nnJ A
2
\,
j(A
1
A
2
) _ j(A
1
) j(A
2
)
2. Tneory oI CnoIce under \ncertaInty 35
AxIon 2.5.3 {IosItIve nonogeneIty) 1: n|| ` _ 0 nnJ n|| A 1,
j(`A) = `j(A)
AxIon 2.5.4 {AonotonIcIty) 1: n|| A nnJ 1 \ .h A _ 1 ,
j(A) _ j(1 )
AxIon 2.5.5 {HeIevance) 1: n|| A \ .h A < 0, j(A) 0
Givon llosos axioms, ono woulo liko lo claraclorizo a coloronl risk moasuro.
1lo following lloorom says llal any coloronl risk moasuro arisos as a supromum
of llo oxpocloo nogalivo of llo oiscounloo nnal woalll for somo colloclion of
proLaLilily moasuros.
Tneoren 2.5.1 {HeresentatIon tneoren) G.n h n| :&:n : n n
:J:n .n:&nn, n :.| nn&: j . h:n .J nnJ n|j .J h: r.
n Jnn.|j T J :hnh.|.j nn&: n h J n J h :|J, &h hn
j(A) = svp H

[A,:[ [ I T
Horo a quoslion arisos: aro llo commonly usoo risk moasuros coloronl Nol
all of llom. Arlznor n|. (1000, [6[) sluoioo somo oxisling molloos of moasur-
ing risk ano suggosloo conoilions for oxlonoing a risk moasuro lo Lo coloronl.
1lo valuo al risk is froquonlly usoo in nnancial inslilulions as a quanlilo-Lasoo
molloo of moasuring risk. Lol us oxamino wlollor il is coloronl.
YaIue at HIsk
1lo Valuo al Iisk (\c1) as a moasuro of polonlial loss from an unlikoly, aovorso
ovonl in a normal, ovoryoay markol onvironmonl. \c1 is oonominaloo in unils
of a curroncy ano compuloo as follows. Givon 0 < c < 1, ano a roforonco
inslrumonl :, llo Valuo al Iisk \c1
c
of llo nnal nol worll A will oislriLulion
I is
\c1
c
(A) = inf a [ I[A _ a.:[ c
2. Tneory oI CnoIce under \ncertaInty 36
For gonoral oislriLulions of A, llo \c1
c
fails lo salisfy llo suLaooilivily
proporly. Howovor, in llo spocial caso wloro quanlilos aro compuloo unoor a
oislriLulion for wlicl all pricos aro joinlly normally oislriLuloo wo lavo
\c1
c
(A) =
_
H

[A[ 1
1
(c) o

(A)
_
wloro 1 is llo slanoaro normal cumulalivo oislriLulion funclion. Sinco 1
1
(0.) =
0, llon llo quanlilos oo salisfy suLaooilivily as long as proLaLililios of oxcoo-
oonco aro smallor llan 0.. Furllormoro, as noloo Ly Wircl ano Haroy (1000,
[11[), llo \c1 can Lo oxprossoo as a moan of a oislorloo oocumulalivo oislri-
Lulion, consislonlly will Dual 1loory. Inoooo,
\c1
c
(A) =
_
o
0
) (o
A
(t)) dt
wloro
)(o
A
(t)) =
_
_
_
0 if 0 _ o
A
(t) < 1 c
1 if 1 c _ o
A
(t) _ 1
=
_
_
_
0 if t \c1
c
(A)
1 if 0 _ t < \c1
c
(A)
so llal
_
o
0
)[o
A
(t)[dt =
_
1o1
o
(A)
0
dt = \c1
c
(A)
1lo oislorlion funclion ) salisnos )(0) = 0, )(1) = 1, ano ) is an incroasing
funclion wlicl salisnos llo conoilions for a valio oislorlion funclion as oonnoo
in Soclion 2.8.1
2.6 ConcIusIon
1lis claplor las comparoo ano conlrasloo llo c| moool ano Dual 1loory.
Dospilo llo proLloms will c|, llis moool is froquonlly usoo in porlfolio soloclion
proLloms Locauso llo unoorlying mallomalics is lraclaLlo. 1lo noxl claplor
2. Tneory oI CnoIce under \ncertaInty 37
roviows llo liloraluro ano survoys llo loclniquos usoo lo solvo llo consumplion-
invoslmonl proLloms in llo c| moool. As il will Lo oomonslraloo in llo Claplor
Six, somo of lloso loclniquos can slill Lo applioo in a non-c| framowork.
lLaplci
LynanIc 1otIIoIIo
OIInIzaIIon In Ihc
ExccIcd !IIIIIy
AodcI
3.1 IntroductIon
Ly oonnilion, llo porlfolio soloclion proLlom involvos cloosing llo Losl` invosl-
monl slralogy. 1lo Losl` slralogy loro, is llo ono llal maximizos llo invoslor`s
oLjoclivo suLjocl lo Luogol conslrainls. Gonorally, invoslors aro facoo will llis
proLlom wlon lloy wanl lo oolormino llo oplimal allocalion of woalll givon
an invoslmonl opporlunily sol. Supposo llal lloro aro : oioronl invoslmonl
opporlunilios calloo socurilios wloso rolurns 1

(i = 1, 2, ..., :) al llo ono of llo

limo porioo aro ranoom variaLlos. 1lo porlfolio is a linoar comLinalion of lloso
socurilios wlicl las a posilivo markol valuo. 1lo porlfolio soloclion proLlom
was originally sol in a singlo porioo, wloro llo invoslor sooks lo maximizo llo
oxpocloo rolurn of lloir porlfolio. Alllougl llo oxpocloo rolurn rulo is simplo,
il is nol approprialo for all lypos of invoslors. Nicolas Lornoulli (18
|I
conlury)
oomonslraloo llo limilalion of llis rulo Ly using Sl. IolorsLurg paraoox, soo
Ingorsoll (1087, [6[) ano Samuolson (1077, [07[). GaLriol Cramor (famous for
Cramor`s rulo) inlrooucoo llo ulilily funclion lo solvo llo Sl. IolorsLurg para-
oox, lonco oomonslraling llo suporiorily of llo oxpocloo-ulilily framowork ovor
llo oxpocloo-rolurn crilorion. 1lo oxpocloo-ulilily framowork was gonoralizoo
Ly Von Noumann ano Morgonslorn (1044, [108[), wlo oxlonooo llo analysis lo a
gonoral proLlom of oocision-making unoor uncorlainly ano oovolopoo a rigorous
axiomalic approacl for llo oxpocloo-ulilily Ly ooriving nvo axioms concorning
88
3. OynanIc IortIoIIo OtInIzatIon vItn c| 39
inoivioual Lolavior unoor uncorlainly. Howovor llo proLlom of maximizing llo
oxpocloo ulilily of lorminal woalll ovor a singlo porioo is nol roalislic. For a long
limo porioo, llo markol paramolors clango ano loao lo a clango in llo invosl-
monl opporlunily sol, so invoslors nooo lo roviso lloir assol allocalion ouring llo
porioo of invoslmonl. 1lis is a roason for consiooring oynamic porlfolio soloclion
llrougl limo.
Novorlloloss, maximizing llo lorminal woalll oynamically llrougl limo is
also nol a fully roalislic proLlom. Inoooo, Morlon(1060, [78[) consioors llo proL-
lom for a lousololo wlicl is Loll an invoslor ano a consumor. A lousololo
is a consumor sinco lloy clooso a parl of lloir woalll lo consumo ano lloroLy
anollor parl lo allocalo for fuluro consumplion. A lousololo is also an invoslor
Locauso lloy invosl a parl of lloir savings in llo availaLlo invoslmonl oppor-
lunilios. In gonoral llo consumplion ano invoslmonl rulos cannol Lo lroaloo
inooponoonlly. 1lis loaos lo llo consiooralion of llo inlorlomporal porlfolio
proLlom wloro llo invoslor las ulilily ovor consumplion. In llo nnancial oco-
nomics liloraluro, llis proLlom las oflon Loon a slarling poinl lo solvo gonoral
oquiliLrium moools. Sucl moools consioor an oconomy wloro sovoral agonls,
wloso joinl aclions oolormino markol pricos llrougl llo law of supply ano oo-
mano, acl so as lo maximizo llo oxpocloo ulilily ovor consumplion llrougl limo.
1lo oplimal consumplion al oquiliLrium implios llo pricos as woll as llo inlorosl
ralos provailing in llis oconomy, soo Lucas (1078, [72[), Lroooon (1070, [10[) ano
Cox n|. (108, [81[).
In llis claplor, wo oo nol aoo valuo lo llo oxisling liloraluro aLoul oplimal
porlfolio proLloms. 1lo aim is lo pul logollor oioronl loclniquos for solving
llis lypo of proLloms ano liglligll llo oioroncos Lolwoon llom. 1lis claplor
sorvos as a Lackgrouno ano a roforonco for fuluro claplors.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 40
3.2 CIassIc IortIoIIo SeIectIon IroLIens
3.2.1 Tne AarkovItz AodeI
1lo inlroouclion of quanlilalivo molloos lo oquily funo managomonl Logan will
llo 102 puLlicalion Ly Harry Markowilz of lis Il.D. oissorlalion Iorlfolio
Soloclion". 1lis work slowoo low lo unoorslano llo lraoo-o Lolwoon risk
ano rolurns inloronl in a porlfolio. 1loso oarly papors (Markowilz (102, [7[)
ano 1oLin (106, [10[)) ooaling will llo porlfolio proLlom consioor slanoaro
moan-varianco oplimizalion. Alllougl a suLjocl lo lloorolical ano ompirical
crilicism, llo moan-varianco analysis provioos a Lasis for llo oorivalion of llo
capilal assol pricing moool ((/T/), llo Slarpo-Linlnor moool, ano llo Llack
moool. Moroovor, llo moan-varianco analysis is fully consislonl will Lxpocloo-
ulilily maximizalion wlon invoslors lavo quaoralic ulilily or wlon llo assol
rolurns aro normally oislriLuloo, soo Ingorsoll (1087, [6[). Wo aro inlorosloo in
llo mallomalical ano compulalional aspocls of llo maximizalion proLlom.
Supposo lloro aro : risky socurilios in llo markol. If oonolos llo voclor of
rolurns of lloso socurilios ano llo covarianco malrix of lloso rolurns, llon an
invoslor cloosos porlfolio woiglls x
j
lo maximizo lis oxpocloo rolurns H[1
j
[ =
x

suLjocl lo a givon a lovol of varianco x

x. 1lis proLlom is oquivalonl lo

minimizing llo varianco suLjocl lo a givon oxpocloo rolurn, soo Morlon (1072,
[80[).
_

_
min

1
2
x

x
suLjocl lo H[1
j
[ = x

1 = 1,
(8.1)
wloro 1 is llo unil :-oimonsional voclor. 1lis is a simplo form of llo proLlom
wloro no inoqualily conslrainls aro consiooroo. Applying llo Lagrango mulliplior
molloo, llo syslom (8.1) is oquivalonl lo
min

1
2
x

x `
_
H[1
j
[ x

_
x

1 1
__
3. OynanIc IortIoIIo OtInIzatIon vItn c| 41
wloro ` ano aro Lagrango mullipliors. 1lo nrsl oroor conoilions aro
x = ` 1
H[1
j
[ = x

1 = 1.
For a givon sol of assol rolurns, llo porlfolios wlicl salisfy llo nrsl oroor
conoilions mako up llo sol of oplimal porlfolios. 1lo omcionl porlfolios aro
lloso for wlicl lloro aro no ollor porlfolios will llo samo or groalor oxpocloo
rolurn ano loss varianco. In gonoral, llo sol of omcionl porlfolios is a suLsol of
oplimal porlfolios. 1lo foasiLlo porlfolios, Ly oonnilion, salisfy llo conslrainls
in llo syslom (8.1). 1lo foasiLlo porlfolios llal minimizo llo varianco givon a
lovol of oxpocloo rolurns aro calloo fronlior porlfolios ano form a lyporLola in
slanoaro oovialion, oxpocloo rolurn spaco. 1lis lyporLola (soo Figuro (8.1))
las ils conlor al (0, ,() ano asymplolos of oqualions
H[1
j
[ =

(

_
1
(
o
j
will
=

1
1, 1 =

1
, ( = 1

1
1, 1 = 1(
2
Horo for simplicily, is assumoo lo Lo non-singular, Lul in gonoral llis is
nol nocossarily llo caso. 1lo oplimal porlfolio composilion is
x
j
=
1
1
1
1

1

(
1

1
1
1
H[1
j
[
Ono way lo limil llo soarcl for omcionl porlfolios is lo provo llal oacl
invoslor`s oplimal porlfolio is a comLinalion of a fow oislincl porlfolios wlicl
aro common lo all invoslors. Sucl rosulls aro known as porlfolio soparalion
or mulual funo llooroms, soo Markowilz (1087, [74[). Il sloulo Lo slrossoo,
lowovor, llal llo informalion roquiroo Ly llo moan-varianco porlfolio proLlom
grows quaoralically will llo numLor of assols. 1lis inpul incluoos llo moans,
variancos ano covariancos of llo availaLlo assols.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 42
-4
-2
0
2
4
6
8
Expected return
-1 1 2 3 4
Std deviation
Figuro 8.1: Moan-Slanoaro Dovialion Fronlior Iorlfolios
3.2.2 SIngIe-IerIod Exected \tIIIty AaxInIzatIon
CeneraI \tIIIty FunctIon
In llis framowork, llo invoslor cloosos al llo Loginning of llo invoslmonl po-
rioo a foasiLlo porlfolio allocalion wlicl maximizos llo oxpocloo valuo of a von
Noumann-Morgonslorn ulilily funclion for ono of porioo woalll, n(\
1
) wlicl is
assumoo lo Lo lwico conlinuously, oioronliaLlo, slriclly concavo ano incroasing
funclion.
An invoslor will inilial woalll \
0
, wlo las a suLjoclivo joinl oislriLulion
of llo rolurns of socurilios (1
1
, ..., 1
n
), cloosos llo porlfolio woiglls u

(i =
1, 2, ..., :) llal solvo llo following proLlom
_
_
_
max
u
1
,...,u
r

Hn(

n
=1
u

\
0
)
suLjocl lo

n
=1
u

= 1.
If a riskloss socurily will a rolurn : is aoooo lo llo monu of availaLlo socu-
3. OynanIc IortIoIIo OtInIzatIon vItn c| 43
rilios, llon llo proLlom Locomos
_
_
_
max
u
1
,...,ur
Hn([

n
=1
u

(1

:) :[ \
0
)
suLjocl lo

n
=1
u

= 1.
If wo assumo llal llo ulilily funclion is slriclly concavo, lwico oioronliaLlo
ano llo covarianco malrix of rolurns is nonsingular, llon llo proLlom can Lo
solvoo using Lagrango mulliplior ano llo solulion is uniquo. For oiscussion aLoul
nocossary ano sumcionl conoilions, soo Lolano (1072, [70[) ano Lorlsokas (1074,
[14[). In llo caso wlon llo ulilily funclion n is slriclly concavo ano incroasing
llo nrsl oroor conoilions aro nocossary ano sumcionl for a maximum. 1lon, llo
oplimal porlfolio is oLlainoo Ly solving llo following syslom of : oqualions
H[(1

:)n
t
[\
0
(1 1
+
)[[ = 0, i = 1, 2, ..., :, (8.2)
wloro 1
+
=

n
=1
u
+

(1

:) : ano (u
+
1
, u
+
2
, ..., u
+
n
) is a solulion lo llo maxi-
mizalion proLlom.
If wo imposo moro roslriclions on woalll, liko forLiooing Lankruplcy (1
+
_
0), Lorrowing or slorl solling (u

_ 0), ollor molloos liko Klun ano 1uckor

(101, [6[) sloulo Lo consiooroo. For llo impacl of Lankruplcy rulos on llo
oplimal porlfolio, soo Mason (1081, [76[).
QuadratIc \tIIIty
Moan-varianco porlfolio soloclion moools commonly assumo llal llo ulilily func-
lion is quaoralic of llo form
n(\) = \
1
2/
\
2
, will / 0 ano \ < /.
From llo nrsl oroor conoilions (8.2) wo lavo
H
_
(1

:)
_
1
1
/
\
0
_
1 :
n

=1
u

(1

:)
___
= 0, i = 1, ..., :,
wlicl simplinos lo
_
1
1
/
\
0
(1 :) H[1

:[
1
/
\
0
n

=1
u

H[(1

:) (1

:)[
_
= 0, i = 1, ..., :.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 44
If wo lol
V =
_

_
H[(1
1
:) (1
1
:)[ . . . H[(1
n
:) (1
1
:)[
H[(1
1
:) (1
2
:)[ . . . H[(1
n
:) (1
2
:)[
.
.
. . . .
.
.
.
H[(1
1
:) (1
n
:)[ . . . H[(1
n
:) (1
n
:)[
_

_
,
E =
_

_
H[(1
1
:)[
H[(1
2
:)[
.
.
.
H[(1
n
:)[
_

_
,
v =
_

_
u
1
u
2
.
.
.
u
n
_

_
,
llon llo solulion lo llo nrsl oroor conoilions can Lo wrillon as
v
+
=/V
1
E (8.8)
wloro
/ =
/
\
0
(1 :) .
1lo paramolor / is rolaloo lo llo risk avorsion of llo invoslor. Inoooo, if 1
1
oonolos llo rolalivo risk avorsion of llo invoslor, llal is, 1
1
(\) =
&

(W)
&

(W)
\,
llon
/ =
1
1
1
:
ano lonco llo oplimal allocalion ooponos on llo risk avorsion of llo invoslor.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 45
A Seven-Asset ExanIe
Wo uso sovon assol classos: US casl, US Lonos, Japanoso Lonos, Luro-Lonos, US
oquilios, Japanoso oquilios ano Luro-oquilios. Using lypical oala givon in Ianjor
n|. (1008, [84[), llo following oxpocloo rolurns ano slanoaro oovialions aro
slown from lofl lo rigll for lloso assol classos in llo aLovo oroor. 1lo corrolalion
malrix also rospocls llo givon oroor of llo assol classos.
=
_
6.0 6. 6.0 . 0. 0. 0.
_
o =
_
0.0 .23 14.66 12.2 14.4 26.10 17.06
_
j =
_

_
1.00 0.20 0.04 0.12 0.08 0.02 0.12
0.20 1.00 0.22 0.34 0.33 0.13 0.30
0.04 0.22 1.00 0.68 0.07 0.3 0.30
0.12 0.34 0.68 1.00 0.04 0.38 0.1
0.08 0.33 0.07 0.04 1.00 0.21 0.61
0.02 0.13 0.3 0.38 0.21 1.00 0.40
0.12 0.30 0.30 0.1 0.61 0.40 1.00
_

_
For llis sol of inpuls, wo vary llo risk avorsion paramolor / ano calculalo
llo corrosponoing oplimal allocalion using oqualion (8.8). 1aLlo (8.1) givos llo
oplimal allocalion.
Figuro (8.2) plols llo moan of llo oplimal porlfolio in lorms of ils slanoaro
oovialion. 1lis lracos llo omcionl fronlior corrosponoing lo llis moool. 1lo
omcionl fronlior is also plolloo for llo samo proLlom, Lul will slorl solling
conslrainls.
In singlo porioo moools, llo invoslor lolos llo samo assol allocalion unlil llo
ono of llo porioo. For slorl-lorm invoslmonl, llis is oflon calloo n.n|` assol
allocalion. Il lurns oul llal llo oplimal porlfolio proporlions of an invoslor
will a long lorizon comparoo lo lloso of an invoslor will a slorl lorizon aro
signincanlly oioronl, soo Lronnan, Sclwarlz ano Lagnaoo (1007, [20[). 1lis
3. OynanIc IortIoIIo OtInIzatIon vItn c| 46
Initial Wealth
b Stand Mean
(risk aversion) 1 2 3 4 5 6 7 Deviat
1013000 108.75% -6.46% -0.38% 6.75% -2.16% -1.11% -5.40% 1.35% 5.63%
1026000 106.57% -4.91% -0.07% 4.70% -1.53% -0.79% -3.97% 1.03% 5.73%
1039000 104.39% -3.37% 0.24% 2.64% -0.90% -0.46% -2.54% 0.74% 5.83%
1052000 102.21% -1.83% 0.55% 0.58% -0.27% -0.14% -1.11% 0.53% 5.93%
1065000 100.03% -0.28% 0.87% -1.47% 0.36% 0.19% 0.32% 0.51% 6.04%
1078000 97.85% 1.26% 1.18% -3.53% 0.99% 0.51% 1.75% 0.69% 6.14%
1091000 95.66% 2.81% 1.49% -5.59% 1.62% 0.83% 3.17% 0.96% 6.24%
1104000 93.48% 4.35% 1.80% -7.65% 2.25% 1.16% 4.60% 1.28% 6.34%
1117000 91.30% 5.90% 2.11% -9.70% 2.88% 1.48% 6.03% 1.61% 6.44%
1130000 89.12% 7.44% 2.42% -11.76% 3.52% 1.80% 7.46% 1.94% 6.54%
1143000 86.94% 8.99% 2.73% -13.82% 4.15% 2.13% 8.89% 2.28% 6.64%
1156000 84.76% 10.53% 3.04% -15.87% 4.78% 2.45% 10.32% 2.62% 6.75%
1169000 82.57% 12.08% 3.35% -17.93% 5.41% 2.77% 11.75% 2.96% 6.85%
1182000 80.39% 13.62% 3.66% -19.99% 6.04% 3.10% 13.17% 3.31% 6.95%
1195000 78.21% 15.17% 3.97% -22.04% 6.67% 3.42% 14.60% 3.65% 7.05%
1208000 76.03% 16.71% 4.28% -24.10% 7.30% 3.75% 16.03% 4.00% 7.15%
1221000 73.85% 18.26% 4.59% -26.16% 7.93% 4.07% 17.46% 4.35% 7.25%
1234000 71.67% 19.80% 4.90% -28.21% 8.56% 4.39% 18.89% 4.69% 7.35%
1247000 69.48% 21.35% 5.21% -30.27% 9.20% 4.72% 20.32% 5.04% 7.46%
1260000 67.30% 22.89% 5.52% -32.33% 9.83% 5.04% 21.75% 5.39% 7.56%
1273000 65.12% 24.44% 5.83% -34.39% 10.46% 5.36% 23.17% 5.73% 7.66%
1286000 62.94% 25.98% 6.14% -36.44% 11.09% 5.69% 24.60% 6.08% 7.76%
1299000 60.76% 27.53% 6.45% -38.50% 11.72% 6.01% 26.03% 6.43% 7.86%
1312000 58.58% 29.07% 6.76% -40.56% 12.35% 6.34% 27.46% 6.78% 7.96%
1325000 56.40% 30.62% 7.07% -42.61% 12.98% 6.66% 28.89% 7.12% 8.06%
1338000 54.21% 32.16% 7.38% -44.67% 13.61% 6.98% 30.32% 7.47% 8.17%
1351000 52.03% 33.71% 7.69% -46.73% 14.25% 7.31% 31.74% 7.82% 8.27%
1364000 49.85% 35.25% 8.00% -48.78% 14.88% 7.63% 33.17% 8.17% 8.37%
1377000 47.67% 36.80% 8.31% -50.84% 15.51% 7.95% 34.60% 8.52% 8.47%
1390000 45.49% 38.34% 8.62% -52.90% 16.14% 8.28% 36.03% 8.86% 8.57%
1403000 43.31% 39.88% 8.94% -54.96% 16.77% 8.60% 37.46% 9.21% 8.67%
1416000 41.12% 41.43% 9.25% -57.01% 17.40% 8.92% 38.89% 9.56% 8.77%
1429000 38.94% 42.97% 9.56% -59.07% 18.03% 9.25% 40.32% 9.91% 8.88%
1442000 36.76% 44.52% 9.87% -61.13% 18.66% 9.57% 41.74% 10.26% 8.98%
1455000 34.58% 46.06% 10.18% -63.18% 19.29% 9.90% 43.17% 10.61% 9.08%
1468000 32.40% 47.61% 10.49% -65.24% 19.93% 10.22% 44.60% 10.95% 9.18%
1481000 30.22% 49.15% 10.80% -67.30% 20.56% 10.54% 46.03% 11.30% 9.28%
1494000 28.03% 50.70% 11.11% -69.35% 21.19% 10.87% 47.46% 11.65% 9.38%
1507000 25.85% 52.24% 11.42% -71.41% 21.82% 11.19% 48.89% 12.00% 9.48%
1520000 23.67% 53.79% 11.73% -73.47% 22.45% 11.51% 50.32% 12.35% 9.59%
1533000 21.49% 55.33% 12.04% -75.52% 23.08% 11.84% 51.74% 12.70% 9.69%
1546000 19.31% 56.88% 12.35% -77.58% 23.71% 12.16% 53.17% 13.04% 9.79%
1559000 17.13% 58.42% 12.66% -79.64% 24.34% 12.49% 54.60% 13.39% 9.89%
1572000 14.94% 59.97% 12.97% -81.70% 24.97% 12.81% 56.03% 13.74% 9.99%
1585000 12.76% 61.51% 13.28% -83.75% 25.61% 13.13% 57.46% 14.09% 10.09%
1598000 10.58% 63.06% 13.59% -85.81% 26.24% 13.46% 58.89% 14.44% 10.19%
1611000 8.40% 64.60% 13.90% -87.87% 26.87% 13.78% 60.31% 14.79% 10.30%
1624000 6.22% 66.15% 14.21% -89.92% 27.50% 14.10% 61.74% 15.14% 10.40%
1637000 4.04% 67.69% 14.52% -91.98% 28.13% 14.43% 63.17% 15.48% 10.50%
1650000 1.85% 69.24% 14.83% -94.04% 28.76% 14.75% 64.60% 15.83% 10.60%
Asset Allocation
1,000,000
1aLlo 8.1: Sovon-Assol Oplimal Iorlfolio Allocalion will Quaoralic Ulilily
3. OynanIc IortIoIIo OtInIzatIon vItn c| 47
Comparison of Efficiency Frontiers
0
0.02
0.04
0.06
0.08
0.1
0.12
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18
Standard Deviation
M
e
a
n
Unconstrained
Constrained
Figuro 8.2: Lmcionl Fronliors in llo Moan-Varianco Iorlfolio will ano willoul
Slorl-Solling Conslrainls
3. OynanIc IortIoIIo OtInIzatIon vItn c| 48
slows llo nooo for mulli-porioo moool wloro llo invoslor las llo possiLilily
of roLalancing lloir porlfolio al inlormooialo lraoing porioos ouring llo lifo of
invoslmonl. 1lis is oynamic porlfolio allocalion, wlicl is also calloo :nj.`
assol allocalion wlon llo lorm of invoslmonl is long. If ono of llo following
assumplions is maoo:
1. Logarillmic ulilily
2. Non-sloclaslic opporlunily sol
1
8. Opporlunily sol uncorrolaloo will assol rolurns
llon llo porlfolio is inooponoonl of llo oislriLulion of assol rolurns ovor rovision
porioos Loyono llo curronl ono. 1lo assol allocalion in llis silualion is calloo
nj.` lo roocl llis iooa of looking al llo curronl porioo only. Willoul ono of
llo aLovo assumplions, llo myopic ano non-myopic porlfolios aro ioonlical only
in llo nnal porioo of mulli-porioo moool, or as llo romaining lorizon approaclos
zoro in a conlinuous-limo moool, soo Kim ano OmLorg (1006, [62[).
3.3 AuItIerIod SettIng, ContInuous or
OIscrete TIne?
1lo main crilicism aLoul ono porioo moools is llal lloy oo nol allow for possiLlo
rovisions of porlfolio posilions ouring llo lifo of llo invoslmonl. 1lis roquiromonl
is crilical if llo unoorlying assol pricos aro liglly volalilo. Mulliporioo moools
allow for roaclion from llo invoslor lo clangos in llo slock markol, lowovor, will
a liglly volalilo naluro of assol pricos, fasl roaclion roquiros llo limo Lolwoon
lraoing oalos lo Lo small, wlicl implios a largo numLor of lraoing limos lo
Lo mooolloo. As wo slall soo in Claplor Four, in oroor lo solvo llo oplimal
porlfolio proLlom in a oiscrolo-limo solling, oillor llo numLor of limo porioos
1
1lo oporlunily sol is oonnoo lo Lo llo curronl risk-froo ralo ano llo invoslor`s Loliofs
aLoul fuluro assol rolurns. For formal oonnilion soo Iago 62.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 49
or llo numLor of llo unoorlying assols musl Lo small, ollorwiso, llo proLlom
Locomos compulalionally coslly.
Ono migll arguo llal llo numLor of llo unoorlying assols can Lo rooucoo lo
ono or lwo Ly using llo funo soparalion lloorom. 1lis is lruo only will somo
suilaLlo assumplion aLoul llo assol prico oynamics or llo proforonco ulilily
funclion. Moroovor, llis lypo of rosull is oslaLlisloo in a conlinuous-limo solling.
On llo ollor lano, conlinuous-limo moools wloro llo invoslor roLalancos
llo porlfolio conlinuously in limo (oxlromo assumplion) lako aovanlago of llo
liglly oovolopoo lools of sloclaslic conlrol lloory ano sloclaslic calculus lo
proouco oxplicil solulions wloro llo roquiroo compulalional oorl is loss llan
in llo caso of oiscrolo-limo moools.
Ono foaluro of llo conlinuous-limo solulion is llal llo agonl lrying lo im-
plomonl il will Lo conlinuously aojusling llo slaro loloing ano llo consumplion
ralo, wlicl is cloarly impraclical. A moro roalislic sconario woulo Lo llal llo
agonl cloosos lo roviow lis invoslmonl ano consumplion oocisions on a rogu-
lar Lasis Locauso oillor lo las somolling olso lo oo will lis lifo or possiLly
Locauso of lransaclion cosls associaloo will llo roLalancing. Lorlsimas n|.
(2000, [16[) look al llo quoslion Wlon is 1imo Conlinuous" in llo conloxl
of conlinuous-limo oorivalivo-pricing moools, Ly claraclorizing llo roplicalion
orrors llal ariso from oolla looging oorivalivos in oiscrolo limo.
Noooloss lo say, lloro is a groal ooal of ooLalo aLoul conlinuous-limo vorsus
oiscrolo-limo moools. 1lo oiscrolo-limo caso is moro roalislic Lul soloom yiolos
closoo form solulions, wloroas llo conlinuous-limo proLlom is mallomalically
moro lraclaLlo Lul llo quoslion llal romains: low roalislic is il
Lrioy, llo porlfolio proLlom in conlinuous-limo, for an invoslor-consumor
will inilial woalll \
0
, consisls of llo following oplimizalion proLlom
_

_
svp
,,c
H
_
_
T
0
n(c
|
, t)dt 1(\
T
)
_
suLjocl lo c
|
_ 0, \
|
0, \
0
0
ano Luogol conslrainls,
wloro llo oplimizalion is carrioo ovor all aomissiLlo consumplion ano invoslmonl
3. OynanIc IortIoIIo OtInIzatIon vItn c| 50
slralogios c ano ,. A moro rigorous oonnilion follows lalor in Soclion 8.4.2. In
oiscrolo-limo, llo porlfolio proLlom is
2
_

_
max
(C,1)
H
_

T
|=0
,
|
n((
|
)
_
suLjocl lo = inilial woalll
ano ((, H) is aomissiLlo.
Givon llo imporlanco of llis lypo of porlfolio proLlom in gonoral oquiliLrium
moools ano assol pricing, wo aro inlorosloo in llo oioronl loclniquos lo solvo il
ano aiming lo oxlono il lo a non-oxpocloo ulilily framowork in oiscrolo-limo.
A slanoaro assumplion aLoul capilal markol slrucluro is llo aLsonco of
lransaclion cosls, laxos ano proLloms will inoivisiLilily of assols. Givon lloso
assumplions, an invoslor woulo profor lo roviso lloir porlfolios as oflon as lloy
can al any limo. In roalily markol friclions oxisl, so a woll-oonnoo oquiliLrium
moool sloulo lako lloso aooilional cosls inlo accounl. 1lo solulion will llon
oopono on llo closon lraoing inlorval as slown in Morlon (1002, [77, Claplor
8[) ano Iogors (2001, [08[).
Moroovor, llo conlinuily assumplion will oopono on llo parlicular procoss
Loing moooloo, lonco ono las lo vorify llis approximalion wlon calculaling
llo nrsl, socono ano liglor oroor momonls as will Lo slown in llo following
oxamplo. Consioor a moool wloro no raro ovonls" occur, llal is a moool wlicl
is oioronl from a jump procoss. Lol A
|
Lo llo prico of a socurily al limo t ano
lol )(A
|
, t) Lo a (
2
funclion of llo procoss A ano limo. Consioor a parlilion
0, h, 2h, ..., :h of [0, 1[, wloro :h = 1. For clarily of prosonlalion, lol 1(/) Lo
a slorllano for )(A
II
, /h).
Using 1aylor`s oxpansion, wo lavo
1(/) 1(/ 1) =
_
1
a
(/ 1)j
I
1
|
(/ 1)
1
2
1
aa
(/ 1)o
2
I
n
2
(/h)
_
h
1
|
(/ 1)o
I
n(/)h
1
2
o(h),
2
1lo rolovanl variaLlos aro oonnoo in Soclion 8..1
3. OynanIc IortIoIIo OtInIzatIon vItn c| 51
wloro
j
I
= H
I1
_
A(/h) A((/ 1)h)
h
_
is llo conoilional oxpocloo oollar rolurn por unil limo on llo socurily givon
informalion al limo (/ 1)h,
o
2
I
=
H
I1
[A(/h) A((/ 1)h) j
I
h[
2

h
is llo conoilional varianco por unil limo of llo oollar rolurn on llo socurily givon
informalion al limo (/ 1)h ano
n(/h) =
[A(/h) A((/ 1)h) j
I
h[
(o
2
I
h)
1
2
Wo can provo (soo Morlon (1002, [77, Claplor 8[)) llal
H
I1
_
[1(/) 1(/ 1)[
2
_
= 1
a
(/ 1)o
I

2
h o(h)
H
I1
_
[1(/) 1(/ 1)[
`
_
= o(h
1
2
) = o(h) for A 2
Honco, for h vory small, only llo nrsl lwo momonls mallor.
On llo ollor lano, wlon llo socurily moool allows for jumps raro ovonls",
in sucl a way llal
c(/) / A(/h) A[(/ 1)h[ H
I1
A(/h) A[(/ 1)h[ = C(1)
is of oroor 1 will
c(/) =
_
_
_
n(/h)h
1
2
will proLaLilily 1 `(/h)h
(/h) will proLaLilily `(/h)h
llon
H
I1
_
[1(/) 1(/ 1)[
2
_
=
_
_
_
`H
I1
[)(A
(I1)I
(/h), / 1)
1(/ 1)[
2
[1
a
(/ 1)o
I
[
2
_
_
_
h o(h)
ano
H
I1
_
[1(/) 1(/ 1)[
`
_
= `H
I1
_
[)(A
(I1)I
(/h), / 1) 1(/ 1)[
`
_
h
o(h) for A 2.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 52
1loroforo, liglor momonls mallor ano oopono on llo lraoing inlorval h.
Anollor praclical rosull rolaloo lo conlinuous lraoing moools, wloro no raro
ovonls" oxisl, is llal socurily prico oynamics can Lo ooscriLoo will no loss of
gonoralily Ly an Ilo procoss, llal is,
o(t) o(0) =
_
|
0
j[o(n), n[dn
_
|
0
o[o(n), n[d1(n),
wloro 1(t) is a mullioimonsional Lrownian molion. In llis caso, oplimal porl-
folio oomano funclions oopono only upon llo nrsl lwo momonls.
3.4 ContInuous-TIne FInance
Mooolling slock oxclango socurily pricos oalos from 1000. In oocl, Louis Laclo-
lior in lis llosis 1loory of Spoculalion" usoo Lrownian molion as a moool for
slock oxclango porformanco, soo 1aqqu (2001, [108[). Sinco llon, llo main oo-
volopmonl in conlinuous-limo nnanco las Loon using sloclaslic procossos orivon
Ly llo Lrownian molion ano somolimos comLinoo will a jump procoss. How-
ovor, llo normalily assumplion implioo Ly llo Lrownian molion ooos nol agroo
will lypical log rolurn oala wlicl slows a loplokurlic oislriLulion (mucl liglor
poak ano loavior lails llan llo Gaussian). Ioconl oovolopmonls in porlfolio
soloclion uso Lcvy procoss as a moool for llo unoorlying socurily procoss, for
oxamplo soo Kallson (2000, [8[), Lonll n|. (2001, [11[) ano Yan n|. (2000,
[110[).
As far as llis oissorlalion goos, Lrownian molion will Lo consiooroo as a
sourco of ranoomnoss in socurily pricos. 1lis soclion slarls Ly solling llo La-
sic olomonls of conlinuous-limo nnanco. 1lon oynamic programming, Lagrango
mulliplior ano llo marlingalo approaclos aro prosonloo will an oyo on llo ap-
plicalion lo llo oplimal consumplion-invoslmonl proLlom.
3.4.1 ContInuous-TIne Set-\
In llis suLsoclion, wo follow llo nolalion of Linglam ano Kiosol (1008, [17[).
3. OynanIc IortIoIIo OtInIzatIon vItn c| 53
SecurIty IrIce Irocess
Uncorlainly in llo nnancial markol is moooloo Ly a proLaLilily spaco (!, T, I),
oquippoo will a nllralion, llal is a non-oocroasing family I = (T
|
)
|0
of suL-o-
nolos of T
T
c
_ T
|
_ T for all 0 _ < t <
1lo nlloroo proLaLilily spaco (!, T, I, I) is assumoo lo salisfy llo usual con-
oilions`:
T
0
conlains all I-null sols of I.
I is rigll conlinuous, llal is T
|
= T
|
/
c|
T
c
.
A sloclaslic procoss A = (A
|
)
|0
is a family of ranoom variaLlos oonnoo on
(!, T, I, I). 1lo procoss A is saio lo Lo I-aoaploo if A
|
is T
|
-moasuraLlo for
oacl t, llal is, A
|
is known wlon T
|
is known, al limo t.
On llo nlloroo proLaLilily spaco (!, T, I, I) consioor a markol llal incluoos
a Lono will prico o
0
(t) al limo t, ano : risky assols will pricos o
1
(t), ..., o
n
(t)
following an Ilo procoss. 1lo oynamics of llo socurilios aro
do
0
(t) = o
0
(t):(t)dt, o
0
(0) = 1
do

(t) = o

(t)
_
j

(t, o

(t))dt
n

=1
o

(t, o

(t))d1

(t)
_
o

(0) =

, 1 _ i _ :, for all 0 _ t < ,

wloro j

is llo inslanlanoous conoilional oxpocloo porconlago clango in prico

por unil limo ano o
2

is llo inslanlanoous conoilional varianco por unil limo.

Horo 1(t) = (1
1
(t), ..., 1
n
(t)) is an :-oimonsional Lrownian molion oonnoo
on (!, T, I, I) sucl llal T
|
is llo complolion of llo nllralion 1(n) : 0 _ n _ t .
1lo inlorosl ralo :(t), llo moan ralo of rolurn j(t) = (j
1
(t), ..., j
n
(t))

ano llo
volalilily o(t, o) = (o

(t, o)), (1 _ i, ; _ :) aro lakon lo Lo moasuraLlo, aoaploo

ano Lounooo procossos. 1lo oimonsion of llo Lrownian molion Loing oqual lo
llo numLor of risky assols onsuros llo complolonoss of llo markol.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 54
If wo assumo llal lloro oxisls an 0 sucl llal

o(t, .)o(t, .)

_ ||
2
2
, \ U
n
ano (t, .) [0, ) !
llon llo invorsos of o ano o

oxisl ano aro Lounooo

_
_
o(t, .)
1

_
_
2
_

1
2
||
2
_
_
o

(t, .)
1

_
_
2
_

1
2
||
2
, \ U
n
.
In llis caso, llo nllralion I is oquivalonlly givon as llo complolion of llo nl-
lralion gonoraloo Ly llo voclor of pricos o. Sinco llo volalilily malrix o is
non-singular, llon il is possiLlo lo oonno a procoss calloo llo nn:| :. J
:.| uniquoly Ly
(t, o) = o(t, o)
1
(j(t, o) :(t)1)
wloro 1 is an :-oimonsional unil voclor. Lol us inlroouco llo slriclly posilivo,
I-marlingalo procoss j
j
|
= cxp
_

_
|
0

(o
&
, n)d1
&

1
2
_
|
0
|(o
&
, n)|
2
dn
_
ano oonno llo now proLaLilily moasuro I

Ly solling
dI

dI

TI
= j
|
j is calloo llo Iaoon-Nikoo m oorivalivo
8
wlicl lakos loro llo form of a Dolcans
oxpononlial. Using Girsanov`s lloorom, llo procoss
1

|
= 1
|

_
|
0
(o
&
, n)dn
is a Lrownian molion unoor I

. Lquivalonlly, llo socurily i prico procoss unoor

I

is givon Ly
do

(t) = o

(t)
_
:(t)dt
n

=1
o

(t, o)d1

(t)
_
, 1 _ i _ :.
8
In llo liloraluro, llis procoss was founo lo lavo nvo ollor synonyms: pricing kornol,
slalo-prico oonsily, likolilooo ralio, sloclaslic oiscounl faclor ano slalo-prico ooalor.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 55
In llis silualion, wloro llo markol is complolo, I

is llo uniquo oquivalonl risk-

noulral or marlingalo moasuro. Harrisson ano Krops (1070, [2[) slow llal llo
oxislonco of an oquivalonl marlingalo moasuro is nol only a sumcionl Lul also a
nocossary conoilion for froo lunclos" nol lo Lo availaLlo. 1lo oquivalonco of no
arLilrago opporlunilios ano oxislonco of an oquivalonl marlingalo moasuro lolos
in nnilo oiscrolo limo, Lul Lroaks oown wlon llo lorizon is innnilo. Mooincalion
of llo concopl of aLsonco of arLilrago in llo conlinuous limo can Lo founo in
Sliryaov (1000, [100[). DolLaon ano Sclaclormayor (1004, [84[) oslaLlisloo llo
following rosull: Jh nJ..n n J: |&nh .h h&nJJ :.| . j&.n|n
h r.n J nn j&.n|n nn:.njn| nn&:.
Tne VeaItn Irocess
A porlfolio procoss or a lraoing slralogy (H
0
(t), H(t)) wloro H(t) = (H
1
(t), ...
, H
n
(t))

, is an U
n1
-valuoo procoss llal is I-prooiclaLlo
4
, lofl conlinuous ano
wlicl salisnos
_
T
0
|H()|
2
d < a.s.
1lo procoss (H
0
(t), H(t))
|0
ooscriLos an invoslor`s porlfolio as carrioo forwaro
llrougl limo wloro H
0
(t) ano H

(t) roprosonls llo numLor of unils invosloo in

llo Lono ano llo assol i rospoclivoly.
A consumplion procoss c(t), 0 _ t _ 1, is a nonnogalivo ano I-aoaploo
procoss sucl llal
_
T
0
c(t)dt < a.s.
1lo aoaploo conoilion moans llal llo invoslor cannol anlicipalo llo fuluro, so
insioor lraoing" is nol allowoo.
1lo woalll of llo invoslor al limo t is llon
\(t) =
n

=0
H

(t)o

(t)
_
|
0
c()d.
4
IrooiclaLilily is oonnoo for oiscrolo limo in Soclion 8..1.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 56
H

(t)o

(t) roprosonls llo amounl invosloo in assol i, 0 _ i _ :, ano

_
|
0
c()d
roprosonls llo lolal amounl consumoo up lo limo t.
If llo slralogy H is solf-nnancing, llon no monoy is aoooo lo llo porlfolio so
llal clangos in llo woalll oorivo only from clangos in llo assol pricos, inlorosl
on llo Lono, ano from consumplion, so llal
d\(t) =
n

=0
H

(t)do

(t)
_
1
n

=0
H

(t)
_
do
0
(t) c(t)dt
Wo slall rofor lo llo aLovo oxprossion as llo h&Jj j&n.n. 1lis conlinuous-
limo Luogol oqualion is oLlainoo Ly wriling oown llo varialion of woalll ovor
a small lraoing inlorval h ano llon laking llo limil carofully as h goos lo zoro,
soo Morlon (1002, [77, Claplor 4[).
Tne CaIn Irocess
1lo capilal gain G
1
associaloo will any I-prooiclaLlo lraoing slralogy H is
oonnoo lo Lo llo Ilo inlogral
G
1
(t) =
_
|
0
H(n)

do(n) =
n

=0
_
|
0
H

(n)do

(n).
3.4.2 Tne OynanIc IrogrannIng Aroacn
Dynamic programming is a poworful loclniquo in analyzing corlain lypos of
oplimizalion proLloms. Il las Loon usoo in many nolos sucl as proouclion ano
invonlory planning ano moro gonorally in proLloms wloro an inoivioual musl
mako a soquonco of oocisions in a spocinoo oroor. 1lis ovolulionary claraclor
makos il nalural lo oxpross llo oplimizalion rocursivoly as a cloico of ono`s
curronl aclion on llo Lasis of an alroaoy oplimizoo aclion policy for llo fuluro.
1lis is llo oynamic principlo, or llo Lollman principlo of oplimalily:
An oplimal policy las llo proporly llal wlalovor llo inilial
slalo ano inilial oocision aro, llo romaining oocisions musl conslilulo
an oplimal policy will rogaro lo llo slalo rosulling from llo nrsl
oocision" (Iiclaro Lollman (107, [10[))
3. OynanIc IortIoIIo OtInIzatIon vItn c| 57
A varianl of llis rocursivo formulalion yiolos llo Ionlrayagin Maximum Irin-
ciplo. For llo lloorolical proporlios of oynamic programming, soo Lorlsokas
(1076, [12[ ano 100, [18[), Lorlsokas ano Slrovo (1078, [1[) ano Iulorman
(1004, [80[). Slokoy ano Lucas (1080, [102[) ano Iusl (1006, [0[) oovolop moro
aLoul oynamic programming ano prosonl somo applicalion in oconomic analysis.
1o illuslralo llo iooa of oynamic programming, consioor llo proLlom of nno-
ing llo valuos of llo conlrol variaLlos n
1
ano n
2
for porioos 1 ano 2 wlon llo
slalo variaLlo a
1
is givon ano a
2
is a funclion )(a
1
, n
1
) of a
1
ano n
1
. Lol llo
oLjoclivo funclion lo Lo maximizoo Lo
,
1
(a
1
, n
1
) ,
2
(a
2
, n
2
).
Dynamic programming consisls of llo following slops:
1. 1o nno llo oplimal conlrol n
2
, maximizo ,
2
(a
2
, n
2
) will rospocl lo n
2
ano
oLlain n
2
= q
2
(a
2
) as a funclion of a
2
.
2. 1lo valuo funclion for porioo 2 is
V
2
(a
2
) = ,
2
(a
2
, q
2
(a
2
)).
8. 1lo oplimal conlrol n
1
solvos llo following proLlom
_
_
_
max
&
1
,
1
(a
1
, n
1
) V
2
(a
2
)
.t. a
2
= )(a
1
, n
1
).
If V
1
(a
1
) is llo valuo funclion of llo lasl oplimizalion, llon llo Lollman
oqualion is wrillon as
_
_
_
V
1
(a
1
) = max
&
1
,
1
(a
1
, n
1
) V
2
(a
2
)
.t. a
2
= )(a
1
, n
1
).
For proLloms involving moro llan lwo porioos, llo Lollman oqualion Locomos
V
|
(a
|
) = max
&
I
,
|
(a
|
, n
|
) V
|1
(a
|1
) .
3. OynanIc IortIoIIo OtInIzatIon vItn c| 58
Fron OIscrete to ContInuous
1lo lorm oynamic programming is oflon usoo for oiscrolo limo, wloroas oplimal
conlrol is usoo in conlinuous limo. A lypical sloclaslic oplimal conlrol proLlom
for an Ilo procoss is
_
_
_
svp

H
_
_
T
0
)(A(t), , t)dt
_
.t. dA = q(A, , t)dt h(A, , t)d:
wloro is a n:| variaLlo ano A is a n variaLlo ano ), q ano h aro woll
Lolavoo funclions. 1o oLlain llo oplimalily conoilions for llis proLlom, lol us
roplaco il Ly an approximaling oiscrolo-limo proLlom
_
_
_
max

z
H
_

`
=0
)(A

, t

)^t

_
.t. cA

= )(A

, t

)^t

q(A

, t

):

(^t

)
Using llo principlo of oplimalily, llo oplimal conlrol

al slago i, givon A

= a

,
is llo solulion lo
_
_
_
J

(a

, t

) = max

z
)(A

, t

)^t

[J
1
(a

cA

, t

^t

)[
.t. cA

= )(A

, t

)^t

q(A

, t

):

(^t

)
Wlon llo limo slop ^t

0, llo oLjoclivo funclion in llo syslom aLovo can Lo

wrillon as
J

(a

, t

) = max

z
__
)(A

, t

)

J

(a

, t

)
_
^t

(a

, t

)
_
(8.4)
wloro

(a

, t

) = lim
.|
z
0
H

[J
1
(a

cA

, t

^t

) J

(a

, t

)[
^t

Donning
c

(a, , t) = )(a, , t)

J

(a, t)
wo lavo from (8.4)
c

(a

, t

) _ 0, for all

,
3. OynanIc IortIoIIo OtInIzatIon vItn c| 59
will oqualily loloing for an oplimal

. In llo limil of conlinuous limo llis

conoilion Locomos
0 = svp

)(a, , t) T
a,
[J(a, t)[ (8.)
wloro T
a,
is llo Dynkin oporalor or llo oioronlial gonoralor wlicl will Lo
formally oonnoo in llo noxl suLsoclion.
Il is worll noling llal llo sloclaslic aspocls lavo oroppoo oul from llo
proLlom in llis formulalion. In oocl, llo variaLlo a in (8.) is a roal numLor,
wloroas A in llo original proLlom is an Ilo sloclaslic procoss. 1lo oynamics of
A, lowovor aro capluroo Ly T
a,
.
StocnastIc ControI
In llis suLsoclion wo slall roviow llo lloory of sloclaslic conlrol moro formally,
following Dumo (1002, [88[) ano Morlon (1002, [77[).
Lol 1 = (1
1
, 1
2
, ..., 1
J
) in U
J
oonolo llo slanoaro Lrownian molion voclor
on llo proLaLilily spaco (!, T, I). Wo nx llo slanoaro nllralion I = T
|
: t _ 0
of 1 ano llo limo lorizon [0, 1[ for somo nnilo limo 1 0. 1lo primilivo oLjocls
of a sloclaslic conlrol proLlom aro
a sol / U
n
of aclions
a sol U
1
of slalos
a sol ( of /-valuoo aoaploo procossos, calloo n:|
a conlrolloo orifl funclion q : / U
1
a conlrolloo oiusion funclion h : / U
1J
a running rowaro funclion ) : / [0, 1[ U
a lorminal rowaro funclion 1 : U
3. OynanIc IortIoIIo OtInIzatIon vItn c| 60
A conlrol c in ( is nJn..h| givon an inilial slalo in if lloro is a uniquo
Ilo procoss 1
c
valuoo in will
d1
c
|
= q(c
|
, 1
c
|
)dt h(c
|
, 1
c
|
)d1
|
: 1
c
0
=
suLjocl lo somo loclnical conoilions on c, q ano h.
Lol (
o
() oonolo llo sol of aomissiLlo conlrols givon inilial slalo ano
oonno llo ulilily of any aomissiLlo conlrol c (
o
() as
V
c
() = H
__
T
0
)(c
|
, 1
c
|
, t)dt 1(1
c
T
)
_
(8.6)
wloro V
c
() [, [.
For an inilial slalo in , llo oplimal conlrol proLlom is
V () = svp
cQtn()
V
c
() (8.7)
will V () = if lloro is no aomissiLlo conlrol givon inilial slalo . If lloro
oxisls an aomissiLlo conlrol c
+
sucl llal V
c
W
() = V (), llon c
+
is an oplimal
conlrol al . 1lo oxislonco of woll-Lolavoo solulions is nol always ovioonl. 1lo
usual way lo solvo sucl a proLlom is lo conjocluro a solulion llal if corrocl, can
Lo valioaloo.
1lo way llo ulilily of aomissiLlo conlrols is oonnoo in oqualion (8.6) ano
in llo ligll of llo provious suLsoclion`s oiscussion, ono may conjocluro llal
V () = J(, 0) for somo funclion J in (
2,1
( [0, 1[) llal solvos llo Lollman
oqualion
svp
oQ,
T
o
J(, t) )(c, , t) = 0, (, t) ( [0, 1[),
(8.8)
wloro
T
o
J(, t) = J

(, t)q(c, ) J
|
(, t)
1
2
t:[h(c, )h(c, )

J

(, t)[
will llo Lounoary conoilions
J(, 1) = 1(), .
3. OynanIc IortIoIIo OtInIzatIon vItn c| 61
T
o
is calloo llo Dynkin oporalor ovor llo variaLlo 1 for a givon conlrol c.
1lo non-linoar socono oroor parlial oioronlial oqualion (8.8) is calloo llo
1nn.|n-Jnh.-1||nnn (HE) oqualion. Ono may llink of J(, t) as llo
oplimal ulilily romaining al limo t in slalo .
Now, supposo llal you solvoo for llo oplimal policy funclion c
+
in llo proL-
lom (8.8). Il is nol slraigllforwaro lo say llal c
+
is llo oplimal solulion lo llo
original proLlom (8.7). Firslly, c
+
ooponos on J ano soconoly llo oxislonco of a
uniquo Ilo procoss 1
c
W
valuoo in will
d1
c
W
|
= q(c
+
|
, 1
c
W
|
)dt h(c
+
|
, 1
c
W
|
)d1
|
: 1
c
W
0
=
is nol ovioonl lo provo - llis oxislonco oonnos llo aomissiLilily of llo conlrol c
+
.
Howovor, in oplimal porlfolio allocalion, will somo suilaLlo assumplions on
llo primilivo of llo proLlom, llis oimcully can Lo ovorcomo ano llo oquivalonco
of llo lwo proLloms (8.7) ano (8.8) can Lo provoo. In llo noxl paragrapl, wo
apply llis approacl lo solvo Morlon`s proLlom inlrooucoo in (1060, [78[) ano
(1071, [70[).
Aerton`s IroLIen
Givon an inilial woalll \
0
, an invoslor wlo livos 1 yoars conlinuously cloosos
oplimal consumplion ano allocalion slralogios c ano , Ly solving llo proLlom
_

_
svp
,,c
H
_
_
T
0
n(c
|
, t)dt 1(\
T
)
_
suLjocl lo c
|
_ 0, \
|
0, \
0
0
ano Luogol conslrainls
(8.0)
Horo n(c
|
, t) is llo ulilily of consumplion al limo t, assumoo lo Lo incroasing ano
concavo will n(0, t) = 0 for oacl t, ano 1(\) is a spocinoo Loquosl valualion
funclion" assumoo lo Lo concavo in \. 1lo limo proforonco faclor is nol oxplicil
in llo oLjoclivo sinco il can Lo incluooo in n(c
|
, t).
3. OynanIc IortIoIIo OtInIzatIon vItn c| 62
As oonnoo in llo sol-up, llo prico por slaro i, o

|
, is gonoraloo Ly llo Ilo
procoss
do

|
o

|
= j

(o

|
, t)dt o

(o

|
, t)d1

(t)
wloro j

is llo inslanlanoous conoilional oxpocloo porconlago clango in prico

por unil limo ano o
2

is llo inslanlanoous conoilional varianco por unil limo. 1lo

invoslmonl opporlunily sol al limo t is oonnoo Ly j

(o, t), o

(o, t), j

(o, t),
wloro j

(t) is llo inslanlanoous corrolalion coomcionl Lolwoon Woinor procossos

d1

(t) ano d1

(t). 1lo oynamics of o

(t) las llo Markov proporly sinco llo

opporlunily sol olomonls aro al mosl funclion of o`s.
1lo Luogol oqualion is givon Ly
d\
|
=
n

=0
,

\
|
dt cdt
n

=1
,

\
|
d1

,
wloro llo fraclion of woalll ,

invosloo in socurily i is oonnoo Ly ,

= H

,\
sucl llal

n
=1
,

= 1. Horo llo ooponoonco o ano j on o ano t is oroppoo for

llo clarily of oxprossion. 1loro is no ollor roslriclion on ,

as Lorrowing ano
slorl-solling aro allowoo.
1aking inlo accounl llo riskloss socurily (j
0
= :, o
0
= 0), llo Luogol
oqualion can Lo rowrillon as
d\
|
=
n

=1
,

(t)(j

:)\
|
dt (:\
|
c)dt
n

=1
,

(t)o

\
|
d1

In malrix nolalion
d\
|
= [\
|
(,

|
` :) c
|
[dt \
|
,

|
od1
|
: \
0
(8.10)
wloro ,
|
= (,
1
(t), ..., ,
n
(t)), ` = (j
1
:, ..., j
n
:)

.
1lo primilivos of llo sloclaslic proLlom oonnoo in llo provious paragrapl
can Lo spocinoo as follows:
/ = U

U
n
, will olomonls Loing (c, ,) roprosonling consumplion ano
fraclions of woalll invosloo in llo risky socurilios,
3. OynanIc IortIoIIo OtInIzatIon vItn c| 63
= U

is llo sol woalll valuos \

( is llo sol of aoaploo procossos (c, ,) will valuos in U

ano U
n
rospoc-
livoly will
_
T
0
c
|
dt < ano
_
T
0
|,
|
|
2
2
dt < , a.s.
q [(c, ,), \[ = \(, ` :) c
h[(c, ,), \[ = \,

o
) [(c, ,), \, t[ = n(c, t)
1(\) givon in (8.0)
Will lloso spocincalions, llo proLlom can Lo solvoo in nvo slops:
1. Donno llo invoslor`s .nJ.: &.|.j J&n.n J: n|h
J(\, t) = svp
(c,,)Q,
H
|
__
T
|
n(c
|
, t)dt 1(\
T
)
_
2. 1lo HE oqualion for Morlon`s proLlom is
svp
(c,,)Q,
T
(c,,)
J(\, t) n(c, t) = 0, \ 0, (8.11)
wloro
T
(c,,)
J(\, t) = J
W
(\, t)

\(,

` :) c
_
J
|
(\, t)

\
2
2
,

oo

,J
WW
(\, t)
will llo Lounoary conoilions
J(\, 1) = 1(\), \ 0
8. Apply llo nrsl oroor conoilions lo gol
c
+
(t) = n
1
c
(J
W
, t) (8.12)
3. OynanIc IortIoIIo OtInIzatIon vItn c| 64
wloro n
c
= 0n,0c ano n
1
c
is llo invorso funclion of n
c
, llal is, n
1
c
[n
c
(a, t), t[ =
a for all t ano a, ano
,
+
(t) =
J
W
J
WW
\
(oo

)
1
` (8.18)
or
,
+
I
(t) =
J
W
J
WW
\
n

=1

I
(j

:) / = 1, ..., : 1
wloro
I
is llo common olomonl of llo /th row ano llo ;th column in
llo malrix (oo

)
1
. 1lo lorm
J
V
J
VV
is calloo llo Iisk 1oloranco"
4. Ioplaco oplimal conlrols (8.12) ano (8.18) in llo oqualion (8.11). 1lis
yiolos a TTc in J(\, t)
J
W
(\, t)

\(,
+
` :) c
_
J
|
(\, t)
\
2
2
,
+
oo

,J
WW
(\, t) n(c
+
, t) = 0
(8.14)
will llo Lounoary conoilions
J(\, 1) = 1(\), \ 0
. Solvo llo aLovo TTc lo oLlain J, llon roplaco llis solulion Lack inlo
(8.12) ano (8.18) lo lavo a closoo form of consumplion ano invoslmonl
slralogios
Loforo solving llo aLovo TTc, a ulilily funclion musl Lo spocinoo. Howovor,
sucl TTc`s raiso formioaLlo compulalional oimcullios ouo lo llo non-linoarily
in \. In gonoral, il is roquiroo llal llo HE oqualion aomil a solulion smooll
onougl lo llo oroor of llo oorivalivos involvoo. Unforlunaloly, llis is nol nocos-
sarily llo caso ovon for somo vory simplo silualions. 1o ovorcomo llis oimcully,
Cranoall ano Lions (1088, [88[) inlrooucoo llo so calloo ..j solulions. 1lis
now nolion is a kino of non-smooll solulions lo TTc, wloso koy foaluro is lo
roplaco llo convonlional oorivalivos Ly llo supor-suLoioronlials wlilo main-
laining llo uniquonoss of solulions unoor vory milo conoilions. In llo caso wlon
3. OynanIc IortIoIIo OtInIzatIon vItn c| 65
J is smooll, numorical sclomos Lasoo on linoar or quaoralic approximalions of
J can Lo applioo.
Morlon (1071, [70[) solvoo llis TTc for llo H/1/ class of ulilily funclions
n(c, t) = c
j|
1

_
,c
1
j
_

ano in llo caso of ono risky ano ono riskloss assol, llo TTc (8.11) las an oxplicil
solulion givon Ly
J(\, t) =
c,

c
j|
_
c

1 c
(ji)(T|)c
_
j i
_
c _
\
c

j
,:

1 c
v(T|)
_
_

wloro c = 1 ano i = : (j :)
2
,2co
2
.
1lo oplimal consumplion ano porlfolio rulos can Lo wrillon in oxplicil form
as
c
+
(t) =
(j i)
_
\(t)
cj
ov

1 c
v(T|)
_
_
c [1 c
(ji)(T|)c
[

cj
,
ano
,
+
(t)\(t) =
j :
co
2
\(t)
j(j :)
,:o
2
[1 c
v(T|)
[
1lo aLovo oplimal consumplion invoslmonl rulos aro funclions of woalll wlicl
is a slalo variaLlo. 1loy aro saio lo Lo in a JJhn| n:| form. Moroovor,
lloy aro linoar in woalll. Il can Lo provoo llal llo H/1/ class of ulilily is
llo only class will llis proporly.
LognornaI IrIces - AutuaI Funds
In llo caso of a conslanl opporlunily sol, llal is, j

ano o

aro conslanl, llo

unoorlying socurilios follow a goomolric Lrownian molion, so llo pricos aro Log-
normally oislriLuloo. Il can Lo slown (soo Morlon (1002, [77, Claplor [)) llal
lloro oxisls a uniquo pair of mulual funos" conslrucloo from linoar comLinalion
of llo assols sucl llal, inooponoonl of proforoncos (ulilily funclion), woalll
3. OynanIc IortIoIIo OtInIzatIon vItn c| 66
oislriLulion or llo limo lorizon, llo oplimal porlfolio is a linoar comLinalion of
lloso mulual funos.
1lo composilion of oacl mulual funo, assuming llo oxislonco of a risk-froo
assol, is givon Ly
c
I
=
1 j
i
n

=1

I
(j

:) ano `
I
=
j
i
n

=1

I
(j

:)
wloro i ano j aro arLilrary conslanls (i ,= 0), ano
I
is llo (/, ;) olomonl of
llo malrix (oo

)
1
. 1lo proporlions c
I
ano `
I
aro rospoclivoly llo porconlago
of llo nrsl ano llo socono mulual funo`s valuo lolo in llo /th assol.
Will llis Loauliful rosull, lloro is no nooo for anyono lo purclaso inoivioual
slocks soparaloly, sinco invoslmonl oocisions can Lo oiviooo inlo lwo parls Ly llo
oslaLlislmonl of lwo nnancial inlormooiarios llal provioo a complolo invoslmonl
sorvico for ovoryono.
Now, if wo sol ono of lloso mulual funos lo Lo llo risk-froo assol (j = 0) ano
llo ollor funo lo lolo only risky assols ( =

n
=1

n
=1

(j

:) ) il can Lo
slown llal llo risky funo (c
1
, ..., c
n
) is an omcionl porlfolio in a moan-slanoaro
oovialion spaco. 1loroforo, wlonovor log-normalily of pricos is assumoo, wo
can work willoul loss of gonoralily will jusl lwo assols, ono risk-froo" ano llo
ollor risky will ils prico log-normally oislriLuloo. Moroovor, wo lavo llo samo
analysis as in llo slalic moan-varianco moool Lul willoul llo oLjoclionaLlo
assumplions of quaoralic ulilily or normalily of oislriLulion of aLsolulo prico
clangos.
3.4.3 Tne Lagrange AuItIIIer Aroacn
Clow (1008, [24[ ano 1006, [2[) rocommonos llo Lagrango mulliplior molloo
in oplimal conlrol proLloms involving sloclaslic oioronlial oqualions as an al-
lornalivo lo solving llo Lollman oqualion. 1lis approacl is moro nalural as an
oxlonsion of llo oolorminislic caso. Il lurns oul llal il las somo compulalional
aovanlagos comparoo lo oynamic programming.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 67
AotIvatIon
In llo oolorminislic caso, lo solvo llo proLlom of a consumor maximizing a oif-
foronliaLlo ulilily funclion of consumplion suLjocl lo a Luogol conslrainl, ono
nalurally applios llo molloo of Lagrango mulliplior lo nno llo oplimal oomano
funclion for llo consumplion gooo. In llo sloclaslic caso, llis Lasic iooa can Lo
oxlonooo. 1lo Luogol oqualion can Lo viowoo as a conslrainl on woalll, wlicl
is a slalo variaLlo, ano Loll consumplion ano invoslmonl slralogios wlicl aro
conlrol variaLlos. So llo oplimizalion proLlom can Lo solvoo Ly llo molloo of
Lagrango mulliplior, wloro llo Lagrangoan oxprossion is a mallomalical oxpoc-
lalion of llo sum ovor many porioos of llo oLjoclivo funclion ano llo prooucl
of llo Lagrango mulliplior ano llo Luogol conslrainl.
Applying llis molloo consisls of oioronlialing llo Lagrangoan oxprossion
will rospocl lo llo conlrol ano slalo variaLlos wlicl aro suLjocl lo llo conslrainl
of llo Luogol oqualion. 1lo oioronlialion yiolos lwo nrsl-oroor conoilions
wlicl can Lo solvoo for llo oplimal consumplion ano invoslmonl slralogios ano
llo Lagrango mulliplior, Loll Loing funclions of woalll.
1lo nrsl-oroor conoilion oLlainoo Ly a oioronlialion will rospocl lo con-
sumplion is common lo llo oynamic programming approacl. Howovor, llo
nrsl-oroor conoilion oLlainoo Ly a oioronlialion will rospocl lo woalll is nol
oxploiloo in llo oynamic programming approacl. Il is roplacoo Ly llo oplimal-
ily oqualion (HE) wlicl summarizos llo rolalion Lolwoon llo valuo funclion
(llo inoirocl ulilily) al limo t ano llo valuo funclion al limo t 1. Novorlloloss,
oioronlialion of llo HE oqualion will rospocl lo woalll yiolos llo socono
nrsl-oroor oqualion oLlainoo Ly llo Lagrango molloo.
Honco, in llo oynamic programming approacl, ono solvos in many circum-
slancos a moro oimcull proLlom llan nocossary Ly nnoing nrsl llo inoirocl ulilily
funclion, llon llo oplimal consumplion ano invoslmonl slralogios.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 68
Tne Lagrange Aetnod AIIed to Aerton`s IroLIen
1o illuslralo llo iooa of llis molloo, lol us consioor llo consumor proLlom posoo
Ly Morlon (1060, [78[) wlicl consisls of a moool will ono risky socurily wloso
prico o
|
follows a goomolric Lrownian molion ano ono riskloss assol will conslanl
rolurn :. 1lo oynamics of llo assols aro
do
|
o
|
= jdt od1
|
d1
|
= :1
|
dt,
wloro d1
|
is an incromonl of a Lrownian molion ano j ano o aro rospoclivoly
llo inslanlanoous conslanl rolurn ano llo volalilily of llo risky socurily.
As slown oarlior, clango in woalll \
|
from limo t lo t dt salisnos llo
Luogol conslrainl
d\
|
= [(,
|
(j :) :)\
|
c
|
[ dt ,
|
o\
|
d1
|
,
wloro ,
|
is llo fraclion of woalll invosloo in llo risky socurily al limo t ano c
|
is llo consumplion al limo t. 1lo proLlom is
_
_
_
svp
,,c
H
_
_
T
0
n(c
|
)dt
_
suLjocl lo d\
|
= [(,
|
(j :) :)\
|
c
|
[ dt ,
|
o\
|
d1
|
1lo Lagrangoan oxprossion for llis oplimizalion proLlom is
/ =
_
T
0
H
|
n(c
|
)dt `(t dt) [d\
|
((,
|
(j :) :)\
|
c
|
) dt ,
|
o\
|
d1
|
[
wloro llo conoilional oxpoclalion H
|
is usoo Locauso wlon llo conlrol c
|
ano
,
|
aro oolorminoo, llo informalion al limo t incluoing llo valuo \
|
is givon.
1lo Lagrango mulliplior ` loro is a sloclaslic procoss. Swapping llo oroor of
inlogralion ano oxpoclalion is juslinoo for llo sloclaslic inlogral unoor somo
rogularily conoilions.
Solling lo zoro llo oorivalivos of / will rospocl lo c
|
, ,
|
ano `
|
yiolos llroo
oqualions lo solvo for consumplion, invoslmonl slralogios ano llo Lagrango mul-
liplior as funclions of woalll \
|
. Nolo llal llo Lagrango mulliplior `(t, \
|
) is
3. OynanIc IortIoIIo OtInIzatIon vItn c| 69
a sloclaslic procoss, so
d` =
_
0`
0t
dt
0`
0\
[(,
|
(j :) :)\
|
c
|
[
1
2
0
2
`
0\
2
(,
|
o\
|
)
2
_
dt
0`
0\
,
|
o\
|
d1
|
Dioronlialing / will rospocl lo llo conlrol variaLlos c
|
ano ,
|
is nol slraigll-
forwaro. Clow (1007, [26[) slows llo slops involvoo in llis oorivalion. 1lo nrsl
oroor conoilions aro
n
t
(c
|
) `(t, \
|
) = 0 (8.1)
\
|
`(t, \
|
)(j :) \
2
|
0`(t, \
|
)
0\
,
|
o
2
= 0 (8.16)
Dioronlialing / will rospocl lo llo slalo variaLlo \
|
yiolos (aflor oropping
oxplicil ooponoonco on \ ano t lo ligllon llo prosonlalion)
[,(j :) :[ `

\(,(j :) : ,
2
o
2
) c
_
0`
0\

1
2
\
2
,
2
o
2
0
2
`
0\
2
= 0
(8.17)
1lo oplimal consumplion ano invoslmonl slralogios can Lo oLlainoo Ly solv-
ing oqualions (8.1)-(8.17) will llroo unknowns c, , ano `.
Now lol us go Lack lo llo oynamic programming approacl. 1lo HE oqua-
lion (8.14) in llo caso of ono risky assol ano ono safo assol rooucos lo
svp
c,,
n(c)
0J
0t

0J
0\
[,(j :) :[ \ c
1
2
\
2
,
2
o
2
0
2
J
0\
2
= 0 (8.18)
wloro J is llo inoirocl ulilily. Dioronlialing llo aLovo oqualion will rospocl
lo woalll \ yiolos oqualion (8.17), wloro
` =
0J
0\
.
1lis slows llal llo oynamic programming oqualions imply lloso of Lagrango
mulliplior. Solving llo HE oqualion numorically, wlon no oxplicil solulion
can Lo founo is an aclivo rosoarcl aroa. A common molloo consisls of using
a quaoralic approximalion of J in oqualion (8.18). 1lis oLviously will yiolo
only a linoar approximalion of ` in oqualion (8.17). On llo ollor lano, a
3. OynanIc IortIoIIo OtInIzatIon vItn c| 70
quaoralic approximalion of ` in oqualion (8.17) will improvo upon llis linoar
approximalion ano provioo a moro accuralo approximalion of c ano , Ly solving
oqualions (8.1) ano (8.16) wlicl roquiro ` ano 0`,0\. In llis sonso, solving
oqualion (8.17) is suporior llan solving oqualion (8.18). Kwan ano Clow (1007,
[68[) oiscuss numorical implomonlalion in solving llo nrsl-oroor conoilions for
llo conlrol funclion.
1o sum up, llis molloo suggosls llal llo proLlom is rolurnoo lo solving al-
goLraic oqualions Ly incluoing llo socono nrsl-oroor conoilions. Il is oLviously
moro slraigllforwaro llan ignoring llis conoilion ano solving a TTc for llo
valuo funclion gloLally. Using llo Lagrango mulliplior molloo, llo valuo func-
lion can always Lo calculaloo wlon nooooo Ly suLsliluling llo oplimal conlrol
in llo oLjoclivo funclion.
3.4.4 Tne AartIngaIe Aroacn
Tne AaIn Idea
Harrison ano Krops (1070, [2[) inlrooucoo llo marlingalo molloo lo prico con-
lingonl claims. 1lis approacl was applioo Ly Karalzas n|. (1086, [0[ ano
1087, [60[), Iliska (1086, [8[) ano Cox ano Huang (1080, [20[ ano 1001, [80[) lo
provioo a closoo form solulion for llo oplimal porlfolio wlon llo unoorlying so-
curily pricos follow a gonoral oiusion procoss. For a oolailoo lroalmonl, soo llo
loxlLooks Morlon (1002, [77, Claplor 6[), Dumo (1002, [88[) ano Karalzas ano
Slrovo (1008, [61[). 1lo Lasic iooa is lo uso llo complolonoss ano llo arLilrago-
froo proporly of llo markol lo soparalo llo compulalion of oplimal consumplion
rulos ano llal of a corrosponoing lraoing slralogy. In a nrsl slop, llo oplimal
consumplion is oLlainoo Ly solving llo nrsl-oroor conoilions, ossonlially slaling
llal llo agonl`s marginal ulilily procoss al llo oplimum is proporlional lo an
Arrow-DoLrou slalo prico oonsily procoss. In a socono slop, llo corrosponoing
porlfolio slralogy is oorivoo Ly llo moans of llo marlingalo roprosonlalion llo-
orom Ly assuming llo complolonoss of llo markol. 1lo socono slop is similar lo
3. OynanIc IortIoIIo OtInIzatIon vItn c| 71
llo oplion pricing loclnology wloro consumplion plays llo rolo of caslows.
1o illuslralo llis iooa, consioor llo spocial caso of maximizing llo oxpocloo
ulilily of lorminal woalll. 1lo Jjnnn. :J|. proLlom
max
,
H[n(\
T
)[
is oocomposoo inlo a n. .n..n.n proLlom
max

W
T
Q

V(a)
H
_
n
_

\
T
__

(a) = \ [ \ _ 0, T
T
-moasuraLlo ano 1[j\[ _ a
(8.10)
ano a ::nn.n proLlom
Fino a porlfolio procoss ,
+
sucl llal
\(1) =

\
+
wloro

\
+
solvos (8.10) ano
\(1) is llo woalll procoss al 1 gonoraloo Ly ,
+
AetnodoIogy
Solving llo porlfolio proLlom oillor Ly oynamic programming or Ly llo mar-
lingalo approacl yiolos in principal llo samo solulion. Howovor, llo marlingalo
approacl roquiros aooilional loclnical assumplion aLoul llo consumplion ano
llo lraoing slralogios. Following Cox ano Huang (1080, [20[), llo following
aooilional conoilions musl Lo salisnoo Ly llo consumplion procoss c ano llo
aomissiLlo lraoing slralogy (H
0
(t), H(t)) for oacl t in [0, 1[
1.
_
T
0
[H
0
(t)o
0
(t):(t) H(t)

o(t)j(t)[dt < I-a.s.

2.
_
T
0
[H(t)

o(t)o(t)[
2
dt < I-a.s.
8. H
_
_
T
0
c
2
|
dt
_
< ano H[\
2
T
[ <
Lol /oonolo llo sol of consumplion ano lorminal woalll (c, \
T
) salisfying llo
lliro conoilion.
Givon llo assumplions in llo conlinuous-limo solup, an oquivalonl marlingalo
moasuro oxisls ano is uniquo. Now consioor an invoslor will a ulilily funclion
3. OynanIc IortIoIIo OtInIzatIon vItn c| 72
for consumplion n(a, t) ano a Loquosl funclion of llo lorminal woalll 1(a) ano
an inilial woalll \
0
0. Wo assumo llal n(a, t) ano 1(a) aro slriclly concavo
in a. 1lo invoslor wanls lo solvo llo following proLlom
_
_
_
svp
,,c
H
0
_
_
T
0
c
j|
n(c
|
)dt 1(\
T
)
_
suLjocl lo Luogol conslrainls.
(8.20)
Noling llal llo oLjoclivo funclion in llo proLlom involvos inlorlomporal con-
sumplion ano lorminal woalll only, llo iooa is lo roplaco llo conslrainls involv-
ing Loll inlorlomporal invoslmonl slralogios ano consumplion Ly an oquivalonl
conslrainl involving inlorlomporal consumplion ano lorminal woalll only. Hav-
ing oono llis, llo proLlom can Lo solvoo using llo Lagrango mulliplior molloo.
1lo marlingalo molloo rolios on llo oxislonco of a procoss c for wlicl llo
oiscounloo socurily prico procoss is marlingalo, llal is,
H[c
|
o
|
[ 1
c
[ = c
c
o
c
: _ t.
1lo procoss c is inlorproloo as a syslom of Arrow-DoLrou pricos. 1lal is, llo
valuo of c
|
in oacl slalo givos llo prico por unil proLaLilily of a oollar in llal
slalo. 1lo prico of llo assol is givon Ly llo sum of ils payos in oacl slalo,
mulliplioo Ly llo prico of a oollar in llal slalo, limos llo proLaLilily of llo
slalo occurring. 1lo procoss c is calloo llo slalo-prico ooalor, ano is oqual lo
c
|
=
j
|
o
0
(t)
,
wloro j is llo Iaoon-Nikoo m oorivalivo oonnoo oarlior in Soclion 8.4.1, ano
o
0
(t) is llo prico of llo Lono, consiooroo loro as a numcrairo. For any ranoom
variaLlo 7 will H
"
[[7[[ < , wo lavo
H
"
[7[ = H[j7[,
wloro Q is an oquivalonl marlingalo moasuro for llo oiscounloo socurily pricos.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 73
Cox ano Huang (1080, [20[) slow

llal llo Luogol conslrainls in (8.20) aro

oquivalonl lo
H
__
T
0
c
|
c
|
dt c
T
\
T
_
= \
0
. (8.21)
1lis oquivalonl Luogol conslrainl slalos llal llo lolal cosl of consumplion, as
givon Ly llo amounl consumoo in oacl slalo mulliplioo Ly llo prico of consump-
lion in llal slalo, musl oqual llo invoslor`s inilial woalll. 1lo conlrol c
+
solvos
proLlom (8.20) if ano only if lloro oxisls a scalar Lagrango mulliplior | 0 sucl
llal c
+
solvos llo unconslrainoo proLlom
svp
(c,W
T
)Q/
H
_
_
T
0
[c
j|
n(c
|
) |c
|
c
|
[dt 1(\
T
) |c
T
\
T
_
(8.22)
will llo complomonlary conoilion
H
__
T
0
c
|
c
|
dt c
T
\
T
_
= \
0
.
1lo nrsl-oroor conoilion for llo oplimalily of c
|
ano \
T
aro
c
j|
n
c
(c
+
|
, t) |c
|
= 0
1
t
(\
T
) |c
T
= 0,
wloro n
c
is llo oorivalivo of n will rospocl lo c
|
. 1lo aLovo oqualions aro
oquivalonl lo
c
+
|
= 1(c
j|
|c
|
, t) (8.28)
\
+
T
= 1
1
(|c
T
), (8.24)
wloro 1(, t) ano 1
1
() aro llo invorso funclions of n
c
ano 1 rospoclivoly.
Ly solving for | in llo complomonlary conoilion
H
__
T
0
c
|
1(c
j|
|c
|
, t)dt c
T
1
1
(|c
T
)
_
= \
0

In lloir original papor, llis oquivalonl Luogol conslrainl is givon as Assumplion (2.2). In
a lalor papor, il is provoo using llo complolonoss assumplion.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 74
ano roplacing il in oqualions (8.28) ano (8.24), an oxplicil solulion lo Morlon`s
proLlom is givon. Nolo llal solving for llo oplimal consumplion is complololy
soparalo from solving for invoslmonl slralogios.
Lqualion (8.21) givos llo rolalionslip Lolwoon llo inilial woalll ano fuluro
consumplion. Al limo t, llis rolalionslip slill lolos ano lakos llo form
6
\
|
= c
1
|
H
|
__
T
|
c
c
c
|
d c
T
\
T
_
1lal is, llo woalll al limo t is llo prosonl oiscounloo valuo of fuluro consump-
lion, wloro llo slalo-prico ooalor is llo oiscounl faclor. Wlon llo oplimal
consumplion rulos aro closon, llo woalll al oacl limo is
\
+
|
= c
1
|
H
|
__
T
|
c
c
1(c
j|
|c
|
, t)d c
T
1
1
(|c
T
)
_
. (8.2)
Now, in a complolo markol solling, any conlingonl payo (salisfying somo rog-
ularily conoilions) can Lo roplicaloo Ly a oynamic lraoing slralogy. In ollor
lorms, al oacl limo t, il is possiLlo lo lako posilions in llo : 1 assols so as lo
roplicalo llo woalll \
+
|
. 1lis oplimal lraoing slralogy prooucos llo woalll \
+
|
llal nnancos llo oplimal consumplion c
+
|
.
Inslanlanoous clangos in c
|
rosull in clangos in \
+
|
. Cloosing llo oplimal
porlfolio slralogios is lo porfoclly loogo againsl lloso clangos Ly clanging llo
amounl invosloo in slock. 1lis is possiLlo sinco llo markol is assumoo lo Lo
complolo. Following Cox ano Huang (1080, [20[), oonno a now variaLlo
7
|
=
7
0
o
0
(t)
j
|
= 7
0
c
1
|
,
for somo conslanl 7
0
0. 1lo procoss 7
|
is calloo llo growll-oplimum porlfolio.
Il is a porlfolio llal maximizos llo oxpocloo log ulilily of llo lorminal woalll.
Donno
G(7
|
, o
|
, t) = 7
|
H
|
__
T
|
7
1
c
1(7
1
c
, t)d 7
1
|
1
1
(7
1
T
)
_
. (8.26)
6
Soo Cox ano Huang (1080, [20, Lqualion 2.82[)
3. OynanIc IortIoIIo OtInIzatIon vItn c| 75
SuLjocl lo Lipsclilz-lypo conoilions oonnoo in Cox ano Huang (1080, [20, Con-
oilions A ano C[), llo funclion G las conlinuous socono parlial oorivalivos. For
7
0
= 1,|, llo oplimal woalll is givon Ly
\
+
|
= G(7
|
, o
|
, t).
1lo oplimal lraoing slralogios aro givon Ly
7
H
+
(t) = G
S
(7
|
, o
|
, t)
_
oo

_
1
[o
|
j(t) :(t)o
|
[ 7
|
G
Z
(7
|
, o
|
, t)
H
0+
(t) =

G(7
|
, o
|
, t) H(t)

o(t)
_
,o
0
(t).
If llo joinl proLaLilily of 7 ano A is known, llon G can Lo compuloo oiroclly
from (8.26). Ollorwiso, G salisnos llo following parlial oioronlial oqualion
T
Z,S
GG
|
= G
Z
7

S
o :1 1(7
1
, t)
will llo Lounoary conoilions
G(7, o, 1) = 1
1
(7
1
)
G(7
0
, o
0
, 0) = \
0
wloro T
Z,S
is llo oioronlial gonoralor of (7, o)
T
Z,S
G =
1
2
t:(G
SS
oo

)
1
2
G
ZZ
7
2

SZ
o G

S
j G
Z
7(: ||
2
).
For somo lypo of oynamics of llo unoorlying socurily procossos, il is possiLlo lo
solvo for G oxplicilly. 1lis is acliovoo Ly solving llo parlial oioronlial oqualion
Ly nrsl oocomposing il lo a syslom of oroinary oioronlial oqualions. 1lis locl-
niquo is usoo Ly Dumo ano Kan (1006, [80[) ano applioo lo llo porlfolio proLlom
Ly Kim ano OmLorg (1006, [62[). Wacllor (1000, [100[) usos llis loclniquo lo
nno an oxacl closoo-form solulion lo porlfolio slralogios in llo consumor proLlom
wlon llo orifl of llo unoorlying socurily pricos follows an Ornsloin-UllonLock
procoss.
7
Soo Cox \ Huang (1080, [20, 1loorom 2.1[)
3. OynanIc IortIoIIo OtInIzatIon vItn c| 76
3.5 OIscrete-TIne FInance
In llo moool prosonloo loro, llo invoslor maximizos llo oxpocloo sum of ois-
counloo ulilily of consumplion llrougl limo Ly cloosing invoslmonl ano con-
sumplion rulos oynamically ouring llo porioo of invoslmonl. 1lis oynamic assol
allocalion is Lasoo on llo informalion availaLlo in llo markol up lo llo limo of
rovision of llo porlfolio. 1loroforo, ono nooos lo sol up a mulli-porioo moool
llal aooqualoly incorporalos llo informalion slrucluro. In llis soclion wo follow
Harrison ano Iliska (1081, [1[) ano 1aqqu ano Willingor (1087, [104[). For a
oolailoo lroalmonl, soo Iliska (1007, [86[) ano Linglam ano Kiosol (1008, [17[).
3.5.1 OIscrete-TIne Set-\
1lrougloul llis soclion, wo consioor llo so-calloo nnilo markols, llal is, nnan-
cial markols in wlicl all rolovanl quanlilios lako a nnilo numLor of valuos.
HasIc EIenents oI tne AodeI
1lo mulli-porioo moool in oiscrolo limo is oonnoo Ly llo following:
1 1 lraoing oalos: t = 0, 1, ..., 1.
A nnilo samplo spaco ! will 1 < olomonls: ! = .
1
, .
2
, ..., .
1
,
roprosonling llo sol of llo slalos of llo worlo.
A proLaLilily moasuro I on !, will I(.) 0 for all . !
A nllralion
8
I = T
|
: t = 0, 1, ..., 1
A Lank accounl procoss 1 = 1
|
: t = 0, 1, ..., 1, wloro 1 is a sloclaslic
procoss will 1
0
= 1, ano 1
|
(.) 0 for all t ano .. Usually, 1 is a non-
oocroasing procoss ano llo quanlily :
|
= (1
|
1
|1
) ,1
|1
_ 0 sloulo Lo
llougll of as llo inlorosl ralo ovor llo porioo [t 1, t[.
8
Soo Donnilion 8..1.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 77
A risky socurily procossos o
n
(t) = o
n
(t): t = 0, 1, ..., 1 wloro o
n
is a
non-nogalivo sloclaslic procoss for all : = 1, ..., A, wlicl roprosonls llo
limo t prico of llo socurily :.
Tne InIornatIon Structure
In llo mulli-porioo moool, invoslors roviso lloir posilions al oacl limo t =
1, 2, ..., 1 1. 1lo ovolulion of informalion is moooloo as follows:
Al llo Loginning of llo invoslmonl porioo (t = 0), llo invoslor ooos nol lavo
any informalion aLoul llo fuluro, in llo sonso llal all llo slalos of llo worlo
may occur. A slalo can Lo llougll of as a pall or a soquonco of socurily pricos
from limo 0 lo limo 1. If o
|
oonolos llo sol of possiLlo slalos al limo t, llon o
0
=
! = .
1
, .
2
, ..., .
1
. As limo ovolvos, llo invoslor loarns moro aLoul llo lruo
slalos, so lo rooucos llo numLor of possiLlo fuluro slalos Ly oliminaling llo onos
llal cannol lappon aflor llo limo of rovision. 1lis ovolulion of informalion is
moooloo Ly a oocroasing soquonco of sols o
|
, llal is, o
0
_ o
1
_ ... _ o
T
, wloro
oacl o
|
is a parlilion of ! Lul nnor llan o
|1
. For oxamplo, al limo t = 1,
llo invoslor oLsorvos llo movomonls of llo markol pricos so lo rulos oul llo
impossiLlo slalos ano koops a suLsol of slalos llal aro likoly lo lappon aflor
t = 1. Honco lo forms a parlilion o
1
= .
1
, .
2
, ..., .
j
, .
j1
, .
j2
, ..., .
1

of !. Aflor limo t = 1, lo is moro inlorosloo in oillor llo nrsl or llo socono

suLsol of o
1
as only ono of llom conlains llo lruo slalo .. Ano so on, unlil llo
malurily 1 wloro llo lruo slalo . is rovoaloo, o
T
= .
1
, .
2
, ..., .
n
.
Sone OefnItIons
OefnItIon 3.5.1 ||.n T J &h J !, . n||J nn n|jh:n n ! .J:
1. ! T
.. 1 T =1
c
/ !\1 T
. 1 nnJ G T =1 ' G T
3. OynanIc IortIoIIo OtInIzatIon vItn c| 78
Now, givon an algoLra T
|
on !, lloro oxisls a uniquo parlilion o
|
of ! incluooo
in T
|
. Ano convorsoly, for oacl parlilion of ! ono can form an associaloo algoLra
Ly laking inlorsoclions, complomonls ano unions of llo olomonls of llo parlilion.
Honco lloro is a ono-lo-ono corrosponoonco Lolwoon llo parlilion o
|
of ! ano
llo algoLra T
|
. 1loroforo, llo informalion slrucluro can Lo organizoo as an
incroasing soquonco T
|

0|T
, sucl llal T
0
_ T
1
_ ... _ T
T
. 1lis soquonco of
algoLras is calloo a nllralion I.
OefnItIon 3.5.2
:n|-n|&J :nnJn n:.nh| A . n.J h nn&:nh| .h :
h n|jh:n T .J h J&n.n . A(.) . nnn n nnj &h .n h
n:..n ::nJ.nj T. 1j&.n|n|j, J: :j :n| n&nh: a, h
&h . ! : A(.) = a . nn |nn J h n|jh:n T.
: H = (H(t))
|0
. n.J h nJnJ h ]|:n.n I .J nh
:nnJn n:.nh| H(t) . nn&:nh| .h : T
|
J: n|| t _ 0.
: H = (H(t))
|0
. n.J h :J.nh| .h : h ]|:n-
.n I .J nh :nnJn n:.nh| H(t) . nn&:nh| .h : T
|1
J:
n|| t _ 0.
: A = (A
|
)
|0
. n||J n nn:.njn|
0
:|n. n ]|:n.n I .J:
1. A . nJnJ I
.. H [A
|
[ < J: n|| t _ 0
. H [A
|
[ T
|1
[ = A
|1
J: t _ 1
1lo marlingalo proporly (8) slalos llal, llo Losl forocasl of unoLsorvoo
fuluro valuos of A Lasoo on llo informalion al limo t is A
|
. Moroovor, using
llo lowor proporly of conoilional oxpoclalion, llo oxpoclalion of A
|
, H [A
|
[ is
conslanl for all t _ 0. So a marlingalo is conslanl on avorago. 1lis is wly il is
oflon saio llal a marlingalo is a fair gamo.
0
An oxcollonl analysis of oiscrolo marlingalos can Lo founo in Williams (1001, [114[)
3. OynanIc IortIoIIo OtInIzatIon vItn c| 79
OefnItIon 3.5.3
:nJ.nj :njj H = (H
0
, H
1
, ..., H
`
) . n : J hn. :
H
n
= H
n
(t): t = 1, 2, ..., 1, J: : = 0, 1, ..., A. Jh j&nn.j H
n
(t) . h
n&nh: J &n. J &:.j : hn nn .n: n::. J:n:J J:n .n
t 1 .n t ;H
n
(0) . n J]nJ).
Jh n|& : V = V
|
: t = 0, 1, ..., 1 . n hn. : J]nJ hj
V
|
=
_
_
_
H
0
(1)1
0

`
n=1
H
n
(1)o
n
(0), t = 0
H
0
(t)1(t)

`
n=1
H
n
(t)o
n
(t), t _ 1
V
|
. h .n-t n|& J h :J|. hJ: nnj :nnn.n n: nnJ n
hn nn .n.
n&n.n : ( = (
|
, t = 0, ..., 1 . n nn-njn., nJnJ
hn. : .h (
|
::n.nj h nn&n J J&nJ n&nJ hj
h .n: n .n t.
n&n.n-.nnn |nn ((, H) . n.J h |J-]nnn.nj .J
V
|
= (
|
H
0
(t 1)1(t)
`

n=1
H
n
(t 1)o
n
(t), t = 0, ..., 1 1
(8.27)
3.5.2 Tne OynanIc IrogrannIng Aroacn
CeneraI AetnodoIogy
An invoslor will a von Nouman-Morgonslorn ulilily funclion n, ano inilial woalll
cloosos llo consumplion-invoslmonl plan llal maximizos llo oxpocloo ulilily
of consumplion llrougl limo accoroing lo llo following proLlom
_

_
max
(C,1)
H
_

T
|=0
,
|
n((
|
)
_
suLjocl lo V
0
=
V
|
= (
|
H
0
(t 1)1(t)

`
n=1
H
n
(t 1)o
n
(t): t = 0, ..., 1 1
V
T
= (
T
(8.28)
3. OynanIc IortIoIIo OtInIzatIon vItn c| 80
Following Iliska (1007, [86[), oonno J
|
(\) as llo maximum(ovor all solf-nnancing
lraoing slralogios) ulilily of consumplion llrougl limo, slarling will woalll \
ano consumplion al limo t ano givon llo limo t lislory T
|
. 1lis is llo valuo
funclion of llo proLlom of maximizalion on llo porioo [t, 1[. 1lo iooa is lo
oocomposo llo proLlom lo a sorios of singlo porioo proLloms going Lackwaro in
limo.
Al limo 1, llo invoslor consumos all llo woalll. 1loroforo, J
T
= n. Al limo
1 1, llo invoslor sooks lo
_

_
max
1(T),C
T31
n((
T1
) H[,J
T
(\
T
)[T
T1
[
suLjocl lo \
T1
= (
T1
H
0
(1)1
T1

`
n=1
H
n
(1)o
n
(1 1)
\
T
= H
0
(1)1
T

`
n=1
H
n
(1)o
n
(1)
(
T1
ano H
n
(1) T
T1
\: = 0, ..., A
Lol ^o
+
n
(t) = o
n
(t),1
|
o
n
(t1),1
|1
, llon an oquivalonl formulalion oLlainoo
Ly oliminaling H
0
(1) is
_

_
max
1(T),C
T31
n((
T1
) H
_
_
,J
T
_
_
(\
T1
(
T1
)1
T
,1
T1
1
T

`
n=1
H
n
(1)^o
+
n
(1)
_
_

T
T1
_
_
suLjocl lo (
T1
ano H
n
(1) T
T1
\: = 0, ..., A
1lo valuo funclion for llo aLovo oplimizalion proLlom is J
T1
(\).
Moro gonorally, al oacl limo t [0, 1 1[, laving compuloo J
|
(\), llo valuo
funclion J
|1
(\) is
J
|1
(\) = max
1(|),C
I31
_
_
_
n((
|1
) ,H
_
_
J
|
_
_
(\ (
|1
)1
|
,1
|1
1
|

`
n=1
H
n
(t)^o
+
n
(t)
_
_

T
|1
_
_
_
_
_
1lo aLovo oqualion is calloo llo Jjnnn. :j:nnn.nj J&n.nn| j&n.n.
1lo consumplion procoss is roquiroo lo Lo non-nogalivo. If llo ulilily funclion is
sucl llal n(() = if ( _ 0, wo solvo for llo oplimal conlrols H
+
ano (
+
will-
oul worrying aLoul llo conslrainls (
|
_ 0 for all t = 0, ..., 1. Ollorwiso, al oacl
3. OynanIc IortIoIIo OtInIzatIon vItn c| 81
slop t, llo oplimizalion sloulo lako llo conslrainls oxplicilly inlo consiooralion
using loclniquos liko Kuln ano 1uckor. Inoqualily conslrainls Lring signincanl
aooilional oimcully as llo oLjoclivo funclion of llo oplimizalion proLlom may
fail lo Lo conlinuously oioronliaLlo al poinls wloro llo conslrainl clangos from
Loing aclivo.
Nolo llal llis molloo solvos llo maximizalion proLlom 1 limos. Al oacl
limo, wo calculalo llo valuo funclion J
|
(\) givon llo slarling woalll al llo
Loginning of llo porioo. So wo supposo wo know llo slarling woalll \ ano
llon wo compulo consumplion ano invoslmonl rulos llal corrospono lo J
|
(\).
Howovor, \ is unknown al llis slago sinco il rosulls from llo invoslmonl ovor llo
porioo [0, t 1[. 1loroforo, unloss wo compulo an analylical oxprossion of J
|
(\)
in lorms of \, llo singlo oplimizalion proLloms aro numorically nol inooponoonl.
1o oLlain llo oplimal consumplion ano invoslmonl slralogios, llo nrsl oroor
conoilions aro usoo. 1lis assumos llal llo oLjoclivo funclion is slriclly concavo.
1lis is assumplion follows immooialoly form llo slricl concavily of llo ulilily
funclion. 1lo following analysis provos llis implicalion in a simplo caso of ono
risky assol ano ono riskloss assol, Ly an inouclion argumonl. 1lo proLaLililios
of up ano oown jumps aro sol lo 1,2, ano llo limo proforonco faclor , is sol lo
1. Gonoralizalion lo moro llan lwo assols is slraigllforwaro.
Al limo 1, J
T
= n wlicl is a slriclly concavo funclion Ly assumplion. Sup-
poso llal J
|1
is slriclly concavo, llon wo will slow llal J
|
is also slriclly concavo
ano lloro is a uniquo rogular inlorior maximum.
As slown oarlior, llo mulli-porioo proLlom can Lo rooucoo lo many singlo
porioo proLloms. In llo conloxl of a Linomial moool, al oacl nooo llo proLlom
is
J
|
(\
|
) = max
c,I
d
|
(c, h, \
|
)
wloro
d
|
(c, h, \
|
) = n(c)
1
2

J
|1
_
\
&
|1
_
J
|1
_
\
J
|1
__
3. OynanIc IortIoIIo OtInIzatIon vItn c| 82
\
&
|1
= (1 :)(\
|
c) 1
|
^o
+&
h
\
J
|1
= (1 :)((\
|
c) 1
|
^o
+J
h
wloro c ano h aro rospoclivoly consumplion ano llo numLor of unils lolo in llo
risky socurily alo llo curronl nooo. 1lo funclion d
|
is a slriclly concavo, inoooo
0
2
d
|
0h
2
=
1
2
|
2

(^o
+&
)
2
J
tt
|1
(\
&
1
) (^o
+J
)
2
J
tt
|1
(\
J
1
)
_
0
2
d
|
0c
2
=
(1 :)
2
2

J
tt
|1
(\
&
1
) J
tt
|1
(\
J
1
)
_
0
2
d
|
0h0c
=
1
|
(1 :)
2

^o
+&
J
tt
|1
(\
&
1
) ^o
+J
J
tt
|1
(\
J
1
)
_
Sinco Ly llo inouclion assumplion J
|1
is slriclly concavo, wo lavo
0
2
d
|
0c
2
< 0,
0
2
d
|
0h
2
< 0
ano
oci
_
_
0
2
+
I
0c
2
0
2
+
I
0I0c
0
2
+
I
0I0c
0
2
+
I
0I
2
_
_
=
_
^o
+&
^o
+J
_
2
J
tt
|1
(\
&
1
)J
tt
|1
(\
J
1
) 0
1loso aro sumcionl conoilions for a rogular inlorior maximum.
3.5.3 Tne AartIngaIe Aroacn
In llis soclion, wo solvo llo samo proLlom (8.28) using a marlingalo approacl,
also calloo llo risk-noulral compulalional approacl. An invoslor will an ini-
lial woalll ano a von Nouman-Morgonslorn ulilily funclion n cloosos llo
consumplion-invoslmonl plan llal maximizos llo oxpocloo ulilily of consump-
lion llrougl limo accoroing lo llo following proLlom
_

_
max
(C,1)
H
_

T
|=0
,
|
n((
|
)
_
suLjocl lo V
0
=
V
|
= (
|
H
0
(t 1)1(t)

`
n=1
H
n
(t 1)o
n
(t): t = 0, ..., 1 1
V
T
= (
T
(8.20)
3. OynanIc IortIoIIo OtInIzatIon vItn c| 83
In proLlom (8.20), llo invoslor sooks lo maximizo llo oLjoclivo funclion
wlon facing llo lraoo-o Lolwoon llo consumplion ano invoslmonl slralogy al
llo Loginning of oacl limo porioo [t, t 1[, t = 0, ..., 1 1. Nolo llal llo voclor
of lraoing slralogios H, wlicl is a conlrol variaLlo in llo oplimizalion proLlom,
appoars in llo conslrainls Lul nol in llo oLjoclivo funclion. As wo saw oarlior,
llo oynamic programming approacl consisls of compuling, working Lackwaro
in limo t in a rocursivo mannor, llo oLjoclivo valuo funclion, ano llo oplimal
consumplion ano invoslmonl rulos.
1lo iooa of llo risk-noulral compulalional approacl is lo roplaco llo con-
slrainls in proLlom (8.20) Ly oquivalonl conslrainls llal oo nol involvo llo in-
voslmonl slralogy voclor H. 1lo only conlrol variaLlo Loing llo voclor of con-
sumplion (, llo proLlomcan Lo solvoo using llo Lagrango molloo for a slanoaro
slalic oplimizalion proLlom.
1lo assumplion of a complolo markol onsuros llo oxislonco of an oquivalonl
marlingalo proLaLilily Q, sucl llal llo inilial woalll is oqual lo llo oxpoclalion
unoor Q of llo oiscounloo consumplion llrougl limo.
Iocall llal Q is sucl llal
1. Q(.) 0 for all . !.
2. 1lo oiscounloo prico procoss o
+
|
= o
|
,1
|
is a marlingalo unoor Q for all
t _ 0.
Iliska (1007, [86[) slows llal proLlom (8.20) is oquivalonl lo
_

_
max
C
H
_

T
|=0
,
|
n((
|
)
_
suLjocl lo H
"
_

T
|=0
(
|
,1
|
_
=
ano ( is an aoaploo procoss
wloro (1
|
) is llo Lank accounl procoss ano Q is llo oquivalonl risk-noulral
marlingalo moasuro. H oonolos llo oxpoclalion unoor llo roal worlo proLaLilily
moasuro I ooscriLing llo invoslor`s Loliofs aLoul llo slalos of llo worlo, ano
H
"
is llo oxpoclalion unoor llo risk-noulral moasuro Q.
3. OynanIc IortIoIIo OtInIzatIon vItn c| 84
Lol 1 = Q,ILo llo slalo prico oonsily, ano oonno llo conoilional oiscounloo
slalo prico oonsily
A
|
(.) =
H[1[T
|
[(.)
1
|
for all t _ 0 ano all . in !. (8.80)
1lo proLlom (8.20) is oquivalonl lo
_

_
max
C
H
_

T
|=0
,
|
n((
|
)
_
suLjocl lo H
_

T
|=0
(
|
A
|
_
=
ano ( is an aoaploo procoss.
Using Lagrango mulliplior lo solvo llis proLlom, llo nrsl oroor conoilions aro
(
+
|
(.) = 1
_
`A
|
(.)
,
|
_
for all . ! ano t = 0, 1, ..., 1, (8.81)
wloro 1 = [n
t
[
1
is llo invorso funclion of llo marginal ulilily funclion, ano `
is a Lagrango mulliplior oolorminoo Ly suLsliluling llo oplimal consumplion
policy inlo llo slalic Luogol conslrainl
H
_
T

|=0
1
_
`A
|
,
|
_
A
|
_
= .
Onco llo oplimal consumplion rulos (
+
aro oLlainoo, llo solf-nnancing conoilion
is usoo lo compulo llo lraoing slralogios llal nnancos (
+
, using llo Luogol
oqualion
H
0
(t)1(t)
`

n=1
H
n
(t)o
n
(t) = (
|
H
0
(t 1)1(t)
`

n=1
H
n
(t 1)o
n
(t). (8.82)
In llo following soclion wo slall apply llo marlingalo approacl lo nno llo
oplimal consumplion rulos in llo consumplion-invoslmonl proLlom (8.20) wloro
llo invoslor`s proforoncos aro roprosonloo Ly a spocinc class of ulilily funclions.
3.6 ConcIusIon
1lis claplor las survoyoo oioronl oplimizalion loclniquos in solving oplimal
porlfolio proLloms, namoly 1A(/, llo Lagrango mulliplior ano llo oynamic
3. OynanIc IortIoIIo OtInIzatIon vItn c| 85
programming. In llo noxl claplor wo uso 1A(/ lo nno llo oplimal consump-
lion rulos for llo H/1/class of ulilily funclions using lallicos. Wo also consioor
oynamic programming ano proposo a oioronl way lo implomonl il using sym-
Lolic programming.
lLaplci 1
SIochauIIc LynanIc
1togtannIng vctuuu
AatIIngaIc AcIhodu
In 1otIIoIIo ScIccIIon
4.1 IntroductIon
1lo oynamic programming approacl lo solving llo porlfolio proLlomin conlinuous-
limo, as oolailoo in Soclion 8.4.2, involvos solving llo HE oqualion. Wloro llo
unoorlying oiusion procossos of llo risky assols aro rolalivoly simplo (Goomol-
ric Lrownian molion will possiLly limo-varying orifl), oflon oxplicil solulions
for llo oplimal conlrols (consumplion ano invoslmonl rulos), c
+
ano ,
+
can Lo
founo. For casos wloro llo risky assol procoss involvos jumps, rogimo swilcling,
sloclaslic volalilily ano so on, wo usually rosorl lo numorical molloos. Sucl
molloos nocossarily involvo llo oiscrolizalion of llo proLlom, using for inslanco
Markov clain approximalion.
Sinco in praclico, invoslors roviso lloir porlfolios al oiscrolo momonls llrougl
limo, a nalural approacl consisls of solving llo oplimizalion proLlom oiroclly
in a oiscrolo-limo solling. 1lis is llo approacl consiooroo Ly Samuolson (1060,
[06[), wloro llo proLlom is solvoo Lackwaros in limo using llo principlo of op-
limalily. Lacl Lackwaros slop involvos an oplimizalion proLlom. A llorny
issuo immooialoly prosonls ilsolf: al wlal valuo of woalll sloulo llo Lackwaros
rocursion Lo slarloo 1wo solulions prosonl llomsolvos.
Firslly, ono coulo simply uso a grio of likoly woalll valuos al oacl limo porioo
ano oLlain llo valuos of llo oplimal conlrols c
+
ano ,
+
for oacl valuo of woalll.
Wlilo slraigllforwaro, sucl an approacl is cloarly oxponsivo.
86
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 87
Allornalivoly, ono can viow woalll as llo slalo variaLlo of llo porlfolio proL-
lom, ano oxpross c
+
ano ,
+
oxplicilly in lorms of woalll ano ollor paramolors of
llo proLlom. As wo movo Lack llrougl limo llo calculus involvoo in oolormining
llo oplimal conlrols quickly Locomos onormously looious, lowovor.
1lis loaos us lo suggosl a novol approacl llal usos a symLolic mallomali-
cal packago lo ovalualo llo oplimal conlrols in llo oiscrolo-limo vorsion of llo
oynamic programming approacl. Sucl an approacl is valio for slriclly concavo
ulilily funclions ano for any givon oislriLulion of arLilrago-froo socurily pricos.
Wo lavo calloo llis approacl 5jnh|. 1jnnn. 1:j:nnn.nj.
An allornalivo lo oynamic programming solulions lo llo porlfolio proLlom
is llo risk-noulral compulalional approacl (1A(/). 1lis approacl originalos
from llo insigll llal llo oplimizalion proLlom`s oLjoclivo involvos consumplion
only. 1lon, using a marlingalo argumonl, il is possiLlo lo roplaco llo Luogol
conslrainls involving Loll consumplion ano invoslmonl slralogios Ly an oquiv-
alonl conslrainl involving consumplion only. 1wo slops aro lofl lo complolo
llo solulion. Firsl, solving for oplimal consumplion using Lagrango mulliplior
molloo. 1lon, oolormining llo oplimal lraoing slralogy llal nnancos llo opli-
mal consumplion using a risk-noulral valualion liko in oorivalivo pricing.
1lis claplor is organizoo as follows. Soclions 4.2 ano 4.8 oolail llo consump-
lion-invoslmonl proLlom in oiscrolo limo using 1A(/, giving somo now lloorol-
ical rosulls rolaling lo llo H/1/ class of ulilily funclions, as woll as provioing
an algorillm for numorically solving llo proLlom. Soclion 4.4 givos oolails on us-
ing oTT lo solving llo consumplion-invoslmonl proLlom wlilo Soclion 4. lroals
llo conlinuous-limo caso ano incluoos oolails on Markov clain approximalion
in solving llo HE oqualion. Soclion 4.6 concluoos Ly comparing 1A(/ will
oTT .
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 88
4.2 OtInaI ConsuntIon Ior tne H/1/
CIass oI \tIIIty FunctIons
1lo HyporLolic ALsolulo Iisk Avorsion (H/1/) class of ulilily is a ricl family
of ulilily funclions wloso moasuro of aLsolulo risk avorsion, ((), is posilivo
ano lyporLolic in consumplion. 1lal is,
(() /
n
tt
(()
n
t
(()
=
1
_
C
1

b
o
_ 0
suLjocl lo llo roslriclions
,= 1, c 0,
c(
1
/ 0,
ano / = 1 if =
All olomonls of llo H/1/ class can Lo oxprossoo as
n(() =
1

_
c(
1
/
_

: / 0. (4.1)
Il follows llal
n
t
(() = c
_
c(
1
/
_
1
1(a) / [n
t
[
1
(a) =
1
c
_
_
a
c
_ 1
_31
/
_
. (4.2)
Will suilaLlo aojuslmonl of llo paramolors c, / ano , llo ulilily funclion
corrosponoing lo incroasing, oocroasing or conslanl rolalivo or aLsolulo risk avor-
sion can Lo oLlainoo, soo Soclion 2.2.4. 1lo following lomma is usoful for lalor
oovolopmonl.
Lenna 4.2.1 {HAHA transIornatIon) 1: n H/1/&.|.j J&n.n n, h
.n: J&n.n 1 / [n
t
[
1
n.]
1(a`) = 1(`)a
1
_31

/(1 )
c
_
a
1
_31
1
_
= 1(`)a
1
_31
1(c/
1
a) (4.8)
J: nnj :n|-n|&J n:.nh| a nnJ ` .n h Jnn.n J J]n..n J 1.
IrooI. Slraigllforwaro algoLra using (4.2).
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 89
4.2.1 SIngIe-IerIod AodeI
Lol us consioor llo consumplion-invoslmonl proLlom inlrooucoo in Soclion 8..8,
ano assumo llal llo invoslor las H/1/ ulilily funclion. In llo caso wlon
1 = 1, llo proLlom is
_

_
max
C
n((
0
) ,H[n((
1
)[
suLjocl lo (
0
H[(
1
1,1
1
[ =
ano ( is an aoaploo procoss
wloro 1 is llo slalo-prico oonsily. From llo gonoral oxprossion of llo solulion
(8.81), llo oplimal consumplion is
(
+
0
= 1(`) ano (
+
1
(.) = 1
_
A
o1
1
1(.)
_
, for all . !
wloro ` salisnos
1(`) H
"
_
1
1
1
1
_
`
,1
1
1
__
= (4.4)
ano 1 is llo invorso funclion of llo marginal ulilily givon Ly (4.2).
Iulling H = H
"
_
1
1
1
_
,
1
1,1
1
_ 1
_31
_
, llon llo solulion lo Lqualion (4.4) is
1(`
+
) =

b(1)
o
(H
1
1
1
)
1 H
or `
+
= c
_
c
1
_

b(1)
o
(H
1
1
1
)
1 H
_
/
_
1
.
In llis caso, llo oplimal consumplion rulos al limo t = 0 ano t = 1 rospoc-
livoly aro
(
+
0
=

b(1)
o
(H
1
1
1
)
1 H
(
+
1
(.) =
_
1(.)
,1
1
_ 1
_31
(
+
0

/(1 )
c
_
_
1(.)
,1
1
_ 1
_31
1
_
, for all . !
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 90
4.2.2 Tvo-IerIod AodeI
From llo gonoral oxprossion (8.81) of llo solulion lo llo consumor proLlom, llo
oplimal consumplion al limos t = 0, 1 ano 2 rospoclivoly aro
(
+
0
= 1(`), (
+
1
(.) = 1
_
`
,
A
1
(.)
_
ano (
+
2
(.) = 1
_
`
,
2
A
2
(.)
_
wloro A is llo conoilional oiscounloo slalo-prico oonsily oonnoo in Lqualion
(8.80) ano 1 is llo invorso of llo marginal ulilily givon Ly (4.2).
Dolormining A
|
(.) ooponos on llo moool usoo for pricos. In llo caso of a
non-rocomLining Linomial lallico (soo Figuro (4.1)), lloro aro 4 slalos of llo
worlo .
1
, .
2
, .
S
, .
1
. 1lo valuos of A
1
ano A
2
aro compuloo as follows
1
States
S
2
uu
w1 (1/4)
S
1
u
S
2
ud
w2 (1/4)
S
0
S
2
du
w3 (1/4)
S
1
d
S
2
dd
w4 (1/4)
Figuro 4.1: A 1wo-Iorioo Non-IocomLing Linomial Lallico
Q
1
+$, @
_

_
1
1
1
"(.
1
)"(.
2
)
(.
1
)(.
2
)
$ $
1
> $
2

1
1
1
"(.
3
)"(.
4
)
(.
3
)(.
4
)
$ $
S
> $
1

Q
2
+$, @
O+$,
E
2
$ $
1
> $
2
> $
S
> $
1

ano llo Lagrango mulliplior ` salisnos

1(`) H
_
A
1
1
_
`A
1
,
__
H
_
A
2
1
_
`A
2
,
2
__
= . (4.)
1
Calculaling Q
w
+$, in llo gonoral caso is oiscussoo in Soclion 4.8.1.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 91
Iul H
1
= H
_
A
1
(A
1
,,)
1
_31
_
ano H
2
= H
_
A
2
_
A
2
,,
2
_ 1
_31
_
, ano uso llo
H/1/ lransformalion lomma (4.2.1) lo oLlain a solulion lo Lqualion (4.)
1(`
+
) =

b(1)
o
(H
1
H
2
H[A
1
[ H[A
2
[)
1 H
1
H
2
Honco, llo oplimal consumplion al limos t = 0, t = 1 ano t = 2 aro rospoc-
livoly
(
+
0
= 1(`
+
)
(
+
1
(.) =
_
A
1
(.)
,
_ 1
_31
_
1(`
+
)
/(1 )
c
_

/(1 )
c
(
+
2
(.) =
_
A
2
(.)
,
2
_ 1
_31
_
1(`
+
)
/(1 )
c
_

/(1 )
c
4.2.3 OtInaI ConsuntIon In AuItIerIod AodeI
In llis paragrapl wo provioo an oxplicil solulion for llo porlfolio proLlom
_

_
max
C
H
_

T
|=0
,
|
n((
|
)
_
suLjocl lo H
"
_

T
|=0
(
|
,1
|
_
=
ano ( is an aoaploo procoss
(4.6)
wloro n Lolongs lo llo H/1/class of ulilily funclions givon Ly (4.1). In Soclion
8..8, llo oplimal consumplion is oorivoo as
(
+
|
= 1
_
`
+
A
|
,
|
_
wloro
1(a) =
1
c
_
_
a
c
_ 1
_31
/
_
ano `
+
is llo Lagrango mulliplior, solulion lo
H
_
T

|=0
1
_
`A
|
,
|
_
A
|
_
= (4.7)
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 92
Using llo H/1/ lransformalion lomma (4.2.1), llo solulion lo Lqualion (4.7)
is
1(`
+
) =

T
|=0
H
_
A
|
1
_
c/
1
A
|
,
|
__

T
|=0
H
_
A
|
_
A
|
,
|
_ 1
_31
_ . (4.8)
Using again llo H/1/ lransformalion lomma (4.2.1), llo oplimal consumplion
is
(
+
|
= 1(`
+
)
_
A
|
,
|
_ 1
_31
1
_
c/
1
A
|
,
|
_
.
1lis is an oxplicil solulion sinco llo paramolors c, /, aro llo ulilily inpul pa-
ramolors, , is llo oiscounl faclor in llo proLlom (4.6) ano A
|
is llo oiscounloo
conoilional avorago of llo slalo prico oonsily wloso valuo ooponos on llo proLa-
Lilily oislriLulion in llo moool. In llo following wo uso llis oxplicil solulion lo
oorivo llo oplimal consumplion for somo oxamplos of ulilily funclions llal aro
mosl usoo.
Lxamplo 1: Quaoralic ulilily: ( = 2, c 0, / =
1
o
)
n(() = (
1
2
c
2
(
2
1(a) =
1
c
2
(1 a).
In llis caso (4.8) simplinos lo
1(`
+
) =

1
c
2

T
|=0
1
,
|
H[A
2
|
[

1
c
2
,
ano
(
+
|
=
A
|
,
|
_
_
_
_

1
c
2

T
|=0
1
,
|
H[A
2
|
[

2
c
2
_
_
_
_

1
c
2
.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 93
Lxamplo 2: Logarillmic ulilily: (/ = 0, c = 1, 0)
n(() = ln((),
1(a) =
1
a
.
1lo Lagrango mulliplior salisnos
1(`
+
) =

T
|=0
,
|
ano
(
+
|
=
,
|

T
|=0
,
|

A
|
.
Lxamplo 8: Iowor ulilily: (/ = 0, < 1)
x+F, @
+4 ,
(1)

>
L+{, @
4
d
1
{
1
_31
=
1lo Lagrango mulliplior salisnos
1(`
+
) =

T
|=0
H
_
A
|
_
A
|
,
|
_ 1
_31
_
ano
(
+
|
=

_
`
I
o
I
_ 1
_31

T
|=0
H
_
A
|
_
A
|
,
|
_ 1
_31
_.
From llo provious analysis, il is cloar llal llo risk-noulral compulalional
approacl is an omcionl loclniquo for compuling llo oplimal consumplion rulos
oiroclly as a funclion of llo proLlomparamolors (inilial woalll, proLaLilily of llo
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 94
slalos, ...). 1lo oplimal lraoing slralogy llal nnancos llis consumplion can Lo
compuloo using llo Luogol conslrainl oqualion (8.82) in a Lackwaro rocursion.
Il is worll noling llo oioronco will llo oynamic programming approacl wlicl
givos llo oplimal consumplion ano invoslmonl slralogios in lorms of woalll al
llo Loginning of llo porioo wlicl is unknown al llo curronl limo.
4.3 1A(/ InIenentatIon
1lis soclion roviows llo 1A(/ ano sols oul an algorillm lo implomonl il for
Loll rocomLining ano non-rocomLining lallicos. 1lo slops of llo procoouro aro
as follows:
1. Compulo I(.) ano Q(.) for all . !
2. Compulo A
|
(.) = 1
1
|
H[1[T
|
[(.), wlicl is llo oiscounloo avorago of llo
slalo prico oonsily givon llo informalion al limo t. 1lo informalion al limo
t, corrosponos lo a sol of possiLlo slalos of llo worlo wlicl romain aflor llo
invoslor rulos oul llo irrolovanl salos. Compulalionally, llis corrosponos
lo llo nooo in llo lallico, wlicl al limo t < 1 summarizos a sol of sovoral
slalos of llo worlo.
8. Solvo for llo Lagrango mulliplior salisfying
H
_
T

|=0
1
_
`A
|
,
|
_
A
|
_
= .
4. 1lo oplimal consumplion slroam is oonnoo Ly
(
+
|
(.) = 1
_
`A
|
(.)
,
|
_
fpr all . !
wloro llo variaLlos aro oonnoo in llo provious soclion.
. Compulo llo solf-nnancing slralogy gonoraling llo consumplion (
+
|
using
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 95
llo Luogol oqualion
H
0
(t)1(t)
`

n=1
H
n
(t)o
n
(t) = (
|
H
0
(t 1)1(t)
`

n=1
H
n
(t 1)o
n
(t).
4.3.1 ^on-HeconLInIng HInonIaI LattIce
1lo Linomial moool, nrsl inlrooucoo Ly Cox, Ioss ano IuLinsloin (1070, [82[)
is simplo yol froquonlly usoo lo moool llo prico of a risky assol (slock). Locauso
of ils omcioncy in lorms of compulalion, il is oflon usoo lo prico various kinos
of slock oplions.
1lo non-rocomLining Linomial lallico ooos nol conslrain oillor llo jump
faclors or llo jump proLaLililios lo Lo oqual across limo. 1lis oxiLilily is
componsaloo Ly llo facl llal llo numLor of nooos grows oxpononlially llrougl
limo. 1lis is wly rocomLining Linomial lallico is usoo wlon llo numLor of
porioos is largo ( 13). Novorlloloss, wlon llo moool ooos nol roquiro a largo
numLor of limo porioos lo givo an accuralo pricing, non-rocomLining lallico can
Lo usoo, for oxamplo soo Amin ano Loourlla (100, [2[).
Wlon implomonling a lallico, spocial caro is givon lo cooing lallico nooos
so as lo facililalo calculalions of socurily pricos ano llo proLaLilily llal llo
socurily prico oquals llo valuo assignoo lo llo nooo. In llo following, wo proposo
an implomonlalion llal simplinos llo compulalions consiooraLly.
A nooo is a pair (t,
|
), wloro t = 0, 1, ..., 1 is limo ano
|
0, ..., 2
|
1 is
llo nooo numLor. Aflor an up jump, llo socurily prico is assignoo lo llo nooo
(t 1, 2
|
1) ano aflor a oown jump, llo nooo is (t 1, 2
|
), soo Figuro (4.2).
Al limo t = 0, llo nooo is (0, 0). Calculaling llo prico ano llo proLaLililios al
llo nooo (t,
|
) roquiros kooping lrack of llo pall followoo Ly llo socurily from
limo 0, lo t. 1lis can Lo acliovoo using llo following algorillm.
AIgorItnn 4.3.1
Fxuuhqw qrgh =@ (t,
|
)
Qxpehu ri xs mxpsv @ 3>
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 96
Sdwk =@ O:
Orrs xqwlo wlph 3/
li
|
lv hyhq/
wkhq

|1
:=

|
2
:
Sdwk =@ ~grzq ' Sdwk>
lqfuhphqw Qxpehu ri grzq mxpsv>
hqg li
li
|
lv rgg/
wkhq

|1
=@

|
1
2
Sdwk =@ ~xs ' Sdwk>
hqg li
hqg Orrs
1lo aLovo algorillm is oquivalonl lo llo Linary roprosonlalion of llo nooo
numLor
|
. Inoooo, if 1 roprosonls an up jump ano 0 a oown jump, llon llo
pall of llo socurily movos can Lo roprosonloo Ly llo valuo of
|
in Laso 2. For
oxamplo, al limo t = 4, llo nooo 0 = (1001)
2
corrosponos lo llo pall +xs/
grzq/ grzq/ xs,.
(t+1,2s
t
+1)
(t,s
t
)
(t+1,2s
t
)
Figuro 4.2: Cooing Non-IocomLining Linomial Lallico Nooos
SecurIty IrIces OIstrILutIon
1lo socurily pricos aro oxogonous. 1o oacl nooo (t, i) corrospono an up jump
ano a oown jump faclor n(t, i) ano d(t, i) llal oolormino llo fuluro prico al llo
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 97
s
t
15
14
13
12
11
10
9
8
7 7
6 6
5 5
4 4
3 3 3
2 2 2
1 1 1 1
0 0 0 0 0
t
Figuro 4.8: Non-IocomLining Linomial Lallico
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 98
nooos (t 1, 2i 1) ano (t 1, 2i) rospoclivoly.
o(t 1, ;) =
_
_
_
o(t, i)n(t, i) if ; = 2i 1
o(t, i)d(t, i) if ; = 2i
1lo socurily prico al llo nooo (t, i) is oqual lo llo socurily prico al limo 0
mulliplioo Ly llo prooucl of jump faclors llrougloul llo pall corrosponoing lo
(t, i). 1lis pall is compuloo using Algorillm 4.8.1.
1lo oiscounloo socurily pricos aro givon Ly o
+
(t,
|
) = o(t,
|
),1(t) wloro
1(t) is llo Lank accounl al limo t, oqual lo

|
=1
(1 :

, wloro :

is llo risk-
froo inlorosl ralo provailing ovor llo porioo [i 1, i[.
HeaI-VorId IroLaLIIItIes
Using Markov procoss for llo unoorlying socurily prico, for oacl nooo (t,
|
),
oonno a lransilion proLaLilily I
|
(
|
,
|1
) from llo nooo (t,
|
) lo llo nooo (t
1,
|1
). 1loso proLaLililios aro oxogonous, ano oflon sol lo Lo conslanl across
limo. 1lo proLaLilily llal llo socurily prico coincioos will llo prico assignoo
lo llo nooo (t, i) is oqual lo llo prooucl of lransilion proLaLililios across llo
pall corrosponoing lo llo nooo (t, i), llal is,
Ir[o = o(t,
|
)[ =
|1

=0
I

,
1
)
wloro llo soquonco (
0
,
1
, ...,
|
) ooscriLos llo pall corrosponoing lo llo nooo
(t, i). 1lis pall is compuloo Ly Algorillm 4.8.1.
Henark 4.3.1 1J I

,
1
) = j J: n|| i, hn Ir[o = o(t,
|
)[ = j
n
(1 j)
|n
h: : . h n&nh: J & ]&n :J:nJ hj h &:.j :. J:n h nJ
(0, 0) h nJ (t,
|
). Jh. n&nh: : . n|&|nJ &.nj |j:.hn ..1.
HIsk-^eutraI IroLaLIIItIes
A molloo for compuling llo risk-noulral proLaLililios of a corlain slalo consisls
of compuling llo conoilional risk-noulral proLaLililios al oacl nooo, llon laking
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 99
llo prooucl of llo conoilional proLaLililios along llo pall corrosponoing lo llo
slalo. Al oacl nooo (t,
|
) of llo lallico, llo conoilional risk-noulral proLaLilily
salisnos
H
"
[^o
+
n
(t 1)[T
|
[ = 0
wloro ^o
+
n
(t1) = o
n
(t1),1(t1)o
n
(t),1(t) is llo clango in llo oiscounloo
prico of llo risky socurily :, ano T
|
is llo informalion al limo t.
If
&
(t,
|
) oonolos llo conoilional risk-noulral proLaLilily of lransilion from
(t,
|
) lo (t 1, 2
|
1) (an up jump), llon
o
+
n
(t,
|
) =
&
(t,
|
)o
+
n
(t 1, 2
|
1) (1
&
(t,
|
))o
+
n
(t 1, 2
|
)
1lis yiolos

&
(t,
|
) =
o
+
n
(t,
|
) o
+
n
(t 1, 2
|
)
o
+
n
(t 1, 2
|
1) o
+
n
(t 1, 2
|
)
=
1(t 1),1(t) d(t,
|
)
n(t,
|
) d(t,
|
)
For
&
(t,
|
) lo Lo in (0, 1), llo conoilion d(t,
|
) < 1
|1
,1
|
< n(t,
|
) sloulo
Lo salisnoo. In llis caso, llo risk-noulral lransilion proLaLilily from llo nooo
(t,
|
) lo (t 1,
|1
) is

|
(
|
,
|1
) =
_
_
_

&
(t,
|
) if
|1
= 2
|
1
1
&
(t,
|
) if
|1
= 2
|
1lo risk-noulral proLaLilily assignoo lo llo nooo (t,
|
) is oqual lo llo prooucl
of llo conoilional risk-noulral proLaLililios across llo pall corrosponoing lo llo
nooo (t,
|
), llal is,
Q(t,
|
) =
|1

=0

,
1
)
wloro

=0,...,|
is llo pall corrosponoing lo (t, i), wlicl can Lo compuloo using
Algorillm 4.8.1.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 100
OIscounted CondItIonaI Average State-IrIce OensIty
1lis paragrapl slows low lo compulo A
|
, llo oiscounloo conoilional oxpocla-
lion of llo slalo prico oonsily 1. Lol . Lo any slalo in !, llon Ly oonnilion
A
|
(.) =
H[1[T
|
[(.)
1
|
.
From an oarlior oiscussion of llo informalion slrucluro, rocall llal oacl nooo
(t,
|
) summarizos or sloros a suLsol of slalos. Aflor ono up or oown jump, llo
noxl nooo summarizos a suLsol of llo provious nooo`s suLsol. 1lis corrosponos
lo oliminaling somo slalos llal will nol lappon aflor llal limo. Supposo llal
llo lruo slalo is ., llon al limo t < 1, givon llo informalion rovoaloo in llo
markol, llo invoslor koops . among ollor slalos llal aro likoly lo lappon aflor
limo t. Lol
|
.
oonolo llis suLsol of slalos conlaining . al limo t. 1lo suLsol of
slalos
|
.
is llo only suLsol in llo parlilion of ! al limo t llal conlains .. 1lis
uniquonoss is lruo Locauso llo lallico is non-rocomLining, ano il is roprosonloo
in llo lallico Ly llo only nooo al limo t llal loaos lo llo slalo . al llo malurily
1.
Givon llo gonoral rolalion
H[1[T
|
[ =

'
I
u
=U
H[1[T
|
[ 1

I
u
wloro
1

I
u
(.
t
) =
_
_
_
1 if .
t

|
.
0 if .
t
,
|
.
,
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 101
wo lavo
H[1[T
|
[(.) =

'
I
u

=U
H[1[T
|
[ 1

I
u

(.)
= H[1[T
|
[ 1

I
u
(.)
= H[1[
|
.
[
=

.

Q
I
u
1(.)
I[.[
I(
|
.
)
=
Q(
|
.
)
I(
|
.
)
1loroforo,
A
|
(.) =
1
1
|
Q(
|
.
)
I(
|
.
)
.
1lo oiscounloo conoilional avorago slalo prico oonsily of llo slalo . al limo t is
oqual lo llo oiscounloo ralio of llo risk-noulral ano llo roal worlo proLaLililios
assignoo lo llo nooo wlicl summarizos llo slalo . al limo t.
Hov to conute
|
.

A
w
t
(t,j) w
i
t T
Figuro 4.4: Dolormining llo SuLsol of ! al 1imo t Conlaining .
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 102
Using Algorillm 4.8.1, slarl from llo slalo . in llo lasl column in llo lallico,
ano go Lackwaro following llo pall corrosponoing lo . ano slop al limo t. 1lis
corrosponos lo a corlain nooo (t, ;) (soo Figuro 4.4) wlicl summarizos llo sol

|
.
. Wo lavo
A
|
(.) =
1
1
|
Q(o = o(t, ;))
I(o = o(t, ;))
.
In oroor lo spocify llo suLsol of slalos
|
.
, go onwaro following llo lwo palls
oonning succossivo up jumps ano succossivo oown jumps fromllo nooo (t, ;) unlil
malurily 1. Wlon lloso lwo palls roacl llo malurily 1, lloy oonno rospoclivoly
llo uppor ano lowor Lounos of
|
.
.
Will llo paramolrizalion aooploo in llis paragrapl, llo lowor ano uppor
Lounos of
|
.
aro rospoclivoly: 2
T|
; ano 2
T|
(; 1) 1. 1lo suLsol

|,
/
|
.
=
__
1, 2
T|
;
_
, ...,
_
1, 2
T|
(; 1) 1
__
conlains 2
T|
slalos of llo worlo.
Anotner Aetnod oI CaIcuIatIng tne IroLaLIIItIes
If llo lallico spocincalions incluoo llo proLaLililios (j

)
=0,...,2
T
1
of llo slalos of
llo worlo (nnal column nooos), llon llo proLaLililios assignoo lo any nooo (t, ;)
prior lo malurily 1 is llo sum of llo proLaLililios of llo slalos summarizoo in
llis nooo wlicl aro llo olomonls of llo sol

|,
=
__
1, 2
T|
;
_
, ...,
_
1, 2
T|
(; 1) 1
__
,
lloroforo, llo proLaLilily of llo nooo (t, ;) is
I[o = o(t, ;)[ =
2
T3I
(1)1

I=2
T3I

j
I
1lis is anollor allornalivo of calculaling llo proLaLililios if llo spocincalion
of llo lallico incluoos llo proLaLilily of oacl slalo rallor llan llo proLaLililios
of jumps, in ollor woros, wlon llo lallico is oonnoo Ly nllralion" rallor llan
Ly pall".
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 103
OtInaI TradIng StrategIes
1lo oplimal consumplion is compuloo al all nooos of llo lallico as givon Ly
oqualion (8.81). Il is now possiLlo lo conslrucl a roplicaling slralogy llal n-
nancos llis consumplion.
Sinco il is supposoo llal llo invoslor consumos all llo nnal woalll al llo
ono of llo invoslmonl porioo, llo woalll \
T,
for ; = 0, ..., 2
T
1 is oqual lo
consumplion al lorminal nooos (
T,
. Lol :
|1,
ano :
|1,
Lo llo posilions lolo
in llo riskloss assol ano llo risky socurily rospoclivoly ovor llo porioo [t 1, t[,
corrosponoing lo llo nooo (t 1, ;). 1loso posilions aro solulion lo llo syslom
\
|,21
= 1
|
:
|1,
o
|,21
:
|1,
\
|,2
= 1
|
:
|1,
o
|,2
:
|1,
llal is
_
_
:
|1,
:
|1,
_
_
=
_
_
1
|
o
|,21
1
|
o
|,2
_
_
1

_
_
\
|,21
\
|,2
_
_
(4.0)
proviooo llal o
|,2
,= o
|,21
. Honco llo invoslmonl slralogios for oacl nooo
(t1, ;)
02
I31
1
aro solvoo Ly invorling llo malrix in (4.0). 1lo woalll \
(|1),
al llo nooo (t 1, ;) is oqual lo
\
|1,
= (
|1,
1
|1
:
|1,
o
|1,
:
|1,
1lis Lackwaro rocursion is carrioo oul from limo 1 1 Lack unlil limo t = 0.
SIx-IerIod ExanIe
1lo following numorical oxamplo is an applicalion of llo 1A(/implomonlalion
oovolopoo in llis soclion. 1lo paramolors of llo proLlom aro llo following:
1 = 6 monlls, : = /, j = 10/, o = 20/, , = 0.01. 1loso ralos aro annual.
1lo invoslor slarls will inilial woalll of $100 ano is assumoo lo lavo logarillmic
ulilily ano llo unoorlying socurily prico follows a goomolric Lrownian molion.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 104
In oroor lo caliLralo llo oiscrolo-limo moool lo llo goomolric Lrownian mo-
lion, llo following lallico paramolors aro usoo. Lol i = j o
2
,2, llon
j =
1
2

1
2
_
o
2
i
2
^t
1
_

1
2
ln n =
_
o
2
^t (i^t)
2
_
1
2
lnd = lnn
wloro j is llo proLaLilily of an up jump ano n ano d aro rospoclivoly llo up
ano oown jump faclors.
20.208
17.477
17.477
15.115
17.477
15.115
15.115
13.073
17.477
15.115
Consumption 15.115
13.073
15.115
13.073
13.073
11.306
18.901 17.477
16.346 15.115
16.346 15.115
14.138 13.073
16.346 15.115
14.138 13.073
14.138 13.073
12.227 11.306
17.678 16.346 15.115
15.289 14.138 13.073
15.289 14.138 13.073
13.223 12.227 11.306
16.535 15.289 14.138 13.073
14.300 13.223 12.227 11.306
15.465 14.300 13.223 12.227 11.306
14.465 13.375 12.368 11.436 10.575 9.778
Figuro 4.: Oplimal Consumplion using 1A(/ will Linomial Lallico
Figuro (4.) slows llo oplimal oollar amounl of consumplion al oacl nooo
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 105
of llo lallico. For a malurily of 6 monlls, llo lallico las 7 columns. 1lo
lasl column is omilloo from llo nguro. Nolo llal llo numorical valuos of llo
paramolors aro closon so llal llo lallico is numorically rocomLining. 1lis makos
llo rosulls oasily comparaLlo lo llo caso of rocomLining lallico consiooroo in
Soclion 4.4.8.
1.877
1.824
1.824
1.772
1.824
1.772
1.772
1.721
1.824
1.772
1.772
Risky Investment 1.721
1.772
1.721
1.721
1.672
3.714 1.824
3.608 1.772
3.608 1.772
3.505 1.721
3.608 1.772
3.505 1.721
3.505 1.721
3.405 1.672
5.511 3.608 1.772
5.354 3.505 1.721
5.354 3.505 1.721
5.201 3.405 1.672
7.269 5.354 3.505 1.721
7.062 5.201 3.405 1.672
8.988 7.062 5.201 3.405 1.672
10.670 8.732 6.860 5.053 3.308 1.624
Figuro 4.6: Oplimal Invoslmonl Slralogios in llo Iisky Assol using 1A(/ will
Linomial Lallico
Figuro (4.6) slows llo oplimal numLor of unils of llo risky socurily lo Lo
lolo al oacl limo ano slalo of llo worlo. Nolo llal llo invoslmonl slops al t =
sinco al malurily all woalll is consumoo. 1lis implios lloro aro 6 columns in
llo invoslmonl lallico.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 106
-4.876
-4.218
-4.218
-3.648
-4.218
-3.648
-3.648
-3.155
-4.218
-3.648
-3.648
-3.155
Safe Investment -3.648
-3.155
-3.155
-2.728
-9.141 -4.218
-7.906 -3.648
-7.906 -3.648
-6.838 -3.155
-7.906 -3.648
-6.838 -3.155
-6.838 -3.155
-5.914 -2.728
-12.851 -7.906 -3.648
-11.115 -6.838 -3.155
-11.115 -6.838 -3.155
-9.613 -5.914 -2.728
-16.060 -11.115 -6.838 -3.155
-13.890 -9.613 -5.914 -2.728
-18.816 -13.890 -9.613 -5.914 -2.728
-21.163 -16.273 -12.013 -8.314 -5.114 -2.360
Figuro 4.7: Oplimal Invoslmonl Slralogios in llo Safo Assol using 1A(/ will
Linomial Lallico
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 107
Figuro (4.7) slows llo oplimal numLor of unils of llo Lank accounl lo Lo lolo
al oacl limo ano slalo of llo worlo. Nogalivo signs inoicalos llal llo invoslor
Lorrows monoy form Lank.
40.331
34.881
34.881
30.168
34.881
30.168
30.168
26.091
34.881
30.168
30.168
W ealth 26.091
30.168
26.091
26.091
22.565
56.466 34.881
48.836 30.168
48.836 30.168
42.237 26.091
48.836 30.168
42.237 26.091
42.237 26.091
36.529 22.565
70.272 48.836 30.168
60.776 42.237 26.091
60.776 42.237 26.091
52.564 36.529 22.565
81.988 60.776 42.237 26.091
70.909 52.564 36.529 22.565
91.832 70.909 52.564 36.529 22.565
100 79.423 61.327 45.461 31.593 19.516
Figuro 4.8: Oplimal Woalll Ialls using 1A(/ will Linomial Lallico
Figuro (4.8) slows llo woalll rosulling from oplimal consumplion ano in-
voslmonl slralogios al oacl limo ano slalo of llo worlo.
1lis numorical oxamplo will logarillmic ulilily is a slraigllforwaro appli-
calion of llo procoouro oovolopoo in llis soclion ano can roaoily Lo gonoralizoo
lo ollor oxamplos of ulilily funclions.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 108
4.3.2 HeconLInIng TrInonIaI LattIce
1lo lrinomial lallico givos Lollor approximalion lo llo conlinuous-limo moool
as il allows for llroo oioronl jumps al oacl porioo. Howovor, calculaling llo
proLaLilily llal llo socurily prico is al somo lovol roprosonloo Ly a lallico nooo
is sligllly oioronl from llo Linomial caso.
Calculaling llo proLaLililios al oacl nooo of llo lallico is crilical ano oo-
ponos on wlollor llo lallico is rocomLining or nol. Inoooo, if llo lallico is
non-rocomLining, llon llo proLaLilily assignoo lo a corlain nooo is llo sum of
proLaLililios of llo slalos summarizoo in llis nooo. 1loro is no amLiguily aLoul
sucl sol of slalos sinco al any poinl of limo, llo oisjoinl union of lloso suLsols
of slalos rolaloo lo oacl nooo is oqual lo wlolo slalos of llo worlo !. Howovor,
in llo caso of rocomLining lallico, calculaling llo proLaLililios is oioronl, sinco
al any poinl of limo, llo sols of slalos summarizoo in oacl nooo oo nol form a
parlilion of llo sol of all slalos of llo worlo as lloir inlorsoclion is nol omply.
1loroforo, llo proLaLilily assignoo lo oacl nooo ooos nol oqual llo sum of proL-
aLililios of slalos summarizoo in llis nooo. Anollor molloo of compuling llo
proLaLililios is oxplainoo in llis paragrapl. Figuro (4.0) slows llo slrucluro of
a rocomLining lrinomial lallico.
A nooo (t, i) is a pair in ]

] wloro t is limo ano i [t, t[ is llo numLor

of llo nooo al limo t. Aflor an up jump, llo socurily prico is assignoo lo llo
nooo (t 1, i 1), aflor a mioolo jump, llo nooo is (t 1, i) ano aflor a oown
jump, llo nooo is (t 1, i 1), soo Figuro (4.10). Al limo t = 0, llo nooo is
(0, 0). Will llis paramolrizalion, il is oasy lo oLsorvo llo lovol of llo socurily
prico. For oxamplo, supposo llal al limo t = 10, llo nooo numLor is 1, llon llo
socurily prico las incroasoo Ly ono mulliplicalivo up jump faclor. If llo nooo
numLor is , llon llo socurily prico las oocroasoo Ly nvo mulliplicalivo oown
jump faclors.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 109
2
3
4
t = 0 t = 1
1
-4
-3
-2
-1
0
t = 2
(0,0)
(3,-1)
(3,-3)
(1,1)
(1,0)
(1,-1)
(3,0)
t = 3 t = 4
(2,2)
(2,0)
(2,-1)
(3,2)
Figuro 4.0: IocomLining 1rinomial Lallico
( t+ 1 , 1 + s
t
)
( t , s
t
) ( t+ 1 , s
t
)
( t+ 1 , s
t
- 1 )
Figuro 4.10: Cooing llo 1rinomial Lallico Nooos
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 110
SecurIty IrIce OIstrILutIon
1lo socurily prico procoss is closon lo Lo mulliplicalivo, llal is,
o

(t 1,
|1
) =
_

_
o

(t,
|
)n

will proLaLilily j
&
o

(t,
|
):

will proLaLilily 1 j
&
j
J
o

(t,
|
)d

will proLaLilily j
J
wloro n

, :

ano d

aro jump faclors salisfying llo conoilion for a rocomLining

lallico
n

= :
2

wloro llo suLscripl ; ioonlinos llo ;th socurily.

HeaI-VorId IroLaLIIItIes
Will llo paramolrizalion of llo nooos in (4.0), il is oasy lo calculalo llo proL-
aLilily I[o = o(t, i)[ llal llo socurily prico o coincioos will llo prico assignoo
lo a nooo (t, i). Consioor

o
|
= A
1
A
2
... A
|
wloro A
1
, A
2
, ..., A
|
aro ioonlically oislriLuloo inooponoonl ranoom variaLlos
laking llroo possiLlo valuos 1, 0 ano 1 will rospoclivo proLaLililios j
&
, (1
j
&
j
J
) ano j
J
. Givon llo paramolrizalion of llo nooos, il is cloar llal
I[o = o(t, i)[ = I
_

o
|
= i
_
Il can Lo slown slraigllforwaroly llal
I
_

o
|
= i
_
=

nnx(0,)I
[
Iz
2
[
_
t
/
__
t /
/ i
_
j
I
&
j
I
J
(1 j
&
j
J
)
|2I
wloro
_
t
/
_
=
t!
/! (t /)!
ano [a[ is llo inlogor parl of a
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 111
HIsk-^eutraI IroLaLIIItIes
1lo up, mioolo ano oown jump faclors aro nxoo. 1loroforo llo risk-noulral
lransilion proLaLililios aro llo samo for all llo nooos. For llo moool lo Lo
complolo, lloro sloulo Lo llroo assols in llo moool. Supposo llal lloro aro lwo
risky socurilios o
1
ano o
2
ano a riskloss assol (will nxoo ralo of rolurn oqual lo
:). Al llo nooo (t,
|
) of llo lallico, llo conoilional marlingalo moasuro salisnos
H
"
[^o
+
1
(t 1)[T
|
[ = 0
H
"
[^o
+
2
(t 1)[T
|
[ = 0
wloro ^o
+

(t1) = o

(t1),1(t1)o

(t),1(t) is llo clango in llo oiscounloo

prico of llo risky socurily ;, will 1(t) = (1 :)
|
ano T
|
is llo informalion al
limo t.
If
&
ano
J
oonolo llo conoilional risk-noulral proLaLilily of lransilion in
up ano oown jumps rospoclivoly, llon
o
+

(t,
|
) =
&
o
+

(t 1,
|
1) (1
&

J
) o
+

(t 1,
|
)

J
o
+

(t 1,
|
1): ; = 1, 2
1lis yiolos

&
=
(1(1) :
1
)(d
2
:
2
) (1(1) :
2
)(d
1
:
1
)
(n
1
:
1
)(d
2
:
2
) (d
1
:
1
)(n
2
:
2
)

J
=
(1(1) :
2
)(n
1
:
1
) (1(1) :
1
)(n
2
:
2
)
(n
1
:
1
)(d
2
:
2
) (d
1
:
1
)(n
2
:
2
)
1lrougl cloico of n

, :

, d

ano : (; = 1, 2) llo conoilion (

&
,
J
) (0, 1)
2
musl Lo salisnoo. Givon llo risk-noulral lransilion proLaLililios, llo risk-noulral
proLaLilily of llo nooo (t, i) is calculaloo in llo samo mannor as llo roal worlo
proLaLilily.
T^V @ V+w> l,` @

nnx(0,)I^
Iz
2
`
_
w
n
__
w n
n l
_
t
I
&
t
I
J
+4 t
&
t
J
,
|2I
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 112
OtInaI TradIng StrategIes
Al llo malurily 1, llo invoslor consumos all llo woalll in all slalos of llo worlo,
llal is, \
T,
= (
T,
for all i [1, 1[ . Givon llo woalll \
|,
al llo nooo (t, i),
for t _ i _ t, ono can compulo llo lraoing slralogios ano woalll al limo t 1
for llo nooos (t 1, ;) will (t 1) _ ; _ (t 1), in a Lackwaro rocursion as
follows:
Lol :
|1,
, :
1
|1,
ano :
2
|1,
Lo llo posilions lolo in llo riskloss assol, llo nrsl
risky socurily ano llo socono risky socurily rospoclivoly ovor [t 1, t[ al llo nooo
(t 1, ;). 1loso posilions aro a solulion lo llo syslom
\
|,1
= 1
|
:
|1,
o
1
|,1
:
1
|1,
o
2
|,1
:
2
|1,
\
|,
= 1
|
:
|1,
o
1
|,
:
1
|1,
o
2
|,
:
2
|1,
\
|,1
= 1
|
:
|1,
o
1
|,1
:
1
|1,
o
2
|,1
:
2
|1,
1lal is,
_
_
_
_
:
|1,
:
1
|1,
:
2
|1,
_
_
_
_
=
_
_
_
_
1
|
o
1
|,1
o
2
|,1
1
|
o
1
|,
o
2
|,
1
|
o
1
|,1
o
2
|,1
_
_
_
_
1

_
_
_
_
\
|,1
\
|,
\
|,1
_
_
_
_
(4.10)
proviooo llal llo oolorminanl of llo aLovo malrix is nonzoro. Honco llo invosl-
monl slralogios for oacl nooo (t 1, ;)
(|1)(|1)
aro solvoo Ly invorling llo
malrix in (4.10). 1lo woalll \
(|1),
al llo nooo (t 1, ;) is oqual lo
\
|1,
= (
|1,
1
|1
:
|1,
o
1
|1,
:
1
|1,
o
2
|1,
:
2
|1,
1lis Lackwaro rocursion is carrioo oul from limo 1 Lack unlil limo t = 0.
Henark 4.3.2 n r||n nj h| .J h nh n| nJ| . n:h.:nj-
J: . nn| &: hn h n|h n .n 0 :&|.nj J:n h hn|n:J :&:.n
.n.J .h h .n..n| n|h j.n n nn .n& h :h|n ;.).
4.4 SynLoIIc OynanIc IrogrannIng
In llis soclion wo consioor symLolic sloclaslic oynamic programming as an
allornalivo for implomonling llo consumplion-invoslmonl proLlom. 1lo iooa
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 113
is inlrooucoo in Soclion 8..2. Lol us nrsl consioor llo following lwo-porioo
oxamplo.
4.4.1 A Tvo-IerIod ExanIe
Wo apply llo loclniquo oxplainoo in Soclion 8..2 lo a simplo oxamplo in lwo
porioos wloro llo invoslor las logarillmic ulilily, ano wloro lloro is ono riskloss
socurily will rolurn :, ano ono risky socurily will a non-spocinc oislriLulion ovor
a Linomial lallico, soo Figuro (4.11). 1lis oxamplo is a gonoralizalion of Lxamplo
.7 in Iliska (1007, [86[).
States
S
2
uu
w1 (1/4)
S
1
u
S
2
ud
w2 (1/4)
S
0
S
2
du
w3 (1/4)
S
1
d
S
2
dd
w4 (1/4)
Figuro 4.11: Iisky Socurily DislriLulion ovor a 1wo-Iorioo Non-IocomLining
Linomial Lallico
1lo consumplion-invoslmonl proLlom in llis caso is
_

_
max
(C,1)
n((
0
) ,H[n((
1
)[ ,
2
H[n((
2
)[
suLjocl lo = inilial woalll
ano Luogol oqualions al t = 0, 1, 2
1loro aro four slalos of llo worlo: ! = .
1
, .
2
, .
S
, .
1
. Al limo t = 0, all llo
slalos aro possiLlo ano llo prico of llo socurily is o
0
. Al limo t = 1, llo prico
goos up lo o(1)
&
in llo Losl slalos .
1
, .
2
, ano goos oown lo o(1)
J
in llo worso
salos .
S
, .
1
. Al limo t = 2, lloro aro four possiLlo valuos or llo socurily prico
corrosponoing lo llo slalos .
1
, .
2
, .
S
ano .
1
. 1lo invoslor cloosos llo
oplimal consumplion al limo 0, (
0
ano al limo 1 in llo up slalo, (
&
1
ano in llo
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 114
oown slalo, (
J
1
as woll as llo proporlion of woalll lo invosling llo risky assol al
limo 0, H(0) ano al limo 1 in llo up slalo, H(1)
&
ano in llo oown slalo H(1)
J
.
Applying oynamic programming, wo slarl Ly limo 2 ano go Lackwaro in limo
solving for llo oplimal consumplion ano invoslmonl rulos.
Al t = 2, llo valuo funclion is
J
2
(\
2
) = H[ln((
2
)[T
2
[ = ln((
2
) = ln(\
2
)
sinco al llo ono of llo lasl porioo, llo lolal woalll is consumoo ((
2
= \
2
).
Al t = 1, llo valuo funclion is
J
1
(\
1
) = max
c,I
_
ln(c) ,H[ln
_
(\
1
c)(1 :) (1 :)
2
h^o
+
1
(2)
_
[T
1
[
_
In llo slalos .
1
ano .
2
, wlicl corrospono lo llo nooo wloro llo
socurily prico oquals o
&
1
(soo Figuro (4.11)), llo valuo funclion oquals
J
1
(\) = max
c,I
d
&
1
wloro
d
&
1
= ln(c)
,
2
ln

(\
1
c)(1 :) (1 :)
2
h^o
+
1
(2)
&&
_

,
2
ln

(\
1
c)(1 :) (1 :)
2
h^o
+
1
(2)
&J
_
Dioronlialing will rospocl lo c ano h, ano solling llo syslom lo 0,
0d
&
1
0c
=
0d
&
1
0h
= 0,
llo oplimal consumplion-invoslmonl slralogy is
H(2)
&
=
1
2
,u
1
^o
+
1
(2)
&&
^o
+
1
(2)
&J
(: 1)(1 ,) ^o
+
1
(2)
&J
^o
+
1
(2)
&&
ano (
&
1
=
\
1
1 ,
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 115
1lo oLjoclivo valuo funclion J
1
(\
1
) is oqual lo
J
&
1
(\) = (, 1) ln\ )
&
(,, :)
wloro
)
&
(,, :) =
1
2
, ln
_

1
2
, (1 :)
^o
+
1
(2)
&J
^o
+
1
(2)
&&
(1 ,) ^o
+
1
(2)
&J
_

1
2
, ln
_
1
2
, (1 :)
^o
+
1
(2)
&J
^o
+
1
(2)
&&
^o
+
1
(2)
&&
(1 ,)
_
ln(1 ,)
In llo slalos .
S
ano .
1
, wlicl corrospono lo llo nooo wloro llo
socurily prico oquals o
J
1
, llo valuo funclion oquals
J
1
(\
1
) = max
c,I
_
_
_
ln(c)
o
2
ln[(\
1
c)(1 :) (1 :)
2
h^o
+
1
(2)
J&
[

o
2
ln[(\
1
c)(1 :) (1 :)
2
h^o
+
1
(2)
JJ
[
_
_
_
1lo oplimal consumplion-invoslmonl slralogy is
H(2)
J
=
1
2
,u
^o
+
1
(2)
J&
^o
+
1
(2)
JJ
(1 ,) (1 :) ^o
+
1
(2)
JJ
^o
+
1
(2)
J&
ano (
J
1
=
\
1
1 ,
ano llo oLjoclivo valuo funclion is
J
J
1
(\
1
) = (, 1) ln\
1
)
J
(,, :)
wloro
)
J
(,, :) =
1
2
, ln
_
1
2
, (1 :)
^o
+
1
(2)
JJ
^o
+
1
(2)
J&
^o
+
1
(2)
J&
(1 ,)
_

1
2
, ln
_

1
2
, (1 :)
^o
+
1
(2)
JJ
^o
+
1
(2)
J&
(1 ,) ^o
+
1
(2)
JJ
_
ln(1 ,)
Al t = 0, llo valuo funclion is
J
0
(\) = max
c,I
d
0
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 116
wloro
d
0
= ln(c) ,H[J
1
((\ c)(1 :) (1 :)h^o
+
1
(1)) [T
0
[
= ln(c)
,
2
_
_
_
J
&
1
[(\ c)(1 :) (1 :)h^o
+
1
(1)
&
[
J
J
1

(\ c)(1 :) (1 :)h^o
+
1
(1)
J
_
_
_
_
1lo oplimal consumplion ano invoslmonl slralogios al limo 0 aro
(
0
=
\
0
,
2
, 1
H(1) =
,
2
\
0
_
^o
+
1
(1)
&
^o
+
1
(1)
J
_
, 1
_
,
2
, 1
_
^o
+
1
(1)
&
^o
+
1
(1)
J
4.4.2 Idea oI SynLoIIc OynanIc IrogrannIng
In llo provious oxamplo wo usoo oynamic programming lo solvo a lwo-porioo
oplimizalion proLlom. 1loro aro six conlrol variaLlos (
0
, (
&
1
, (
J
1
, H(1), H(2)
&
ano H(2)
J
. 1lo original oplimizalion proLlom is oiviooo lo llroo oplimizalion
proLloms, oacl ono will only lwo variaLlos (c, h).
In llo gonoral caso, llo oynamic programming funclional oqualion givon in
Soclion 8..2 is
J
|1
(\) = max
1(|),C
I31
_
_
_
n((
|1
) ,H
_
_
J
|
_
_
(\ (
|1
)1
|
,1
|1
1
|

`
n=1
H
n
(t)^o
+
n
(t)
_
_

T
|1
_
_
_
_
_
.
Nolo llal llo oLjoclivo funclion al limo t1 ooponos on llo oLjoclivo funclion al
limo t. Honco, llo sorios of oplimizalions is inlorooponoonl. Anollor imporlanl
issuo illuslraloo Ly llo provious oxamplo is llo following. 1lo valuo funclion
J
|
(\) (t = 0, 1, 2) is funclion of woalll \ al limo t. Howovor, woalll is unknown
al limo t sinco il rosulls from lraoing ovor llo porioo [0, t 1[ . Forlunaloly
wo coulo solvo for J
|
(\), (
|
(\) ano H
|
(\) for any givon woalll \ al llo
Loginning of llo porioo [t, t 1[ (t = 0, 1, 2). Onco limo 0 is roacloo in llo
Lackwaro rocursion, ono usos llo inilial woalll valuo ano suLslilulo il in llo
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 117
valuos of oplimal consumplion ano invoslmonl ano llon go forwaro in llo lallico
lo oLlain numorical valuos of llo oplimal conlrol ano valuo funclion.
In llo gonoral caso, for ollor ulilily funclion llan llo log ulilily ano ovon
for log ulilily will moro llan lwo porioos, llo oxprossion of llo valuo funclion
ano llo oplimal consumplion ano invoslmonl rulos grows formioaLly will llo
numLor of limo slops.
Compulalionally, lloro is a way lo roouco llis oimcully. If llo proLlom pa-
ramolors (:, ,, ^o
+
1
(1), ...) aro suLsliluloo in, ano llo only variaLlo llal romains
is woalll \, llon llo oxprossions can Lo simplinoo oramalically. 1lo oplimal
consumplion ano invoslmonl slralogios aro oLlainoo Ly a oioronlialion of llo
oLjoclivo funclion using a symLolic compulor packago. 1lis assumos slricl con-
cavily of llo oLjoclivo funclion, wlicl can Lo provoo for slriclly concavo ulilily
funclions. Using llo MallaL symLolic loolLox for inslanco, oxamplos of assol
allocalion can Lo givon for a rocomLining ano non-rocomLining lallicos.
4.4.3 SIx-erIod ExanIe vItn HeconLInIng LattIce
In llis oxamplo, llo invoslor`s ulilily funclion is logarillmic. Wo uso llo samo
paramolor valuos as in llo six-porioo oxamplo of Soclion 4.8. Namoly, 1 = 6
monlls, : = /, j = 10/, o = 20/, , = 0.01. 1loso ralos aro annual. 1lo
unoorlying socurily prico follows a goomolric Lrownian molion.
In oroor lo caliLralo llo oiscrolo-limo moool lo llo goomolric Lrownian mo-
lion, llo following lallico paramolors aro usoo.
j =
1
2

1
2
_
o
2
i
2
^t
1
_

1
2
ln n =
_
o
2
^t (i^t)
2
_
1
2
lnd = lnn
wloro j is llo proLaLilily of an up jump, n ano d aro rospoclivoly llo up ano
oown jump faclors ano i = j o
2
,2.
Figuro (4.12) slows llo oplimal consumplion al oacl nooo of llo lallico as
a funclion of woalll u availaLlo al llo Loginning of llo limo porioo. For a
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 118
w
Consum ption .501*w
.335*w w
.252*w .501*w
.202*w .335*w w
.168*w .252*w .501*w
.145*w .202*w .335*w w
.168*w .252*w .501*w
.202*w .335*w w
.252*w .501*w
.335*w w
.501*w
w
Figuro 4.12: Oplimal Consumplion Iulos using SymLolic Dynamic Irogram-
ming
malurily of 6 monlls, llo lallico las 7 columns. In lasl porioo llo invoslor
consumos llo lolal woalll.
Risky Investment .0465*w
.0658*w
.0784*w .0523*w
.0887*w .0739*w
.0979*w .0881*w .0587*w
.107*w .0996*w .083*w
.110*w .0989*w .066*w
.112*w .0932*w
.111*w .0741*w
.0105*w
.0832*w
Figuro 4.18: Oplimal Invoslmonl Iulos using SymLolic Dynamic Irogramming
Figuro (4.18) slows llo oplimal numLor of unils of llo risky socurily lo Lo
lolo al oacl nooo as a funclion of woalll (u). Nolo llal llo invoslmonl slops
al t = sinco al malurily all woalll is consumoo. 1lis implios 6 columns
in llo invoslmonl lallico. In oroor lo oLlain numorical valuos of llo oplimal
consumplion ano invoslmonl slralogios for a spocinoo valuo of inilial woalll, a
forwaro rocursion is carrioo oul from limo 0 lo 6, using llo Luogol conslrainls
oqualion (8.27). Figuros (4.14) ano (4.1) slow llo oplimal oollar amounl of
consumplion ano llo oplimal numLor of unils lolo in llo risky socurily for an
inilial valuo of woalll \
0
= $100. Figuro (4.16) slows llo woalll rosulling from
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 119
oplimal consumplion ano invoslmonl slralogios al oacl limo ano slalo of llo
worlo.
Consumption 21.605
20.208
18.901 18.685
17.678 17.477
16.535 16.346 16.160
15.465 15.289 15.115
14.465 14.300 14.138 13.977
13.375 13.223 13.073
12.368 12.227 12.088
11.436 11.306
10.575 10.455
9.778
9.042
Figuro 4.14: Oplimal Consumplion Iulos aflor a Forwaro Iocursion
Risky Investment 1.877
3.714
5.511 1.824
7.269 3.608
8.988 5.354 1.772
10.670 7.062 3.505
8.732 5.201 1.721
6.860 3.405
5.053 1.672
3.308
1.624
Figuro 4.1: Oplimal Invoslmonl Slralogios aflor a Forwaro Iocursion
Quick comparison will llo six-porioo oxamplo in Soclion slows llal llo ro-
sulls aro oxaclly llo samo Ly llo cloico of llo samo sol of paramolors. Will
symLolic oTT, if llo inilial woalll clangos, forwaro rocursion sumcos lo ro-
compulo llo oplimal consumplion ano invoslmonl rulos. For logarillmic ulilily,
oplimal consumplion ano invoslmonl rulos aro linoar in woalll. 1lis is nol
nocossarily llo caso for ollor ulilily funclions.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 120
Wealth 21.605
40.331
56.466 18.685
70.272 34.881
81.988 48.836 16.160
91.832 60.776 30.168
100 70.909 42.237 13.977
79.423 52.564 26.091
61.327 36.529 12.088
45.461 22.565
31.593 10.455
19.516
9.042
Figuro 4.16: Oplimal Woalll aflor a Forwaro Iocursion
4.5 OescretIzIng tne ContInuous-TIne
AodeI
4.5.1 Tne HE EquatIon and Aarkov CnaIn AroxIna-
tIon
In Soclion 8.4.2 wo saw llal llo porlfolio proLlom in conlinuous limo involvos
llo solulion of llo HE oqualion (8.11) in oroor lo oLlain llo valuo of llo in-
oirocl ulilily funclion, J(\, t). Having oono llis, llo oplimal conlrols c
+
ano ,
+
aro oLlainoo Ly Lqualions (8.12) ano (8.18). In llis soclion, wo aoopl a proL-
aLilislic approximalion lo solvo llo sloclaslic oplimal conlrol proLlom, known
gonorically as llo Markov clain approximalion molloo, ano is woll ooscriLoo
in Kuslnor (1077, [66, Claplor 7[) ano Kuslnor ano Dupuis (1002, [67[). 1lo
approximalion involvos a oiscrolizalion of llo HE oqualion, wlilo al llo samo
limo approximaling llo original conlrol procoss Ly an approprialo conlrolloo
Markov clain on a nnilo slalo spaco. 1lo nrsl lask is familiar from classical
numorical analysis, wloro nnilo oioronco or nnilo olomonl molloos aro usoo lo
solvo a parlial oioronlial oqualion. 1lo socono lask involvos clovorly rocasling
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 121
llo nnilo oioronco or olomonl maclinory inlo an approximaling Markov clain,
llo proporlios of wlicl lavo local proporlios" (moan ano varianco) of llo clain
closoly malcl lloso of llo original procoss.
Lolow wo consioor an oxplicil" solulion approacl. 1lo oxplicil" solulion
approacl involvos a nnilo oioronco approximalion lo llo HE oqualion wlicl
is a socono-oroor linoar paraLolic parlial oioronlial oqualion. 1lo solulion
molloo is known as oxplicil" Locauso il rosulls in an oqualion wlicl can Lo
solvoo Ly simplo rocursion. An allornalivo solulion molloo, known as implicil",
is sligllly moro complicaloo as il can`l Lo solvoo Ly simplo rocursion. Gonorally,
llo implicil molloo provioos a moro accuralo approximalion llan llo oxplicil
molloo, soo Kuslnor ano Dupuis (1002, [67[). Howovor, llis loss of accuracy
can, lo somo oxlonl, Lo conlrolloo Ly caroful paramolrizalion of llo moool.
1lo slarling poinl of llo numoric solulion molloo is llo HE oqualion. 1lo
oqualion is approximaloo using slanoaro nnilo oioronco loclniquos. 1lo rosull-
ing approximalion is llon ro-wrillon in llo form of a Markov clain Ly caroful
roarrangomonl of llo approximalion lo llo HE. 1lo lransilion proLaLililios
of llo Markov clain aro closon in sucl a way as lo Lo locally consislonl will llo
unoorlying oiusion of llo slalo variaLlo. 1lo consisloncy loro is oLlainoo wlon
llo moan ano llo varianco of llo approximaling Markov procoss closoly follow
lloso of llo unoorlying slalo variaLlo procoss. 1lo convorgonco of llis approx-
imalion molloo las Loon oslaLlisloo Ly Loll woak convorgonco ano viscosily
solulion loclniquos, for inslanco, soo Filzpalrick ano Flomming (1001, [4[).
1lo mollooology of llis approximalion is Losl unoorslooo Ly ils applicalion
lo llo porlfolio proLlom.
4.5.2 Aerton`s IroLIen vItn Aarkov CnaIn AroxIna-
tIon
Horo, wo consioor llo numorical solulion lo Morlon`s proLlom. Wo limil llo
moool lo consiooralion of only ono risky socurily ano ono safo assol. 1lo woalll
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 122
procoss is
d\
|
= [(,
|
(j :) :)\
|
c
|
[ dt ,
|
o\
|
d1
|
(4.11)
ano llo HE oqualion is
svp
c,,
_
n(c(t)) jJ J
|
[,c\ (1 ,):\ c[J
W

1
2
o
2
,
2
\
2
J
WW
_
= 0
(4.12)
1lo numorical solulion of nnilo lorizon sloclaslic oplimal conlrol proLloms is
woll ooscriLoo in Kuslnor (1077, [66, Claplor 7[) ano Kuslnor ano Dupuis (1002,
[67[). 1lo oxplicil" solulion approacl involvos a nnilo oioronco approximalion
lo llo HE oqualion (4.12), as ooscriLoo Lolow.
Firslly, consioor llo coomcionl of J
W
in (4.12). Iarlilion llo lorms llal
mako up llis coomcionl inlo a posilivo group, d

= (j :),\ :\, ano a

nogalivo group d

= c, wloro d = d

, d Loing llo coomcionl of J

W
. 1lo
parlial oorivalivos in oqualion (4.12) aro as follows
)
|
(a, t)
~
=
)(a, t c) )(a, t)
c
)
a
(a, t)
~
=
)(a h, t c) )(a, t c)
h
for d

)
a
(a, t)
~
=
)(a, t c) )(a h, t c)
h
for d

)
aa
(a, t)
~
=
)(a h, t c) )(a h, t c) 2)(a, t c)
h
2
wloro c ano h aro small incromonls in limo ano llo slalo variaLlo a. Lqualion
(4.12) can Lo wrillon as follows, wloro V (, ) roprosonls llo solulion lo llo nnilo
oioronco oqualion
0 = max
c,,
_

_
n(c(t)) jV (\, t)
\ (W,|c)\ (W,|)
c

\ (WI,|c)\ (W,|c)
I
d

\ (W,|c)\ (WI,|c)
I
d

1
2
(o,\)
2
\ (WI,|c)\ (WI,|c)2\ (W,|c)
I
2
_

_
(4.18)
Lqualion (4.18) can also Lo wrillon as
V (\, t) =
1
1 jc
max
c,,
1

0=1
j(\, \ 0h)V (\ 0h, t c) cn(c(t)) (4.14)
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 123
wloro llo j(, ) may Lo inlorproloo as lransilion proLaLililios of a Markov clain
givon Ly:
j(\, \ h) =
c
h
2
_
1
2
(o,\)
2
h[(j :),\ :\[
_
j(\, \ h) =
c
h
2
_
1
2
(o,\)
2
hc
_
j(\, \) = 1 j(\, \ h) j(\, \ h)
wloro c ano h
2
aro closon so llal llo conoilion 0 _ j(, ) _ 1 is salisnoo.
1lis sclomo is locally consislonl will Lqualion (4.11). In oocl, llo moan ano
varianco of small clangos in llo slalo variaLlo \ aro
E[\(t c) \(t)[ = dc
var[\(t c) \(t)[ = (o,\)
2
c o(h) .
4.5.3 ^unerIcaI HesuIts
Horo, wo uso llo sol-up ooscriLoo in Iurcal ano Iiggoll (2001, [88[). Lqualion
(4.14) was solvoo using Lackwaro iloralion ovor a grio of llo slalo variaLlo. 1lo
procoss is illuslraloo in Figuro (4.17).
A grio sizo of A = 1 000 was usoo, will slalo variaLlo \ laking valuos of
from 0 llrougl 20.00, in slops of h = 0.02. As noloo in Iurcal ano Iiggoll (2001,
[88[), valuos al llo lop ano Lollom of llo grio aro inaccuralo, wlilo valuos in llo
mioolo aro accuralo. A zoom al llo mioolo Lano of llo grio for oioronl limos
Lolwoon t = 0 ano 1 = 6 monlls, aro givon in Figuro (4.18). In llis nguro,
wloro llo invoslor las a logarillmic ulilily, for oacl valuo of possiLlo woalll,
valuos of oplimal consumplion, proporlion of woalll lo Lo invosloo in llo risky
socurily ano llo corrosponoing valuo funclion aro compuloo
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 124
13.94 -200.3 13.94 -200.04
13.92 -22.01 13.92 -22.02
13.9 -200 13.9 -200.01
13.88 -199.8 13.88 -200
13.86 -199.5 13.86 -199.9
13.84 -199.3 13.84 -199.7
13.82 -199 13.82 -199.5
Value Function
Wealth
at t=10.000
Value Function
Wealth
at t=10.002
One-step backwards
recursion
Figuro 4.17: Lxplicil Finilo Dioronco Molloo in Discrolizing llo HE Lqua-
lion
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 125
wealth value consum- proportion wealth value consum- proportion wealth value consum- proportion
function ption in risky function ption in risky function ption in risky
10.20 2.87 6.93 1.2482 10.20 2.79 7.32 1.2483 10.20 2.43 9.44 1.2487
10.18 2.86 6.92 1.2482 10.18 2.78 7.30 1.2483 10.18 2.42 9.42 1.2487
10.16 2.86 6.91 1.2482 10.16 2.78 7.29 1.2483 10.16 2.42 9.41 1.2487
10.14 2.86 6.89 1.2482 10.14 2.78 7.28 1.2483 10.14 2.42 9.39 1.2487
10.12 2.85 6.88 1.2482 10.12 2.78 7.26 1.2483 10.12 2.42 9.37 1.2487
10.10 2.85 6.87 1.2482 10.10 2.77 7.25 1.2483 10.10 2.42 9.35 1.2487
10.08 2.85 6.85 1.2482 10.08 2.77 7.23 1.2483 10.08 2.41 9.33 1.2486
10.06 2.84 6.84 1.2482 10.06 2.77 7.22 1.2483 10.06 2.41 9.31 1.2486
10.04 2.84 6.82 1.2482 10.04 2.77 7.20 1.2483 10.04 2.41 9.29 1.2486
10.02 2.84 6.81 1.2482 10.02 2.76 7.19 1.2483 10.02 2.41 9.28 1.2486
10.00 2.84 6.80 1.2482 10.00 2.76 7.18 1.2483 10.00 2.41 9.26 1.2486
9.98 2.83 6.78 1.2482 9.98 2.76 7.16 1.2483 9.98 2.40 9.24 1.2486
9.96 2.83 6.77 1.2482 9.96 2.75 7.15 1.2482 9.96 2.40 9.22 1.2486
9.94 2.83 6.76 1.2482 9.94 2.75 7.13 1.2482 9.94 2.40 9.20 1.2486
9.92 2.82 6.74 1.2482 9.92 2.75 7.12 1.2482 9.92 2.40 9.18 1.2486
9.90 2.82 6.73 1.2482 9.90 2.75 7.10 1.2482 9.90 2.39 9.17 1.2486
9.88 2.82 6.72 1.2482 9.88 2.74 7.09 1.2482 9.88 2.39 9.15 1.2486
9.86 2.82 6.70 1.2481 9.86 2.74 7.07 1.2482 9.86 2.39 9.13 1.2486
9.84 2.81 6.69 1.2481 9.84 2.74 7.06 1.2482 9.84 2.39 9.11 1.2486
9.82 2.81 6.67 1.2481 9.82 2.73 7.05 1.2482 9.82 2.39 9.09 1.2486
9.80 2.81 6.66 1.2481 9.80 2.73 7.03 1.2482 9.80 2.38 9.07 1.2486
t = 0 t =1 month t = 5 month
Figuro 4.18: Mioolo of Grio Solulion al Dioronl Momonls ouring llo Invoslmonl
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 126
4.6 ConarIson Letveen 1A(/ and Oy-
nanIc IrogrannIng
In llis claplor wo usoo Loll 1A(/ ano oynamic programming lo solvo llo
consumplion-invoslmonl proLlom in somo spocinc casos. Somo oioroncos Lo-
lwoon lloso lwo approaclos aro poinloo oul in llo following.
Using 1A(/, llo oplimal consumplion is a funclion of inilial woalll,
wloroas will oynamic programming, oplimal consumplion is a funclion of
woalll al llo Loginning of llo curronl porioo. For inslanco, will logarill-
mic ulilily, using oynamic programming, llo oplimal consumplion is
(
+
|
=
\
|
1 , ,
2
... ,
T|
wloro \
|
is woalll availaLlo al limo t, llo conslanl , is a limo proforonco
oiscounl faclor ano 1 is malurily. Using 1A(/, llo oplimal consumplion
is
(
+
|
=
,
|

T
|=0
,
|
\
0
A
|
Honco, if an invoslor oio nol Lolavo oplimally on llo porioo [0, t) wloro 0 <
t < 1 llon llo woalll al limo t is nol oplimal. 1lo oynamic programming
approacl will givo llo oplimal amounl of consumplion al limo t, lowovor.
In conlrasl, llo 1A(/ oplimal consumplion al limo t, wloro llo proLlom
was originally sol for [0, 1[, is nol valio. 1o uso 1A(/ ono las lo rosolvo
llo oplimizalion proLlom for llo porioo [t, 1[.
Using 1A(/, lloro is ono oplimizalion lo carry oul. 1lo numLor of
conlrol variaLlos in llo oplimizalion is oqual lo llo numLor of nooos in
llo lallico. 1lis yiolos llo oplimal consumplion al ovory nooo. 1lon in
aooilion lo llo oplimizalion, lloro is a Lackwaro rocursion lo compulo llo
oplimal lraoing slralogy al oacl nooo.
4. StocnastIc OynanIc IrogrannIng vs. AartIngaIe Aetnods 127
Using oTT, lloro aro A oplimizalions lo carry oul, wloro A is llo num-
Lor of nooos in llo lallico oxcopl lloso of llo lasl column, wloro al oacl
oplimizalion lloro aro lwo slalo variaLlos. Will numorical oynamic pro-
gramming (Markov clain approximalion) llis comploxily is mulliplioo Ly
llo numLor of possiLlo valuos of woalll al oacl nooo (sizo of llo column of
llo grio) ano llo numLor of llo oiscrolizalion inlorvals Lolwoon succossivo
limo porioos.
1A(/ is moro slraigllforwaro llan oynamic programming in solving llo
consumplion-invoslmonl proLlom sinco il involvos only ono oplimizalion
ano yiolos roaoily llo oplimal consumplion in a nrsl slop. 1lo socono
slop is similar lo oplion pricing wlicl is woll unoorslooo Ly praclilionors.
In praclico, will 1A(/, in many casos wo lavo oxplicil solulion (o.g.
for llo H/1/ class of ulilily), so llo oplimizalion is nol carrioo oul Ly
compulor (il is oono Ly lano) lonco llo only lask romaining is lo compulo
llo oplimal lraoing slralogy Ly a Lackwaro rocursion.
1lis claplor slows llal llo risk-noulral compulalional approacl is a gonoral
molloo lo solvo llo consumplion-invoslmonl proLlom wloro llo oLjoclivo is lo
maximizo llo oxpocloo-ulilily of consumplion llrougl limo. Il is woll aoaploo
if llo moool is complolo ano arLilrago-froo.
Wlon llo framowork is oioronl from oxpocloo ulilily, llis molloo can slill
Lo applioo, will a lilllo aojuslmonl. In Claplor Six, wo uso llis approacl lo
solvo llo consumplion-invoslmonl proLlom will a risk moasuro Lasoo on llo
Iroporlional Hazaros lransform.
lLaplci 0
AuucI 1tIcIng uuIng
1tobabIIIIy LIuIotIIon
FuncIIonu
5.1 IntroductIon
Will llo convorgonco of nnancial ano insuranco markols, lloro las Loon a major
incroaso in llo lraoing ano socurilizalion of insuranco ano similar risks incluoing
woallor ano onorgy oorivalivos. 1oclniquos usoo in insuranco pricing aro Loing
consiooroo for llo pricing of oorivalivo conlracls incluoing lloso for onorgy risk
lraooo on oxclangos sucl as llo CLO1. 1lis las rosulloo in an inlorosl in
insuranco pricing ano low lloso loclniquos rolalo lo nnancial lloory.
Al llo samo limo lloro lavo Loon somo roconl oovolopmonls in moools for
pricing insuranco risks Lasoo on an approacl originally oovolopoo Ly Wang (1006,
[111[). 1lis approacl usos a corlainly oquivalonl ano a non-oxpocloo ulilily
framowork lo oolormino llo prico lo Lo clargoo for an insuranco risk. 1lo
approacl can Lo applioo lo roinsuranco conlracls sinco lloso can Lo consiooroo as
conlingonl claims on an unoorlying insuranco risk. Moro roconlly llo approacl
las Loon oovolopoo furllor ano applioo lo nnancial risks as woll as woallor
risk. Wang (2000, [118[) proposos a form of llis insuranco risk pricing approacl
will ils founoalions in non-oxpocloo ulilily lloory llal, assuming a normal
oislriLulion of rolurns, is consislonl will nnancial lloory. Wo formally consioor
llis approacl ano slow llal il prooucos llo Llack-Sclolos oplion pricing formula
for conlingonl claims.
In llis claplor wo consioor llis approacl furllor ano rolalo il lo nnancial
lloory. Conlingonl claims in nnancial markols aro usually valuoo using no-
arLilrago assumplions. If nnancial markols aro arLilrago-froo llon llo curronl
128
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 129
prico of a socurily or conlingonl claim musl Lo oqual lo llo oxpocloo valuo of
ils fuluro payo unoor a risk-noulral moasuro, oiscounloo lo prosonl valuos al
llo risk froo ralo. If llo nnancial markol is complolo ano all conlingonl claims
aro allainaLlo using lraooo socurilios, llon llo arLilrago-froo prico is uniquo. In
incomplolo markols, llo arLilrago-froo prico is nol nocossarily uniquo ano llo
arLilrago-froo approacl can only Louno llo conlingonl claim prico. In lloso
casos an oquiliLrium approacl can Lo usoo, in wlicl all invoslors acl so as lo
maximizo llo oxpocloo ulilily of consumplion ano llo oquiliLrium pricos for
conlingonl claims aro lloso for wlicl nol supply is zoro.
Alllougl llo approacl oovolopoo Ly Wang, Lasoo on a parlicular form of
non-oxpocloo ulilily corlainly oquivalonl, is llo samo as llo Llack-Sclolos conlin-
gonl claim prico wlon llo unoorlying socurily pricos aro log-normally oislriLuloo,
a nalural quoslion arisos as lo wlollor llo uso of llis approacl is approprialo in
llo non-normal caso. Wang las roconlly proposoo a mooincalion of llo approacl
llal aims lo prico conlingonl claims on socurilios or risks will a non-normal ois-
lriLulion. 1lo molloo involvos a caliLralion of a markol prico of risk paramolor
lo an unoorlying non-normal prico oislriLulion using llo normal oislriLulion
Lasoo formula. 1lo caliLraloo formula is llon usoo lo prico conlingonl claims.
1lis claplor formally sluoios llo non-normal caso ano oomonslralos llo
limilalion of using Wang`s approacl in llis caso Ly consiooring llo Cox, Ioss
ano IuLinsloin Linomial lallico moool ano llo conslanl olaslicily of varianco
moool for socurily pricos.
5.2 EquIIILrIun IrIcIng
5.2.1 Exected \tIIIty EquIIILrIun
Financial lloory las Loon oovolopoo for various moools of pricing risky assols
incluoing conlingonl claims. 1lo koy rosulls aro covoroo in many loxls incluoing,
for oxamplo, Coclrano (2001, [27[), Hunl ano Konnooy (2000, [[) ano Iliska
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 130
(1007, [86[). Wo will uso llo nolalion ano approacl sol oul in Coclrano (2001,
[27[)
1lo mosl Lasic assumplion unoorlying mucl of llo lloory unoorlying conlin-
gonl claim pricing is llal an oconomy is arLilrago-froo. In llis caso, an oconomy
is arLilrago-froo if ano only if, in a singlo porioo moool, llo assol prico is givon
Ly
A

(0) = H

[:A

(1)[
wloro : is a posilivo ranoom variaLlo roforroo lo as a sloclaslic oiscounl fac-
lor ano llo oxpoclalion is lakon will rospocl lo llo roal-worlo" proLaLilily
moasuro, I.
In gonoral, llo law of ono prico guaranloos llo oxislonco of a sloclaslic ois-
counl faclor :. No-arLilrago guaranloos llal llo oiscounl faclor is slriclly
posilivo so llal llo prico of an assol can Lo wrillon as
j = H[:A[
for any assol payo A, soo Coclrano (2001, [27, Claplor 4[). 1lo (/T/, Llack-
Sclolos pricing ano lorm slrucluro moools for Lono pricos aro spocial casos.
Furllormoro, if lloro is a socurily will posilivo prico ano slriclly posilivo
pay-o in all fuluro slalos, say socurily /, llon llo oconomy is arLilrago-froo if
ano only if lloro oxisls a proLaLilily moasuro Q, oquivalonl lo I, sucl llal
A

(0)
A
I
(0)
= H
"
_
A

(1)
A
I
(1)
_
ano llo moasuro Q is roforroo lo as an oquivalonl marlingalo moasuro will
rospocl lo A
I
. If markols aro complolo llon llo oquivalonl marlingalo moasuro
Q will Lo uniquo.
Complolo markols onsuro llal any conlingonl claim will Lo allainaLlo. 1lis
moans llal llo oxisling assols in llo oconomy can Lo usoo lo roplicalo llo
conlingonl claim will a solf-nnancing lraoing slralogy.
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 131
1lo assol prico for an oconomy llal is arLilrago-froo will complolo markols
is lloroforo
A

(0) = A
I
(0)H
"
_
A

(1)
A
I
(1)
_
If a risk-froo assol oxisls llal las inilial prico of $1 ano pay-o (1 :) llon
A

(0) =
1
(1 :)
H
"
[A

(1)[
ano in llis caso Q is llo risk-noulral proLaLilily moasuro.
1loso pricing approaclos involvo a clango of moasuro lo llo oquivalonl mar-
lingalo moasuro, or lo llo risk-noulral moasuro wloro llo risk froo socurily is llo
numcrairo, ano llo prico is oorivoo as an oxpocloo valuo unoor llo now moasuro.
1lo mulli-porioo nnilo lorizon oconomy is a nalural oxlonsion of llo singlo
porioo caso. Markols now nooo lo Lo oynamically complolo in oroor for conlin-
gonl claims lo Lo allainaLlo. Dynamic solf-nnancing lraoing slralogios can Lo
usoo lo roplicalo llo conlingonl claim. In llo mulli-porioo caso, unoor an oquiv-
alonl proLaLilily moasuro Q, llo assol prico procoss in lorms of llo numcrairo
assol / is a marlingalo. Unoor llo risk-noulral proLaLilily moasuro llo assol
prico oiscounloo al llo risk-froo ralo lo prosonl valuos is a marlingalo.
Markols, incluoing markols for insuranco ano onorgy risk, aro oflon incom-
plolo. In oroor lo prico conlingonl claims in lloso markols il is nocossary lo uso
assumplions aLoul llo agonls in llo oconomy ano lloir proforoncos in oroor lo
oolormino an oquivalonl marlingalo moasuro lo uso for pricing. Ono approacl is
Lasoo on oxpocloo ulilily.
Consioor an oconomy al limo t consisling of inoiviouals will ulilily funclion
ovor consumplion givon Ly
l (c
|
, c
|1
) = n(c
|
) ,H
|
[n(c
|1
)[
wloro c
|
is consumplion al limo t, n(.) is an incroasing concavo ulilily funclion, ,
is a suLjoclivo oiscounl faclor ano H
|
is llo conoilional oxpoclalion oporalor ovor
fuluro slalos al limo t1. Inoiviouals maximizo llis ulilily funclion Ly solocling
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 132
llo oplimal amounl of oacl socurily lo lolo, incluoing conlingonl claims, ano
lloir oplimal consumplion.
Assumo llal llo oplimal lovol of consumplion is (
+
|
ano (
+
|1
() in slalo
al limo t 1. Socurily i las pay-o al limo t 1 of A

(t 1, ) in slalo ano is
assumoo lo lavo prico 1

(t) al limo t. Donolo Ly 0 llo aooilional amounl

of socurily i purclasoo al prico 1

(t) ovor ano aLovo llo oplimal loloing.

1lo inoivioual will solocl for any givon prico Ly solving llo following proL-
lom
J (c
|
) = max

[n(c
|
) ,H
|
[n(c
|1
)[[
sucl llal
c
|
= (
+
|
1

(t)
c
|1
() = (
+
|1
() A

(t 1, ) for all
SuLsliluling llo conslrainls inlo llo oLjoclivo givos
J (c
|
) = max

n((
+
|
1

(t) ) ,H
|

n
_
(
+
|1
A

(t 1)
___
Dioronlialing will rospocl lo ano solling lo zoro givos llo conoilion for
oplimal loloing of llo socurily i ano oplimal consumplion al llo oquiliLrium as
follows
0
0
J (c
|
) [
=0
= 1

(t) n
t
((
+
|
) ,H
|

(t 1)n
t
_
(
+
|1
__
so llal
1

(t) = H
|
_
,
n
t
_
(
+
|1
_
n
t
((
+
|
)
A

(t 1)
_
If wo lol llo sloclaslic oiscounl faclor Lo
: = ,
n
t
_
(
+
|1
_
n
t
((
+
|
)
llon
1

(t) = H
|
[:A

(t 1)[
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 133
wloro oxpoclalion is lakon will rospocl lo llo roal worlo" proLaLilily moasuro
I.
If a risk froo socurily oxisls llon an invoslmonl of 1 in llis socurily will pay-o
(1 :) in ono limo porioo so llal
1 = H
|
[:(1 :)[
or
1
(1 :)
= H
|
[:[
Dolormining pricos of conlingonl claims in an arLilrago-froo oconomy roquiros
llo form of llo sloclaslic oiscounl faclor lo Lo spocinoo.
5.2.2 OuaI Tneory EquIIILrIun
In Dual 1loory llo proLlom for a singlo-porioo is
_

_
max
C
u
,C
1
(
0
,H((
1
)
suLjocl lo (
0
, (
1
_ 0
ano \
0
= (
0

1
1 :
H
"
[(
1
[
(.1)
wloro (
0
ano (
1
aro consumplion al limo 0 ano 1 rospoclivoly. Supposo llal (
+
0
ano (
+
1
aro solulion lo (.1). IorlurL llo consumplion (
+
0
in sucl a way llal llo
consumor consumos loss llan (
+
0
in oroor lo invosl in a socurily ; wloso prico al
limo 0 is a

. 1lis lranslalos lo
t = 0 : (
+t
0
= (
+
0
a

t = 1 : (
+t
1
= (
+
1
A

wloro is llo fraclion invosloo in llo socurily ; ano A

is llo socurily ; prico

al limo 1.
1lo oLjoclivo is
C/; = (
+
0
a

H ((
+
1
A

)
= (
+
0
a

H
I
[(
+
1
A

[
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 134
wloro

H
I
[(
+
1
A

[ =

U
I
I

(.) ((
+
1
(.) A

(.))
ano
I
I

(.) = h(I[(
+
1
A

_ (
+
1
(.) A

(.)[) h(I[(
+
1
A

(
+
1
(.) A

(.)[)
Nolo llal is nol an oxpoclalion sinco llo woiglls I
I

(.) oopono on A ano llo

oporalor

H
I
is nol linoar.
Wo know llal C/; is maximizoo for = 0 (sinco (
+
0
ano (
+
1
aro oplimal).
If C/; is concavo in ano oioronliaLlo llon is maximizoo wlon llo oorivalivo
0Ob
0
is zoro.
0C/;
0
= a

U
01
I

0
(.) ((
+
1
(.) A

(.))

U
I
I

(.)A

(.)
Now,
0Ob
0

=0
= 0 implios
a

=

U
I
It
0
(.)(
+
1
(.)

U
I
I
0
(.)A

(.)
1lis givos a rolalionslip Lolwoon llo prico of llo socurily ; al limo 0 ano limo
1. If I
It
0
= 0, llon wo lavo
a

=

U
I
I
0
(.)A

(.)
= H(A

)
5.3 CertaInty EquIvaIent, HIsk AversIon
and IroLaLIIIty OIstortIon FunctIons
In oxpocloo ulilily lloory, risk avorsion is claraclorizoo Ly a ulilily funclion
wlicl is concavo ano incroasing in woalll. Inoiviouals aro risk avorso if lloy
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 135
aro unwilling lo accopl a fair gamLlo llal loavos lloir woalll unclangoo. If A
is a risk (ranoom variaLlo) sucl llal H[A[ = 0 (fair gamLlo), ano \ is llo
inoivioual`s woalll, llon for a risk-avorso inoivioual
n(\) H[n(\ A)[
wloro n is llo inoivioual`s ulilily funclion.
1o assumo sucl a risk, a risk-avorso inoivioual nooos lo rocoivo a risk promium
H(A) sucl llal
n(\ H(A)) = H[n(\ A)[
\ H(A) is calloo llo corlainly oquivalonl of \A, as il roprosonls llo sum of
monoy wlicl, wlon rocoivoo will corlainly is consiooroo as oquivalonl lo \A.
Ioarranging givos
H(A) = n
1
(H[n(\ A)[) \
ano if llo ulilily funclion is sucl llal
n
1
(H[n(\ A)[) = \ n
1
(H[n(A)[)
llon
H(A) = n
1
(H[n(A)[)
will Lo inooponoonl of curronl woalll.
Yaari (1087, [118[) oovolopoo llo oual lloory of cloico unoor risk (loroaflor
Dual 1loory) llal is llo oual of oxpocloo ulilily. Wang`s approacl lo pricing
insuranco risks is consislonl will Yaari`s Dual 1loory. In Dual 1loory, llo
corlainly oquivalonl of a risk A (non-nogalivo ranoom variaLlo) is oonnoo as
H(A) =
_
o
0
q(o
A
(a))da =
_
o
0
aq
t
(o
A
(a))d1
A
(a) (.2)
wloro o
A
(a) = I[A a[ , ano q is an incroasing oioronliaLlo funclion will
0 < q(n) < 1 ano q(0) = 0 ano q(1) = 1. 1lo funclion q is roforroo lo as
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 136
a proLaLilily oislorlion funclion. For oxpocloo ulilily, llo ulilily funclion is
applioo lo woalll a ano is llon woiglloo Ly proLaLililios. In Dual 1loory llo
proLaLilily oislorlion funclion is applioo lo survival proLaLililios ano is linoar
in woalll.
Noling llal llo oxpocloo valuo is givon Ly
H[A[ =
_
o
0
ad1
A
(a)
ano comparing H(A) lo H[A[, H(A) can Lo llougll of as a corrocloo moan of A
wloro llo paymonl a rocoivos a woigll q
t
(o
A
(a)) _ 0. Nolo llal lloso woiglls
sum lo 1 sinco
_
o
0
q
t
(o
A
(a))d1
A
(a) =
_
o
0
d
da
[q(o
A
(a))[da
= q(1) q(0)
= 1
If q is convox, llon
a
1
a
2
=o
A
(a
1
) < o
A
(a
2
) =q
t
(o
A
(a
1
)) < q
t
(o
A
(a
2
))
1loroforo, llo woigll assignoo lo a ligl oulcomo is loss llan llo woigll assignoo
lo a low oulcomo. Honco, Ly oislorling llo lail oislriLulion will a convox
funclion, an inoivioual Lolavos possimislically, in llo sonso llal lloy assign a
liglor proLaLilily lo low oulcomos ano lowor proLaLilily lo ligl oulcomos.
1lo Arrow-Irall moasuro of aLsolulo risk avorsion
1
is a local moasuro of
risk-avorsion for a ulilily funclion, as usoo in llo corlainly oquivalonl assuming
oxpocloo ulilily. In a similar faslion lo llo ulilily funclion, q las associaloo will
il a moasuro of risk avorsion. 1lo comparison of risk avorsion in llis framowork
is nalurally Lasoo on llo convoxily of llo funclion q roprosonling llo agonl`s
proforonco funclion. 1lo moro convox llo funclion q, llo moro risk avorso llo
agonl. 1lo oual Arrow-Irall risk avorsion woulo Lo in llis caso q
tt
(j),q
t
(j) for
1
Arrow-Irall`s aLsolulo risk avorsion is oonnoo as D+Z, @
x
33
+Z,
x
3
+Z,
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 137
0 < j < 1, as oonnoo in Yaari (1086, [117[). In llo sonso of Ioss (1081, [04[),
agonls aro slrongly moro risk avorso, if lloy roquiro a largor componsalion for
any moan prosorving sproao in lloir prospocls, ovon if llo inilial silualion is nol
ono of porfocl corlainly. Iisk avorsion moasuromonl in llo sonso of Yaari (1086,
[117[) ano Ioss (1081, [04[) is oiscussoo in Iooll (1087, [02[).
1o sum up, wlilo risk avorsion in ulilily lloory is moasuroo Ly llo ulilily
funclion, in Dual 1loory, il is moasuroo Ly llo proLaLilily oislorlion funclion.
1lo cloico of llo proLaLilily oislorlion funclion q oolorminos llo proporlios of
llo corlainly oquivalonl.
In llo liloraluro, Wang (1006, [111[) proposos a gonoral class of proLaLil-
ily oislorlion funclions lo uso in oolormining insuranco promiums. Wlon llo
proLaLilily oislorlion funclion is a powor funclion, q(a) = a
v
, llo mapping
o
A
(a) q(o
A
(a))
is calloo llo Iroporlional Hazaros lransform. Alllougl llo Iroporlional Haz-
aros lransform las proporlios llal aro consiooroo approprialo for insuranco pric-
ing, llo lransform is inconsislonl in llo lroalmonl of assols ano liaLililios.
Wang (2000, [118[) proposos anollor class of oislorlion funclions
q
c
(n) = 1[1
1
(n) c[
wloro 1(n) =
_
&
o
1
_
2
c

a
2
2
da is llo slanoaro normal cumulalivo oislriLulion
funclion.
van oor Hook ano Slorris (2001, [106[) consiooroo llo proLaLilily oislorlion
funclion approacl ano proposoo llo uso of lwo oioronl oislorlion funclions, q
ano h, lo allow a oioronl lroalmonl of llo upsioo ano oownsioo of llo risk.
Il is imporlanl lo rocognizo llal corlainly oquivalonls aro nol markol pricos
for risks. 1lis issuo is oiscussoo in Lanosman ano Slorris (2001, [60[).
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 138
5.4 Vang`s IroLaLIIIty OIstortIon Func-
tIon and Asset IrIcIng
Wang (2000, [118[) rocognizoo llal llo Iroporlional Hazaros proLaLilily lrans-
form can nol Lo applioo consislonlly lo assols ano liaLililios simullanoously. Ho
proposoo a oioronl class of proLaLilily oislorlion funclion llal aims lo inlo-
gralo nnancial ano acluarial insuranco pricing lloorios. 1lo proLaLilily oislor-
lion funclion proposoo is Lasoo on llo slanoaro cumulalivo normal oislriLulion.
In lis papor Wang slalos llal llo now oislorlion funclion connocls four oioronl
approaclos:
1. llo lraoilional acluarial slanoaro oovialion principlo,
2. Yaari`s oconomic lloory of risk,
8. (/T/, ano
4. oplion-pricing lloory.
Wo will oovolop llo approacl in llis soclion of llo claplor. Consioor A
a ranoom variaLlo will a oocumulalivo oislriLulion funclion o
A
(a) = I[A
a[. Lol 1(a) =
_
a
0
1
_
2
c

I
2
2
dt Lo llo slanoaro normal cumulalivo oislriLulion
funclion ano oonno
q
c
(j) = 1[1
1
(j) c[
for j in [0, 1[. 1lis oporalor slifls llo jth quanlilo of A, assuming llal A is
normally oislriLuloo, Ly a posilivo or nogalivo valuo c ano ro-ovalualos llo
normal cumulalivo proLaLilily for llo slifloo quanlilo. Wang slows llal q
c
(j)
is concavo for posilivo c ano convox for nogalivo c. In facl il is oasy lo soo llal
if c 0, llon q
c
(j) j, ano if c < 0, llon q
c
(j) < j. Sinco q
c
is conlinuous
ano q
c
(j) [0, 1[, llon il follows llal
q
c
is convox if c < 0
q
c
is concavo if c 0
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 139
Unoor llis oislorlion funclion, an inoivioual Lolavos possimislically Ly slifling
llo quanlilos lo llo lofl, lloroLy assigning liglor proLaLililios lo low oulcomos,
ano Lolavos oplimislically Ly slifling llo quanlilos lo llo rigll lloroLy assigning
liglor proLaLililios lo ligl oulcomos.
Wang (2000, [118[) oonnos llo risk-aojusloo promium for a risk A, Ly llo
Cloquol inlogral roprosonlalion
H[A: c[ =
_
0
o
q
c
[o
A
(a)[ 1da
_
o
0
q
c
[o
A
(a)[da
wloro A will Lo nogalivo if il is an insuranco loss ano will lako posilivo valuos
for llo pay-o from a limiloo-liaLilily assol. Nolo llal llo oxpoclalion of A can
Lo wrillon as follows
2
H[A[ =
_
0
o
[o
A
(a) 1[da
_
o
0
o
A
(a)da
Wlon A is a posilivo ranoom variaLlo, llo Cloquol inlogral roprosonlalion las
llo simplor form
H[A: c[ =
_
o
0
q
c
[o
A
(a)[da
1lo lail proLaLilily oislriLulion o
A
(a) is oislorloo Ly llo funclion
q
c
(j) = 1[1
1
(j) c[
Iroporlios of llis proLaLilily oislorlion funclion aro incluooo in Wang (2000,
[118[). In parlicular, llo casos wloro llo risk las a normal oislriLulion ano
wloro llo risk las a log-normal oislriLulion aro consiooroo.
If a risk A las a normal oislriLulion, A(j, o
2
), llon
H[A: c[ = j co
ano if (ln A) q A(j, o
2
), llon
H[A: c[ = c
jco
o
2
2
2
Soo llo Apponoix for oolails
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 140
For complolonoss lloso rosulls aro oorivoo in llo Apponoix.
Ollor proporlios of inlorosl, llal oo nol oopono on llo oislriLulion of A,
aro:
For a conslanl c, H[c: c[ = c ano H[A c: c[ = H[A: c[ c,
H[A: c[ < H[A[ if c < 0 ano H[A: c[ H[A[ if c 0,
For / 0, H[/A: c[ = /H[A: c[,
For / < 0, H[/A: c[ = /H[A: c[ ano as a spocial caso H[A: c[ =
H[A: c[.
Wang (2000, [118[) oovolops an approacl lo assol pricing Ly applying H [A: c[
lo llo prosonl valuo of an assol wloro llo prosonl valuo is oolorminoo Ly ois-
counling al llo risk froo inlorosl ralo. 1lo oconomic assumplions unoorlying llo
approacl amounl lo lroaling llo corlainly oquivalonl as a markol prico. 1lo
H [A: c[ can Lo consiooroo as llo corlainly oquivalonl of a risky casl ow. In
oroor lo oorivo pricing rosulls using H [A: c[, an implioo c is oorivoo llal on-
suros llo corlainly oquivalonl is consislonl will llo markol prico of llo assol.
1lis caliLralos llo corlainly oquivalonl lo llo markol prico.
Wang consioors Loll an lorizon of ono yoar ano also a mulli-porioo lorizon.
For llo singlo porioo lorizon lol A

(0) Lo llo assol prico al limo 0 of a socu-

rily i, ano A

(1) llo pay-o of llo socurily al limo 1. 1lo por porioo rolurn
compounooo annually is oonoloo Ly 1

=
A
z
(1)
A
z
(0)
1 ano :
)
is llo risk-froo ralo.
Assuming llal 1

is normally oislriLuloo will a moan H[1

[ ano a slanoaro
oovialion o[1

[ llon
H[1

: c

[ = H[1

[ c

o[1

[
Wang rofors lo H[1

: c

[ as llo risk-aojusloo ralo of rolurn for socurily i.

Now if c

is solocloo so as lo oqual
c

=
H[1

[ :
)
o[1

[
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 141
llon
H[1

: c

[ = H[1

[
H[1

[ :
)
o[1

[
o[1

[
= :
)
For llis soloclion of c, using llo proporlios of H[A: c[, llo corlainly oquiva-
lonl will Lo
H
_
A

(1)
1 :
)
: c

_
=
1
1 :
)
H [A

(1): c

[
=
A

(0)
1 :
)
[H [(1 1

) : c

[[
=
A

(0)
1 :
)
[1 H [1

: c

[[
= A

(0)
wloro llo rosull rolios on llo assumplion llal llo por porioo rolurn is normally
oislriLuloo ano llal c

is solocloo so llal H [1

: c[ oquals llo risk-froo ralo.

Wang consioors llo mulli-porioo lorizon caso ano Ly a limiling argumonl
oorivos rosulls for a conlinuous-limo moool. Ho assumos llal llo socurily prico
A

(t) follows goomolric Lrownian molion will

dA

(t)
A

(t)
= j

dt o

d\

wloro d\

is an incromonl in a Lrownian molion. In llo conlinuous-limo caso,

llo cloico of
c

=
j

:
c
o

_
1
wloro :
c
oonolos llo conlinuously compounooo risk-froo ralo, rosulls in q
c
z
lransforming llo assol prico oislriLulion o
A
z
(T)
lo o
Y
z
(T)
wloro
ln 1

(1) ~ A
_
lnA

(0)
_
:
c

1
2
o
2

_
1, o
2

1
_
Wang`s pricing approacl givos
A

(0) = c
v
o
T
H [A

(1): c

[
Wang slalos llal llis rosulls follows sinco llo
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 142
no arLilrago conoilion (or simply markol valuo concopl) implios llal llo risk-
aojusloo prosonl valuo of fuluro slock prico musl oqual llo curronl slock
prico".
For llo caso wloro
A

(1) = (A
T
1)

llo corlainly oquivalonl oiscounloo al llo risk froo inlorosl ralo is llo samo as
llo Llack-Sclolos formula. A formal proof is givon lalor in llis claplor.
5.5 ContIngent CIaIn IrIcIng
1lo nnancial lloory usoo lo oorivo llo Llack-Sclolos oplion pricing formula usu-
ally assumos llo unoorlying socurily pricos follow a goomolric Lrownian molion.
In llis caso llo no-arLilrago approacl involving a clango of moasuro is slown
lo Lo oquivalonl lo llo proLaLilily oislorlion funclion approacl oovolopoo in
llo insuranco liloraluro. In ollor woros, pricing a conlingonl claim using risk-
noulral valualion Ly laking llo oxpoclalion of llo payo unoor llo Q moasuro is
llo samo as llo insuranco promium oolorminoo Ly Wang`s proLaLilily oislorlion
funclion.
5.5.1 Vang`s Aroacn and HIack-ScnoIes
Wang`s proLaLilily oislorlion funclion is Lasoo on llo slanoaro normal cumula-
livo oislriLulion funclion. Wlon llo unoorlying socurily pricos aro log-normal,
Wang`s approacl rosulls in a vory simplo form for llo prico of a conlingonl claim.
1lis rosull is provoo in llo following proposilion.
IroosItIon 5.5.1 1 7 h n nnJn:J n:nn| n:.nh| nnJ A h n :nnJ:-
nn.n J 7 &h hn A = h(7) h: h . n n.n&&, .. nnJ .n:n.nj
J&n.n. Jhn
H(A: c) = H[h(7 c)[ (KLINLL)
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 143
h:
H(A: c) =
_
o
0
q
c
(o
A
(t))da
q
c
(j) = 1[1
1
(j) c[
nnJ
1(a) =
_
a
0
1
_
2:
c

I
2
2
dt
IrooI. Wo lavo
H(A: c) =
_
o
0
q
c
(o
A
(t))dt
Now
o
A
(t) = I[A t[
= I[h(7) t[
= I[7 h
1
(t)[
= 1 1(h
1
(t))
= 1(h
1
(t))
ano
q
c
(o
A
(t)) = 1[1
1
(1(h
1
(t))) c[
= 1[h
1
(t) c[
= 1 1[h
1
(t) c[
= I[7 h
1
(t) c[
= I[h(7 c) t[
1loroforo
H(A: c) =
_
o
0
I[h(7 c) t[dt
= H[h(7 c)[
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 144
1lo posilivonoss of h assumplion can Lo rolaxoo. 1lo lasl form of llo oxprossion
for H(A: c) follows from a slanoaro rosull on oxpocloo valuos incluooo in llo
Apponoix.
Moro gonorally, llis proposilion can Lo oxlonooo lo llo caso wlon llo socurily
prico is a funclion of a symmolrically oislriLuloo ranoom variaLlo.
Inoooo, as wo will slow lalor, any proLaLilily oislorlion funclion of llo form
1(1
1
(a) c)
wloro 1 is llo cumulalivo oislriLulion funclion of llo unoorlying ranoom vari-
aLlo yiolos a pricing formula will a simplo form.
IrIcIng a SecurIty If o
|
is llo prico of a socurily al limo t, following a
goomolric Lrownian molion so llal o
|
= o
0
c
(j
o
2
2
)|oWI
wloro \
|
is a Lrownian
molion unoor I llon o
T
can Lo wrillon as a funclion of llo slanoaro normal
ranoom variaLlo 7. In llis caso o
T
= h(7) wloro h(a) = o
0
c
(j
o
2
2
)To
_
Ta
.
Applying llo rolalion (KLINLL) in Iroposilion ..1 wo llon lavo
H(o
T
: c) = H[h(7 c)[
= H[o
0
c
(j
o
2
2
)To
_
TZo
_
Tc
[
= o
0
c
(j
o
2
2
)To
_
Tc
o
2
T
2
For c =
j :
c
o
_
1 llo oxprossion for H(o
T
: c) simplinos lo
H(o
T
: c) = o
0
c
v
o
T
If wo oolormino llo prosonl valuo of llo corlainly oquivalonl using Wang`s
approacl llon llo curronl prico of llo assol Locomos
c
v
o
T
H(o
T
: c) = c
v
o
T
o
0
c
v
o
T
= o
0
1lus llo paramolor c caliLralos llo oiscounloo corlainly oquivalonl of llo so-
curily prico on a fuluro oalo lo llo inilial prico of llo socurily.
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 145
IrIce oI a Euroean CaII OtIon In llo slanoaro Llack-Sclolos moool
assol pricos follow a goomolric Lrownian molion will
do(t)
o(t)
= jdt od\
|
so llal
o
T
= o
0
c
(j
o
2
2
)ToW
T
A slanoaro Luropoan call oplion las pay-o al malurily 1:
((1, 1) = (o
T
1)

ano wo can wrilo llis as ) (7) wloro 7 is a slanoaro normal ranoom variaLlo
ano
)(7) =
_
o
0
c
(j
o
2
2
)To
_
TZ
1
_

Applying llo rolalion (KLINLL) in Iroposilion ..1 wo lavo

H(((1, 1), c) = H[)(7 c)[
=
_
o
o
_
o
0
c
(j
o
2
2
)To
_
Tco
_
T:
1
_

1
_
2:
c

:
2
2
d:
1lo valuos of : for wlicl o
0
c
(j
o
2
2
)To
_
Tco
_
T:
_ 1 oolorminos llo rogion of
inlogralion. 1lis rogion is [:
nin
, ) wloro
:
nin
=
ln(1,o
0
) (j o
2
,2)1 o
_
1c
o
_
1
Honco
H(((1, 1): c) =
_
o
:
nIn
_
o
0
c
(j
o
2
2
)To
_
Tco
_
T:
1
_
1
_
2:
c

:
2
2
d:
=
_
o
:
nIn
o
0
c
(j
o
2
2
)To
_
Tco
_
T:
1
_
2:
c

:
2
2
d: 1
_
o
:
nIn
1
_
2:
c

:
2
2
d:
= o
0
c
jTo
_
Tc
_
o
:
nIn
c

1
2
(ao
_
T)
2 1
_
2:
c

:
2
2
d: 1
_
o
:
nIn
1
_
2:
c

:
2
2
d:
= o
0
c
jTo
_
Tc
_
1 1(:
nin
o
_
1)
_
1 [1 1(:
nin
)[
= o
0
c
jTo
_
Tc
1(:
nin
o
_
1) 11(:
nin
)
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 146
CaliLraling Wang`s oiscounloo corlainly oquivalonl lo llo unoorlying socurily
prico using
c =
(j :
c
)
o
_
1
givos
c
voT
H (((1, 1): c) = o
0
1
_
ln(
S
u
1
(:
c

o
2
2
)1
o
_
1
_
c
voT
11
_
ln(
S
u
1
(:
c

o
2
2
)1
o
_
1
_
wlicl is llo Llack-Sclolos prico of llo call oplion al limo 0.
1lis oomonslralos llal Wang`s proLaLilily oislorlion funclion approacl ro-
covors llo Llack-Sclolos prico of a Luropoan call oplion will c =
jv
o
o
_
1.
5.5.2 IroLaLIIIty OIstortIon Aroacn and Cnange oI Aea-
sure
Givon llal Wang`s approacl using a proLaLilily oislorlion oporalor is consislonl
will nnancial lloory wlon llo unoorlying socurily prico is orivon Ly a goomolric
Lrownian molion, il sloulo Lo possiLlo lo slow llal il is oquivalonl lo a clango
of moasuro wlon oolormining llo oxpocloo pay-o of llo socurily unoor a risk-
noulral proLaLilily moasuro.
For llo Llack-Sclolos caso wloro o
|
las a log-normal oislriLulion, llo oy-
namics of o
|
aro givon Ly llo sloclaslic oioronlial oqualion
do
|
= o
|
(jdt od\
|
)
unoor llo roal-worlo` proLaLilily moasuro I. 1lo solulion lo llis SDL is
o
|
= o
0
c
(j
o
2
2
)|oWI
1lo risk-noulral proLaLilily moasuro Q, unoor wlicl llo oiscounloo socurily
pricos aro a marlingalo is oolorminoo Ly llo likolilooo ralio, or Iaoon-Nikoo m
oorivalivo, givon Ly
:(t) =
dQ
d1

T
I
= cxp
_

_
j :
o
_
\
|

1
2
_
j :
o
_
2
t
_
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 147
sucl llal
H
"
[A[ = H[:A[
Ly Girsanov`s lloorom, llo procoss
\
+
|
= \
|

j :
o
t
is a slanoaro Lrownian molion unoor Q ano
d\
+
|
= d\
|

j :
o
dt
Wriling llo oynamics of o unoor Q givos
do
|
= o
|
(:dt od\
+
|
)
so llal
o
|
= o
0
c
(v
o
2
2
)|oW
W
I
1lo oocl of llo clango of proLaLilily moasuro is lo slifl llo orifl from j lo
:. 1lo procoss :(t) is llo sloclaslic oiscounl faclor ano in llo Llack-Sclolos
caso wo lavo an oxplicil form for llis oiscounl faclor. In facl il las a log-normal
oislriLulion.
Now
I[o
|
_ a[ = I
_
ln o
0
(j
o
2
2
)t o\
|
_ lna
_
= 1
_
ln(a,o
0
) (j
o
2
2
)t
o
_
t
_
Unoor llo risk-noulral moasuro
Q[o
|
_ a[ = 1
_
ln (a,o
0
) (:
o
2
2
)t
o
_
t
_
Wo llon lavo
ln (a,o
0
) (:
o
2
2
)t
o
_
t
=
ln(a,o
0
) (j
o
2
2
)t
o
_
t

j :
o
_
t
= 1
1
(I[o
|
_ a[)
j :
o
_
t
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 148
so llal
Q[o
|
_ a[ = 1
_
1
1
(I[o
|
_ a[)
j :
o
_
t
_
1lis roprosonlalion is usoo in crooil risk moooling wloro llo oofaull proLaLilily
unoor llo roal worlo" proLaLilily oislriLulion is rolaloo lo llo oofaull proLa-
Lilily unoor llo risk-noulral oislriLulion usoo for pricing, soo Loln (1000, [18[).
In llo log-normal caso llo inluilion Lolino using Wang`s approacl is cloar
sinco llo proLaLilily unoor llo Q moasuro is llo samo as llal givon Ly Wang`s
proLaLilily oislorlion funclion. Wo can soo llis sinco
Q[o
|
a[ = 1 Q[o
|
_ a[
= 1 1
_
1
1
(I[o
|
_ a[)
j :
o
_
t
_
= 1
_
1
1
(I[o
|
_ a[)
j :
o
_
t
_
ano
1
1
() = 1
1
(1 )
So
Q[o
|
a[ = 1
_
1
1
(1 I[o
|
_ a[)
j :
o
_
t
_
= 1
_
1
1
(I[o
|
a[)
j :
o
_
t
_
(.8)
Now, for any allainaLlo conlingonl claim of llo form A
T
= h(o
T
), wloro h is a
posilivo incroasing funclion wo lavo
Q[A
T
a[ = Q[h(o
T
) a[
= Q

o
T
h
1
(a)
_
= 1
_
1
1
_
I[o
T
h
1
(a)[
_

j :
o
_
1
_
= 1
_
1
1
(I[h(o
T
) a[)
j :
o
_
1
_
= 1
_
1
1
(I[A
T
a[)
j :
o
_
1
_
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 149
Sinco oxpoclalion unoor llo moasuro Q is givon Ly
H
"
[A
T
[ =
_
o
0
Q[A
T
a[da
for a posilivo ranoom variaLlo A
T
. Wo oLlain
H
"
[A
T
[ =
_
o
0
1
_
1
1
(I[A
T
a[)
j :
o
_
t
_
da
= H(A
T
:
j :
o
_
t)
5.6 CeneraIIzatIon oI Vang`s Aroacn
5.6.1 SynnetrIc OIstrILutIons
Wo can gonoralizo llo provious proposilion wloro llo unoorlying variaLlo 7 las a
normal proLaLilily oislriLulion lo llo caso wloro 7 is symmolrically oislriLuloo.
IroosItIon 5.6.1 1 7 h n :nnJn n:.nh| .h n &n&|n. J.:.h&.n
J&n.n 1 h :hnh.|.j Jn.j J&n.n . jnn:. n:&nJ 0. nJ | A
h n :nnJ:nn.n J 7 &h hn A = h(7) h: h . n n.n&&, ..
nnJ .n:n.nj J&n.n. 1]n h :n:
1(A, c) =
_
o
0
1[1
1
(Ir[A t[) c[dt
1 hn
1(A, c) = H[h(7 c)[
IrooI. For any 1 wloso proLaLilily oonsily is symmolric arouno 0 wo will
lavo 1(a) = 1 1(a). For A = h(7):
o
A
(t) = I[A t[
= I[h(7) t[
= I[7 h
1
(t)[
= 1 1(h
1
(t))
= 1(h
1
(t))
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 150
Donno q
c
(o
A
(t)) = 1[1
1
(o
A
(t)) c[, llon
q
c
(o
A
(t)) = 1[1
1
(1(h
1
(t))) c[
= 1[h
1
(t) c[
= 1 1[h
1
(t) c[
= I[7 h
1
(t) c[
= I[h(7 c) t[
1loroforo
1(A, c) =
_
o
0
q
c
(o
A
(t))dt
=
_
o
0
I[h(7 c) t[dt
= H[h(7 c)[
1lis is a gonoral oxprossion for H(A: c) wlon A = h(7) is a funclion of a
ranoom variaLlo 7 wloso proLaLilily oonsily funclion is symmolric arouno 0.
Sinco 7 = h
1
(A), wo lavo
1(A, c) = H[h(h
1
(A) c)[
5.6.2 TIne-varyIng OrIIt and YoIatIIIty Ior tne SecurIty
IrIce
Wo will consioor llo caso wloro llo unoorlying socurily prico is log-normally
oislriLuloo will limo-varying orifl ano volalilily ano slow low Wang`s approacl
can Lo oxlonooo in oroor lo oorivo pricos consislonl will nnancial lloory.
Lol A
|
Lo a slalo variaLlo following llo roal-worlo" oynamics
dA
|
= j(t)dt o(t)d\
|
(.4)
wloro llo orifl ano llo volalilily j(t) ano o(t) aro funclions of limo. Formally
wo lavo
A
|
= A
0

_
|
0
j()d
_
|
0
o()d\
c
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 151
Assumo llal llo unoorlying socurily prico
o
|
= c
AI
so llal o
|
is log-normally oislriLuloo. 1lo oynamics of o
|
aro givon Ly Ilo`s
formula as
do
|
= o
|
_
j(t)
1
2
o
2
(t)
_
dt o
|
o(t)d\
|
(.)
Il is slraigllforwaro lo rolalo llo roal worlo proLaLililios lo llo risk-noulral
proLaLililios. In facl, for a posilivo roal numLor a, wo lavo
I[o
|
_ a[ = I[A
|
_ ln(a)[
= 1
_
ln(a) j
|
o
|
_
(.6)
wloro
j
|
= A
0

_
|
0
j()d
o
2
|
=
_
|
0
o
2
()d
ano 1 is llo slanoaro normal cumulalivo oislriLulion funclion.
Donolo llo markol prico of risk for llo socurily o
|
Ly
|
. 1lo form of
|
is
oolorminoo Ly llo facl llal llo socurily prico, oiscounloo lo prosonl valuo al
llo risk froo inlorosl ralo, will Lo a marlingalo unoor llo risk-noulral proLaLilily
moasuro. 1lo markol prico of risk in an arLilrago-froo oconomy is givon Ly

|
=
j(t)
o(|)
2
2
:
c
o(t)
(.7)
wloro :
c
is llo risk froo inlorosl ralo assumoo lo Lo conslanl. Ly Girsanov`s
lloorom, soo Cox ano Huang (1080, [20, Lomma 2.1[), llo procoss
\
+
|
= \
|

_
|
0

c
d
is a Q-Lrownian molion, wloro Q is llo risk-noulral proLaLilily moasuro. 1lo
aLovo roprosonlalion is oquivalonl lo
d\
+
|
= d\
|

|
dt
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 152
1lo oynamics of A
|
unoor llo risk-noulral proLaLilily will lloroforo Lo
dA
|
= [j(t) o(t)
|
[ dt o(t)d\
+
|
or
A
|
= A
0

_
|
0
[j() o()
c
[ d
_
|
0
o()d\
+
c
For a 0, llo proLaLilily oislriLulion of o
|
unoor Q is givon Ly
Q[o
|
_ a[ = Q[A
|
_ ln(a)[
= Q[A
0

_
|
0
(j() o()
c
)d
_
|
0
o()d\
+
c
_ ln(a)[
= Q[A
0

_
|
0
j()d
_
|
0
o()d\
+
c
_ ln(a)
_
|
0
o()
c
d[
1lo volalilily o(t) is oolorminislic, so
_
|
0
o()d\
c

~ A
_
0,
_
|
0
o
2
()d
_
ano
_
|
0
o()d\
+
c
"
~ A
_
0,
_
|
0
o
2
()d
_
sinco \
+
|
is a Q-Lrownian molion. Moroovor, A
0
ano j(t) aro also assumoo lo
Lo oolorminislic, so
Q
_
A
0

_
|
0
j()d
_
|
0
o()d\
+
c
_ (t)
_
= I
_
A
0

_
|
0
j()d
_
|
0
o()d\
c
_ (t)
_
for any oolorminislic funclion . Il follows llon llal
Q[o
|
_ a[ = I[A
|
_ ln(a)
_
|
0
o()
c
d[
= 1
_
ln(a)
_
|
0
o()
c
d j
|
o
|
_
From oqualion (.6) wo lavo
ln(a) = j
|
o
|
1
1
(I[o
|
_ a[)
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 153
Honco
Q[o
|
_ a[ = 1
_
_
1
1
(I[o
|
_ a[)
_
|
0
o()
c
d
_
_
|
0
o
2
()d
_
_
(.8)
1lo aLovo oqualion oxprossos llo rolalionslip Lolwoon llo cumulalivo ois-
lriLulions of llo socurily prico unoor llo roal-worlo ano llo risk-noulral proLa-
Lililios. Using llo symmolry of 1 wo also lavo
Q[o
|
a[ = 1
_
_
1
1
(I[o
|
a[)
_
|
0
o()
c
d
_
_
|
0
o
2
()d
_
_
(.0)
For a formal proof of (.0), soo llo apponoix. Lol us oonno llo following proLa-
Lilily oislorlion funclion
q

(n) = 1
_
_
1
1
(n)
_
|
0
o()
c
d
_
_
|
0
o
2
()d
_
_
ano oonno llo corlainly oquivalonl as llo following
H(1 : ) =
_
o
0
q

(I[1 n[) dn
for any non-nogalivo ranoom variaLlo 1.
From llo oqualion (.0) ano llo oonnilion of llo oislorlion funclion q

wo
lavo
Q[o
|
a[ = q

(I[o
|
a[)
Now, sinco H
"
[o
|
[ =
_
o
0
Q[o
|
a[ da, il follows llal
H
"
[o
|
[ = H(o
|
: )
Honco, llo oiscounloo corlainly oquivalonl of o
|
is oqual lo llo arLilrago-froo
prico of llo socurily. Lol us consioor llo caso of any allainaLlo conlingonl claim
of llo form A
T
= h(o
T
), wloro h is a posilivo incroasing funclion wo lavo
Q[A
T
a[ = Q[h(o
T
) a[
= Q

o
T
h
1
(a)
_
= q

_
I

o
T
h
1
(a)
__
= q

(I[A
T
a[)
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 154
Inlograling Loll sioos from 0 lo innnily yiolos
H
"
[A
T
[ =
_
o
0
q

(I[A
T
a[) da
= H(A
T
: )
Horo again, llo arLilrago-froo prico of any conlingonl claim of llo form A
T
=
h(o
T
) wloro h is a posilivo incroasing funclion, is oqual lo c
voT
H(A
T
: ). 1lo
aovanlago of sucl roprosonlalion is llal arLilrago-froo pricos can Lo compuloo
slraigllforwaroly from llo oislriLulion of llo unoorlying risk ano llo markol
prico of risk .
5.7 AIIcatIons
Wang`s approacl is roaoily implomonloo using simulalion. For gonoral unoorly-
ing socurily prico oislriLulions il is nol possiLlo lo oorivo an analylical formula
for llo corlainly oquivalonl. In llis caso il is nocossary lo implomonl conlin-
gonl claim valualion using simulalion. 1lis is oflon llo caso in praclico wloro
ompirical sluoios suggosl llal socurily pricos aro nol log-normal.
1o illuslralo llo procoouro wo consioor llo valualion of Luropoan call oplions.
1lo rosulls aro Lasoo on a simulalion of 1000 log-normal pricos will orifl j =
16/ ano volalilily o = 20/. 1lo risk froo inlorosl ralo : = 8/ ano llo curronl
markol prico of llo unoorlying socurily is assumoo lo Lo $20. 1lo malurily of
llo call is 0. yoars ano , = 1.
1lo simulaloo socurily pricos aro usoo lo oslimalo c =
jvo
o
_
1 sucl llal
llo oiscounloo corlainly oquivalonl using llo simulaloo fuluro socurily pricos,
ano Wang`s normal Lasoo proLaLilily oislorlion funclion, will oqual llo inilial
socurily prico. Wo llon oLlain c = 0.283080. 1lis valuo for c is usoo lo llon
prico 8 calls will slrikos $18, $20, $22. Nolo llal llo aclual valuo of c = 0.282843
Lasoo on llo assumplions usoo lo simulalo llo socurily pricos.
1lo following valuos woro oLlainoo ano aro comparoo will llo lloorolical
Llack-Sclolos prico llal woulo lavo Loon oolorminoo using llo analylical for-
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 155
strike price 18.000 20.000 22.000
B-S price 2.913 1.541 0.678
Wangs price 2.927 1.563 0.707
1aLlo .1: A Comparison of Call Oplion Valuos Lolwoon Llack-Sclolos ano
Wang`s Approacl in llo Log-normal Caso
mula.
1lis slows llal llo caliLralion procoss using simulaloo valuos is roasonaLly
accuralo for lloso calls ano suggosls llal pricing conlingonl claims will simula-
lion ano llo corlainly oquivalonl is numorically roliaLlo.
So far llo caso of log-normal socurily pricos las Loon mainly consiooroo. Il
is possiLlo lo apply llis approacl lo ollor socurily prico oislriLulions. In oroor
lo oo llis wo apply a similar algorillm lo llal usoo aLovo. 1lis is oono for
Loll llo commonly usoo Linomial moool ano also for llo conslanl olaslicily of
varianco moool. Wo nrsl caliLralo llo corlainly oquivalonl for llo fuluro socurily
prico lo llo inilial prico in oroor lo oolormino llo paramolor c lo Lo usoo in
conlingonl claim pricing. 1lis caliLraloo paramolor is llon usoo lo ovalualo llo
corlainly oquivalonl using llo normal Lasoo proLaLilily oislorlion funclion of
Wang for conlingonl claims.
5.7.1 Tne Cox, Hoss and HuLInsteIn HInonIaI AodeI
Wo comparo risk-noulral pricos oolorminoo oxaclly ano Wang`s corlainly oquiv-
alonl pricos for a Luropoan call oplion using a Linomial lallico moool for llo
unoorlying socurily, soo Figuro (.1).
1lo valuo of a call oplion will pay-o A
T
= (o
T
1)

wloro o
T
is llo
prico of llo unoorlying socurily al limo 1 is givon Ly
1
Q
[A
T
[ =
T

I=0
Q(.
I
)A
T
(.
I
)
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 156
w
w
T
w
T-1
w
T-2
w
0
0 1 2 3 4 T
Figuro .1: IocomLining Linomial Lallico for 1 Iorioos
wloro
Q(.
I
) =
_
1
/
_

I
(1 )
TI
ano is llo risk-noulral proLaLilily of llo socurily up jump in llo lallico.
Hamaoa n|. (2001, [0[) oslaLlisloo a simplo form for H[A: c[ in llis
oiscrolo-limo caso. Il is givon Ly
H[A
T
: c[ =
T

I=0
q
c
(I[A _ A(.
I
)[) q
c
(I[A A(.
I
)[) A
T
(.
I
)
In lloory wo may Lo aLlo lo oolormino an oxplicil oxprossion for c as follows.
Lol o(/) oonolo llo funclion I[A _ A(.
I
)[. Wo lavo
o(/) =
T

=I
_
1
i
_
j

(1 j)
T
If H[A
T
: c[ = H
Q
[A
T
[ for any conlingonl claim, llon llis is lruo for Arrow-
DoLrou socurilios paying 1 al somo slalo . ano 0 olsowloro. 1lis implios llal
Q(.) = q
c
(I[A _ A(.)[) q
c
(I[A A(.)[) , \. !
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 157
or
_
_
_
_
T
I
_

I
(1 )
TI
= q
c
[o(/)[ q
c
[o(/ 1)[ for all / = 0 lo 1 1

T
= q
c
[j
T
[
1loro is cloarly no valuo for c llal will salisfy all of lloso 1 1 oqualions
simullanoously. Howovor wo can oslimalo an c Ly oolormining llo corlainly
oquivalonl of llo socurily prico oislriLulion ano llon caliLraling llo c so llal
llo oiscounloo corlainly oquivalonl is oqual lo llo curronl prico. 1lis paramolor
oslimalo is llon usoo lo valuo conlingonl claims on llis socurily.
1lo moool for llo socurily prico is llo Linomial moool will a conlinuous
compounoing oxpocloo rolurn of j = 20/ ano a volalilily of o = 20/. 1lo
risk-froo inlorosl ralo is : = 6/, llo limo slop is ^1 = 1,12 of a yoar. For
lloso assumplions, llo roal worlo ano llo risk-noulral proLaLililios of an up
jump in llo Linomial lallico aro j =
_
c
j.T
d
_
, (n d) = 0.631 ano =
_
c
v.T
d
_
, (n d) = 0.20 rospoclivoly. 1lo sizo of an up jump is n = c
o
_
.T
ano llo oown jump is d = n
1
. 1lis prooucos an arLilrago-froo lallico for llo
risk-noulral socurily prico oislriLulion.
1lo socurily prico oislriLulion al llo ono of a yoar is slown in llo 1aLlo
Lolow. 1lo columns in llo 1aLlo slow llo roal worlo socurily prico oislriLulion
j (a), llo oocumulalivo socurily prico oislriLulion I[A a[ , llo risk-noulral
socurily prico oislriLulion (a), llo oislorloo oocumulalivo roal worlo proL-
aLilily oislriLulion using llo normal proLaLilily oislorlion funclion of Wang
q (I[A a[) ano llo oislorloo proLaLilily socurily prico oislriLulion corro-
sponoing lo Wang`s oislorlion funclion
+
(a). In oroor lo oorivo llo oislorloo
proLaLililios il was nocossary lo solvo iloralivoly for llo c llal caliLraloo llo
oiscounloo corlainly oquivalonl of llo socurily prico al llo ono of llo yoar lo
llo inilial socurily prico of $100. 1lo paramolor llal caliLraloo llo prico oislri-
Lulion was c = 0.73102. Lasoo on llo oquivalonl conlinuous-limo socurily prico
procoss llo valuo is c = (0.2 0.06) ,0.2 = 0.7.
In oroor lo illuslralo llo pricing of a conlingonl claim wo prico a call oplion
on llo socurily will slriko $10. 1aLlo (.8) slows llo pay-o al llo ono of
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 158
Node S(T) p(x) P[X>x] q(x) g (P[X>x] ) q*(x)
0 199.93 0.0040 0.0000 0.0005 0.0000 0.0004
1 178.13 0.0280 0.0040 0.0051 0.0004 0.0045
2 158.71 0.0900 0.0320 0.0251 0.0049 0.0241
3 141.40 0.1753 0.1219 0.0745 0.0290 0.0743
4 125.98 0.2307 0.2973 0.1494 0.1032 0.1511
5 112.24 0.2158 0.5279 0.2128 0.2543 0.2153
6 100.00 0.1472 0.7437 0.2211 0.4696 0.2219
7 89.09 0.0738 0.8909 0.1688 0.6916 0.1676
8 79.38 0.0270 0.9647 0.0939 0.8592 0.0925
9 70.72 0.0070 0.9916 0.0372 0.9517 0.0366
10 63.01 0.0012 0.9986 0.0099 0.9883 0.0099
11 56.14 0.0001 0.9999 0.0016 0.9982 0.0017
12 50.02 0.0000 1.0000 0.0001 0.9999 0.0001
1aLlo .2: Ioal-Worlo, Iisk-Noulral ano Dislorloo IroLaLililios ovor a Linomial
Lallico
llo yoar for llo call oplion along will llo pay-o woiglloo Ly llo risk-noulral
proLaLililios ano also llo oislorloo proLaLililios.
1lo risk-noulral prico of llo call is 8.628 ano Wang`s oislorloo proLaLilily
prico is 8.60, a oioronco of 0.068 or 0.7/. Sinco llo Linomial lallico convorgos
lo llo log-normal oislriLulion in llo limil, Wang`s oislorloo proLaLilily prico will
also convorgo lo llo Llack-Sclolos prico as ooos llo risk-noulral prico oolorminoo
from llo lallico. 1lo lwo pricos will lowovor oior for rolalivoly small numLors
of slops in llo lallico.
Alllougl llo oislorloo proLaLilily approacl can Lo implomonloo in a Lino-
mial lallico for Luropoan oplions, il is nol as oasy lo implomonl for oplions will
oarly oxorciso.
5.7.2 Tne (c\ AodeI
As anollor oxamplo of unoorlying socurily pricos llal aro nol lognormal, wo
consioor llo conslanl olaslicily of varianco moool inlrooucoo Ly Cox ano Ioss
(1076, [28[). 1lo oynamics of llo unoorlying socurily pricos aro givon Ly
do
|
= jo
|
dt oo
o2
d7
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 159
payoff Y(x) Y(x)q(x) Y(x)q*(x)
94.93 0.046 0.034
73.13 0.375 0.331
53.71 1.349 1.292
36.40 2.713 2.704
20.98 3.133 3.169
7.24 1.541 1.559
0.00 0.000 0.000
0.00 0.000 0.000
0.00 0.000 0.000
0.00 0.000 0.000
0.00 0.000 0.000
0.00 0.000 0.000
0.00 0.000 0.000
1aLlo .8: IroLaLilily Dislorlion ano Iisk-Noulral Iricing of a Call Oplion will
Slriko $10
wloro d7 is an incromonl of Woinor procoss. 1lo olaslicily of rolurn varianco
will rospocl lo prico oquals ,2, ano if , < 2, volalilily ano pricos aro invorsoly
rolaloo. If , = 2 llon olaslicily is zoro ano pricos aro lognormally oislriLuloo
will llo varianco of rolurns conslanl, as assumoo in llo Llack-Sclolos moool.
Lockors (1080, [0[) oslimalos , for forly sovon slocks ano concluoos llal llo (c\
oiusion procoss coulo Lo a Lollor ooscriplor of llo aclual slock prico Lolavior
llan llo lraoilionally usoo lognormal moool".
1lis moool is usoo as a moro roalislic allornalivo for llo unoorlying socurily
oynamics, wloro llo pricos oxliLil skownoss ano kurlosis, wlicl is also lypically
llo caso for insuranco claims. Cox ano Ioss (1076, [28[) slow llal for llo (c\
moool will , loss llan lwo, llo oonsily funclion of llo slock prico al limo 1
conoilional on llo curronl slock prico in a risk-noulral worlo (will j = : c) is
givon Ly
)(o
T
, 1[o
|
, t) = (2 ,)/
1
23
_
a.
12o
_ 1
{432)
c
a.
1 1
{23)
_
2
_
a.
_
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 160
wloro
/ =
2(: c)
o
2
(2 ,) [c
(vo)(2o)t
1[
a = /o
2o
|
c
(vo)(2o)t
. = /o
2o
T
ano t = 1 t: 1
q
(.) is llo mooinoo Lossol funclion of llo nrsl kino of oroor :
: oonolos llo risk froo inlorosl ralo ano c oonolos llo conlinuous proporlional
oivioono ralo.
Sclrooor (1080, [00[) oLlains a closoo form solulion lo a Luropoan call oplion
wlon llo unoorlying socurily oynamics aro givon Ly llo (c\ moool. 1lo prico
is givon as a funclion of llo non-conlral Cli-squaro cumulalivo funclion. If ( is
llo prico of llo call will oxorciso prico H, llon
( = o
|
c
ot

_
2: 2
2
2 ,
, 2a
_
1c
vt
_
1
_
2a:
2
2 ,
, 2
__
(.10)
wloro = /1
2o
ano (:: d, a) is llo non-conlral Cli-squaro J&n&|n. ois-
lriLulion funclion ovalualoo al :, will d oogroos of froooom ano non-conlral
paramolor a.
Wo will prico a numLor of call oplions using Wang`s proLaLilily oislorlion
funclion approacl ano comparo llo pricos will llo risk-noulral arLilrago-froo
prico givon Ly (.10). Wo will oo llis Ly simulaling 2000 socurily pricos for
llo (c\ moool al llo ono of a yoar using a oiscrolo-limo approximalion lo llo
oiusion procoss will a limo slop of 1,100. 1lo roal worlo socurily pricos aro
simulaloo will j = 1/ ano wo uso : = / ano volalilily o = 20/. 1lo curronl
markol prico of llo unoorlying socurily is $20. 1lo malurily of llo call is 1 yoar
ano llo valuo of , is 0..
Onco again llo c paramolor is oolorminoo from llo simulaloo pricos al llo
ono of llo yoar lo malcl llo inilial socurily prico. 1lo inilial valuo of c, oqual
lo 2.2407 is lwoakoo lo llo valuo c = 2.1410. 1lis valuo is llon usoo lo prico 6
call oplions on llo socurily will slrikos from $18 lo $23.
1aLlo (.4) slows llo oioronco Lolwoon llo arLilrago-froo prico ano llo
oplion prico using Wang`s proLaLilily oislorlion.
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 161
strike price 18.000 19.000 20.000 21.000 22.000 23.000
Arbitrage-free price 2.8779 1.9304 1.0332 0.3645 0.0693 0.0062
Wangs price 2.8779 1.9351 1.1123 0.4308 0.0948 0.0104
Relative Difference -0.003% 0.25% 7.66% 18.18% 36.80% 68.51%
1aLlo .4: AriLlrago-Froo Iricos Comparoo will Wang`s IroLaLilily Dislorlion
Iricing for llo CLV Moool
strike price 18.000 19.000 20.000 21.000 22.000 23.000
B-S price 2.9132 2.1673 1.5413 1.0463 0.6782 0.4203
Wangs price 2.9267 2.1820 1.5629 1.0769 0.7068 0.4396
Relative Difference 0.46% 0.68% 1.41% 2.92% 4.22% 4.59%
1aLlo .: AriLlrago-Froo Iricos Comparoo will Wang`s IroLaLilily Dislorlion
Iricing in Llack-Sclolos Solling
In oroor lo illuslralo llo oocl of llo ooparluro from log-normalily on llo
pricing wo lavo also valuoo llo oplions using llo Llack-Sclolos moool ano llo
simulalion approacl lo implomonl Wang`s proLaLilily oislorlion funclion ap-
proacl. 1lo rosulls aro givon in 1aLlo (.).
Unliko llo log-normal moool, wloro Wang`s proLaLilily oislorlion funclion
approacl only oiors from llo risk-noulral oxacl prico ouo lo llo orrors inlro-
oucoo Ly llo oiscrolizalion ano simulalion, in llo (c\ moool llo oioronco
Lolwoon llo pricos is incroasing as llo oplion goos furllor oul-of-llo monoy.
1lis rosulls from llo skownoss ano kurlosis of llo unoorlying socurily prico ois-
lriLulion oioring signincanlly from llo log-normal socurily prico oislriLulion.
1lo roason for llis can Lo unoorslooo Ly noling llal llo oocl of llo c
paramolor is lo slifl only llo moan of llo oislriLulion Lul il ooos nol aojusl
for llo skownoss or llo kurlosis. 1lis is illuslraloo Ly Figuro (.2). 1lis oxam-
plo oomonslralos llal applying Wang`s proLaLilily oislorlion funclion approacl
using llo normal proLaLilily lransform lo prico conlingonl claims wloro llo
unoorlying socurily oynamics aro nol lognormal will rosull in suLslanlial orrors.
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 162
0 10 20 30 40 50 60
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
Noncentral Chi
square distribution

Lognormal distribution
Figuro .2: Slifling llo Moan of llo Lognormal DislriLulion lo Malcl llo Moan
of llo Nonconlral Cli-Squaro DislriLulion ooos nol Capluro llo Kurlosis
5. Asset IrIcIng usIng IroLaLIIIty OIstortIon FunctIons 163
5.8 ConcIusIon
1lis claplor las consiooroo a roconlly oovolopoo approacl proposoo for conlin-
gonl claims pricing originally oovolopoo for pricing insuranco risk. 1lo approacl
is consislonl will Dual 1loory lo oxpocloo ulilily lloory wlicl is mosl oflon
usoo as llo Lasis of nnancial lloory incluoing oquiliLrium pricing of conlingonl
claims. Wo formally provo llal llo approacl will roproouco llo Llack-Sclolos
oplion pricing formula assuming llal socurily pricos aro log-normal. Wo oxlono
llo approacl lo llo caso wloro llo unoorlying socurily or risk las a symmolric
oislriLulion, ano also consioor llo log-normal caso will limo-varying paramolors
ano formally oorivo llo rolalionslip Lolwoon llo paramolor usoo in llo proLaLil-
ily oislorlion funclion approacl ano llo markol prico of risk for llo unoorlying
socurily. Finally wo liglligll llo limilalions of applying llo approacl using llo
normal proLaLilily oislorlion funclion as proposoo Ly Wang ano illuslralo llo
polonlial issuos in implomonling llo loclniquo using llo Linomial lallico moool
ano llo (c\ moool for socurily pricos.
Givon lloso rosulls, il is of inlorosl lo consioor assol allocalion will risk
moasuros Lasoo on oislorlion funclions. 1lis is llo oLjocl of llo noxl claplor.
lLaplci 0
AuucI AIIocaIIon 1n
LuaI 3hcoty
6.1 IntroductIon
1lo majorily of porlfolio cloico moools assumo llal proforoncos aro roprosonloo
Ly a von Nouman-Morgonslorn ulilily funclion ano inoiviouals clooso among
risky allornalivos so as lo maximizo llo oxpoclalion of llo ulilily of possiLlo
oulcomos. Alllougl llo oxpocloo ulilily moool las long Loon llo slanoaro for
cloico unoor uncorlainly, quoslions lavo Loon raisoo concorning ils valioily, ano
Lolavior pallorns wlicl aro syslomalic, yol inconsislonl will oxpocloo ulilily
lloory lavo oflon Loon oLsorvoo as in llo Allais paraoox (108, [1[) ano Kalno-
man ano 1vorsky (1070, [7[). Maclina (1082, [78[) consioors oxpocloo ulilily
willoul llo inooponoonco axiom". Ho slows llal Lasic concopls ano rosulls of
llo oxpocloo ulilily framowork oo nol oopono on llis axiom, Lul may Lo oorivoo
from a mucl woakor assumplion of smoollnoss of proforoncos ovor allornalivo
proLaLilily oislriLulions. FislLurn (1088, [44[) survoys llo roasons wly llo ox-
pocloo ulilily lypollosis fails. Camoror (1080, [22[) carrios oul ompirical losls
of sovoral gonoralizoo moools of ulilily lloory. Yaari (1087, [118[) oovolopoo
llo oual lloory of cloico unoor risk (loroaflor Dual 1loory) wloro llo rolos of
proLaLililios ano paymonls aro inlorclangoo, so llo woalll ulilily funclion is ro-
placoo Ly a proLaLilily oislorlion funclion. Somo of llo oxpocloo ulilily rolaloo
paraooxos aro rosolvoo in Dual 1loory.
Il can Lo arguoo llal ovon llougl somo ollor allornalivo moools coulo lanolo
llo proLloms rolaloo lo llo oxpocloo ulilily moool, llis lallor woulo slill Lo
approprialo for analyzing somo lypos of cloico unoor risk, soo Noilson (1008,
[81[). Ollor lypos of oocision proLloms, lowovor, woulo Lo moooloo Losl using
164
6. Asset AIIocatIon In OuaI Tneory 165
a non-oxpocloo ulilily framowork. 1loroforo, oxpocloo ulilily lloory sloulo nol
Lo aLanoonoo, Lul rallor applioo will moro caulion.
In a non-oxpocloo ulilily framowork, Wang (100, [111[ ano 1006, [110[)
proposos calculaling insuranco promiums Ly applying llo proporlional lazaros
lransform lo llo oocumulalivo oislriLulion funclion, lloroLy inlrooucing a now
risk moasuro. 1lis now moasuro lurns oul lo Lo consislonl will Yaari`s Dual
1loory. Wang (2000, [118[) also usos a oioronl class of oislorlion oporalors
lo rocovor llo Llack-Sclolos formula. van oor Hook ano Slorris (2001, [106[)
inlroouco a now class of risk moasuros for assol allocalion wlicl is Lasoo on llo
oislorlion funclion approacl lo insuranco risk.
Lufman ano Loioorman (1000, [21[) uso Israoli oala Lolwoon 1078 ano 1086
lo losl an inlorlomporal consumplion-invoslmonl moool inlrooucoo Ly Lpsloin
ano Zin (1080, [42[) llal usos Krops-Iorlous (1078, [64[) non-oxpocloo ulilily
proforoncos. 1loy nno an ovioonco lo rojocl llo oxpocloo ulilily moool ano
accopl llo non-oxpocloo ulilily ono. 1loir rosulls oior from lloso of Lpsloin
ano Zin (1080L [41[) ano Giovannini ano Jorion (1080, [47[) wlo look oala from
llo lranquil poslwar US oconomy. 1lis suggosls llal a non-oxpocloo ulilily
moool may porform Lollor in a volalilo oconomy. 1lo rosulls of llo ompirical
losls of llo samo moool using Froncl oala from 1060 lo 1004 conoucloo Ly
Koskiovic (1000, [68[) supporl lloso of Lufman ano Loioorman (1000, [21[).
Ang n|. (2000, [4[) consioor oynamic porlfolio cloico using llo oisappoinl-
monl avorsion of Gul (1001, [48[). 1loy nno llal moooraloly oisappoinlmonl-
avorso invoslors, will low curvaluro ulilily, lolo roasonaLlo porlfolios, unliko
llo oxpocloo ulilily invoslors wloso oplimal loloings incluoo unroasonaLly largo
oquily posilions.
In llis claplor wo formally lroal risk moasuros Lasoo on llo proLaLilily ois-
lorlion funclions. Now class of risk moasuros for porlfolio soloclion Lasoo on llo
proporlional lazaros lransform, proposoo Ly van oor Hook ano Slorris (2001,
[106[) is llon roviowoo ano oxlonooo lo llo mullinomial caso. 1lis is llo nrsl
slop in solling oul a gonoral sclomo for oynamic assol allocalion wlon llo risk
6. Asset AIIocatIon In OuaI Tneory 166
moasuro is Lasoo on a oislorlion funclion. Somo ollor proporlios, usoful for llo
oplimizalion, aro oovolopoo along llo way. Wo llon proposo lo solvo llo opli-
mal porlfolio proLlom using llo risk-noulral compulalional approacl wlon llo
invoslor Lolavior is moooloo Ly llis now class of risk moasuros. Somo numorical
oxamplos for assol allocalion aro proviooo. Wo nnally provioo a comparison of
llo assol allocalion wlon using llo class of oislorlion oporalors proposoo Ly
Wang (2000, [118[). 1lo conclusion liglliglls somo furllor oovolopmonls.
6.2 OIscrete YersIon oI tne CertaInty
EquIvaIent In OuaI Tneory
Lol q Lo a conlinuous, non-oocroasing funclion, q : [0, 1[ [0, 1[ will q(0) = 0
ano q(1) = 1, ano A Lo a posilivo ranoom variaLlo roprosonling a risk. 1lo risk
A is moasuroo Ly ils corlainly oquivalonl oonnoo as
H(A) =
_
o
0
q(o
A
(t))dt
In llo oiscrolo-limo caso, A lakos : possiLlo valuos (A(.
1
), A(.
2
), ..., A(.
n
))
will proLaLililios (j
1
, j
2
, ..., j
n
), wloro : Q
+
. In proLaLilislic nolalion, lol
! = .
1
, .
2
, ..., .
n
Lo llo proLaLilily spaco wloro .

, i 1, .., : aro llo

slalos of llo worlo, llon I[.

[ = j

for i 1, ..., :.
1lis is lypically llo caso of a lroo moool, wloro llo numLor of slalos grows as
limo ovolvos. 1lo following lloorom givos an oxprossion of H(A) in llo oiscrolo
caso.
Tneoren 6.2.1 {CertaInty equIvaIent) 1J A . n :nnJn n:.nh| n|.nj :
J..n n|& A(.
1
), A(.
2
), ..., A(.
n
) .h :hnh.|.. j
1
, j
2
, ..., j
n
, hn,
H(A) =

H
g
[A[
h:

H
g
[A[ . n .jhJ n:nj J .h| n|& J A, &h hn h .jh
I
g
(.) n.jnJ A(.) . j.n hj
I
g
(.) = q (I[A _ A(.)[) q (I[A A(.)[) \. !
6. Asset AIIocatIon In OuaI Tneory 167

H
g
[A[ can Lo llougll of as an oxpoclalion wloro llo proLaLilily assignoo lo
a possiLlo valuo of A ooponos also on all llo ollor possiLlo valuos.
IrooI. 1o simplify nolalion, lol a

= A(.

), i 1, ..., :. Willoul loss of

gonoralily, llo possiLlo valuos of A can Lo orooroo sucl llala
1
< a
2
< ... < a
n
ano wo llon lavo
Ir [A t[ =
_

_
1 i) a
1
t

n
I=2
j
I
i) a
2
t _ a
1

n
I=S
j
I
i) a
S
t _ a
2
.... .....
j
n
i) a
n
t _ a
n1
0 i) t _ a
n
1loroforo,
H(A) =
_
a
1
0
q(1)dt
_
a
2
a
1
q(
n

I=2
j
I
)dt
_
a
3
a
2
q(
n

I=S
j
I
)dt ...
_
a
r
a
r31
q(j
n
)dt
= a
1

n1

=1
q
j

. [a
1
a

[
=
n

=1

q
j
1
q
j

_
a

wloro
q
j

= q
_
n

I=1
j
I
_
= q (I[A a

[)
Sinco q is an incroasing funclion from [0, 1[ lo [0, 1[, ano \i

n
I=
j
I


n
I=1
j
I
llon
for all i in 1, ..., :, I
g

= q
_
n

I=
j
I
_
q
_
n

I=1
j
I
_
[0, 1[
Moroovor,

n
=1
I
g

= q (

n
I=1
j
I
) q (0) = q(1) = 1. 1loroforo I
g
1
, I
g
2
, ..., I
g
n

oonno a proLaLilily moasuro on llo proLaLilily spaco ! = .

1
, .
2
, ..., .
n
.
6. Asset AIIocatIon In OuaI Tneory 168
1lis lloorom slalos llal in llo oiscrolo-limo caso, llo corlainly oquivalonl
of A is nolling Lul an oxpoclalion unoor anollor proLaLilily moasuro. 1lis las
Loon slown wlon all llo possiLlo valuos of A aro oislincl. 1lo quoslion llal
arisos immooialoly is: wlal lappons in llo caso wlon somo possiLlo valuos of A
coincioo 1lo following oxamplo provioos an insigll inlo llis quoslion.
ExanIe 6.2.1 1 A h n :nnJn n:.nh| n|.nj h n|& a
1
, a
2
, ..., a
u
.h
:hnh.|.. j
1
, j
2
, ..., j
u
, &h hn
a
1
< a
2
= a
S
< a
1
< a

= a
6
= a
7
< a
S
= a
u
1 hn
I[A t[ =
_

_
1 i) a
1
t

u
I=2
j
I
i) a
2
t _ a
1

u
I=1
j
I
i) a
1
t _ a
2

u
I=
j
I
i) a

t _ a
1

u
I=S
j
I
i) a
S
t _ a

0 i) t _ a
S
5
H(A) =
_
a
1
0
q(1)dt
_
a
2
a
1
q(
u

I=2
j
I
)dt
_
a
4
a
2
q(
u

I=1
j
I
)dt

_
a
5
a
4
q(
u

I=
j
I
)dt
_
a
B
a
5
q(
u

I=S
j
I
)dt
=
_
q(1) q(
u

I=2
j
I
)
_
a
1

_
q(
u

I=2
j
I
) q(
u

I=1
j
I
)
_
a
2

_
q(
u

I=1
j
I
) q(
u

I=
j
I
)
_
a
1

_
q(
u

I=
j
I
) q(
u

I=S
j
I
)
_
a

q(
u

I=S
j
I
)a
S
1]n h n :nnJn n:.nh| 1 n|.nj h n|& (
1
,
2
,
S
,
1
,

) = (a
1
, a
2
, a
1
, a

, a
S
)
.h :hnh.|.. (j
t
1
, j
t
2
, j
t
S
, j
t
1
, j
t

) = (j
1
, j
2
j
S
, j
1
, j

j
6
j
7
, j
S
j
u
). Jh
n |nn

n.Jj
1
<
2
<
S
<
1
<

, , n|j.nj h h:n nh
6. Asset AIIocatIon In OuaI Tneory 169
hn
H(1 ) =
n

=1
_
q
j

1
q
j

h:
q
j

= q
_
n

I=1
j
t
I
_
1j rnnJ.nj h r:.n H(1 ), hn
H(A) = H(1 )
1n, h :h|n nn h :J&J h n h: h .h| n|& n: n||
J..n.
1lo oxamplo illuslralos llo following iooa. In llo gonoral caso wlon somo
valuos of A coincioo, oroor llom in an incroasing oroor, llon from oacl sol of
oqual valuos koop only ono valuo ano assign llo proLaLilily of llo sol lo llis
valuo. 1lus, a now variaLlo 1 is oonnoo in sucl a way llal all llo olomonls of 1
aro slriclly incroasing will aojusloo proLaLilily woiglls sucl llal llo ioonlily
H(A) = H(1 ) is salisnoo.
Anollor approacl consisls of kooping llo roounoanl valuos ano oivioing llo
proLaLilily woiglls Ly llo numLor of lloso valuos. 1lis is llo iooa of llo noxl
corollary:
CoroIIary 6.2.1 1J A . n :nnJn n:.nh| n|.nj : .h| n|& A(.
1
), A(.
2
),
..., A(.
n
) .h :hnh.|.. j
1
, j
2
, ..., j
n
, hn,
H(A) =

H
g
[A[
h:

H
g
[A[ . n .jhJ n:nj J .h| n|& J A, &h hn h .jh

I
g
n.jnJ A(.

) . j.n hj

I
g
(.

) =
q (I[A _ A(.

)[) q (I[A A(.

)[)
,A(.

) : A(.

) = A(.

)
\.

!
6. Asset AIIocatIon In OuaI Tneory 170
1lo nolalion ,A(.

) : A(.

) = A(.

) slanos for llo numLor of valuos

A(.

) oqual lo A(.

)
IrooI. 1lo iooa of llo proof is givon in llo provious oxamplo. In formal
lorms, lol
d
c
= i 1, ..., : : A(.

) = A(.
c
), 1, ..., :
ano
I
g
(.

) = q (I[A _ A(.

)[) q (I[A A(.

)[) \.

!
Wo lavo for all i ind
c
, I
g
(.

) = I
g
(.
c
) ano so

Q+s
I
g
(.

)A(.

) = [d
c
[ I
g
(.
c
)A(.
c
)
wloro
[d
c
[ = ,A(.

) : A(.

) = A(.
c
)
Donno a now ranoom variaLlo 1 ano a suLsol of inoicos o _ 1, ..., :, sucl llal
1 (.

) = A(.

) \i o
1 (.

) ,= 1 (.

) for i ,= ;, \(i, ;) o
2
Im(1 ) = Im(A)
wloro Im(A) is llo sol of all possiLlo valuos lakon Ly A.
Ly applying llo lloorom lo 1 wloso valuos aro all oislincl, wo lavo
H(1 ) =

cQS
I
g
(.
c
)1 (.
c
)
=

cQS
[d
c
[ I
g
(.
c
)A(.
c
)
[d
c
[
=

cQS
1
[d
c
[

Q+
s
I
g
(.

)A(.

)
=
n

=1
I
g
(.

)A(.

)
,A(.

) : A(.

) = A(.

)
6. Asset AIIocatIon In OuaI Tneory 171
Sinco
Ir[A t[ = Ir[1 t[ \t _ 0
llon,
H(1 ) = H(A)
Will lloso ingrooionls, wo proposo lo sluoy somo classos of risk moasuros
Lasoo on oislorlion funclions ano consioor llo applicalion lo assol allocalion.
6.3 van der Hoek and SnerrIs CIass oI
rIsk Aeasures
In lloir papor, van oor Hook ano Slorris (2001, [106[) oonno llo corlainly oquiv-
alonl of a ranoom variaLlo A Ly
H(A) = H
c,g,I
(A) = c H
I
((A c)

) H
g
((c A)

)
= c
_
o
0
h
_
Ir[(A c)

t[
_
dt
_
o
0
q
_
Ir[(c A)

t[
_
dt
(6.1)
Wloro c is a roal conslanl, ano h is a convox ano incroasing funclion on [0, 1[
will h(0) = 0 ano h(1) = 1, ano q is a concavo ano incroasing funclion on [0, 1[
will q(0) = 0 ano q(1) = 1. 1lo convoxily ano concavily of h ano q onsuros llo
concavily of H
c,g,I
(A) wlicl is an appoaling proporly in porlfolio oplimizalion.
OefnItIon 6.3.1 Jh J&n.n q nnJ h n: n.J h n]&jn .J nnJ n|j
.Jh(a) = 1 q(1 a) \a [0, 1[
In wlal follows, wo provioo an oxprossion of H(A) in llo oiscrolo-limo caso,
Lul lol us consioor somo simplo casos nrsl.
6. Asset AIIocatIon In OuaI Tneory 172
6.3.1 HInonIaI Case
If A is a Linomial ranoom variaLlo laking lwo possiLlo valuos c will proLaLilily
j, ano / will proLaLilily (will j = 1), llon H(A) lakos lwo forms ooponoing
on wlollor c / or c < /.
q
p
b
a
X
Figuro 6.1: Linomial Ianoom VariaLlo
If c /, llon
H(A) = c (/ c)

(c c)

h(j)[(c c)

(/ c)

[
q(1 j)[(c /)

(c c)

[
Wlon q ano h aro conjugalo, llon llo aLovo oxprossion simplinos lo
H(A) = h(j)c [1 h(j)[/
H(A) ooos nol oopono on llo paramolor c anymoro.
If c < /, llon
H(A) = c (c c)

(c /)

h(1 j)[(/ c)

(c c)

[
q(j)[(c c)

(c /)

[
Wlon h ano q aro conjugalo, llon
H(A) = h()/ [1 h()[c
1lus, in llo caso wlon q ano h aro conjugalo, if c ,= /, llon,
H(A) = h(I[A = max(c, /)[) max(c, /) q (I[A = min(c, /)[) min(c, /)
6. Asset AIIocatIon In OuaI Tneory 173
6.3.2 QuadrInonIaI Case
Loforo gonoralizing llo proporlios of H for llo mullinomial caso, llis paragrapl
lroals llo quaorinomial caso in oroor lo givo an inluilion for llo moro gonoral
caso. If A is a ranoom variaLlo laving four possiLlo valuos (a
1
, a
2
, a
S
, a
1
) will
proLaLililios ( j
1
, j
2
, j
S
, j
1
), sucl llal

1
=1
j

= 1
p2
p1
a4
a3
a2
a1
a4 > a3 > a2 > a1
p3
X
p4
Figuro 6.2: Quaorinomial Ianoom VariaLlo
H(A) = c (a
1
c)

(c a
1
)

h(j
2
j
S
j
1
)[(a
2
c)

(a
1
c)

[
h(j
S
j
1
) [(a
S
c)

(a
2
c)

[ h(j
1
)[(a
1
c)

(a
S
c)

[
q(j
1
j
2
j
S
)[(c a
S
)

(c a
1
)

[ q(j
1
j
2
)[(c a
2
)

(c a
S
)

[
q(j
1
)[(c a
1
)

(c a
2
)

[
Wlon q ano h aro conjugalo, llon H(A) las a simplor form llal ooos nol
oopono on c :
H(A) = a
1
h(j
1
)[a
1
a
S
[ h(j
S
j
1
)[a
S
a
2
[ h(j
2
j
S
j
1
)[a
2
a
1
[
If wo oonolo A(.

) = a

, llo valuos of llo ranoom variaLlo A in llo slalos .

,
i 1, 2, 3, 4, llon
H(A) = j
I
(.
1
)A(.
1
) j
I
(.
2
)A(.
2
) j
I
(.
S
)A(.
S
) j
I
(.
1
)A(.
1
)
6. Asset AIIocatIon In OuaI Tneory 174
wloro
j
I
(.
1
) = 1 h(j
2
j
S
j
1
)
j
I
(.
2
) = h(j
2
j
S
j
1
) h(j
S
j
1
)
j
I
(.
S
) = h(j
S
j
1
) h(j
1
)
j
I
(.
1
) = h(j
1
).
Sinco \a [0, 1[, h(a) [0, 1[ ano h is incroasing on [0, 1[, llon llo woiglls
j
I
(.

) [0, 1[ for all i 1, 2, 3, 4. Moroovor,

1
=1
j
I
(.

) = 1, so j
I
(.

oo-
nno a proLaLilily moasuro on llo proLaLilily spaco ! = .
1
, .
2
, .
S
, .
1
. Wo can
llon wrilo H(A) as an oxpoclalion unoor llo oislorloo proLaLililios j
I
(.

:
H(A) = H
I
[A[
6.3.3 AuItInonIaI Case
IroosItIon 6.3.1 {Order assuntIon) 1J A . n n&|.nn.n| J.: :nn-
Jn n:.nh| n|.nj h n|& a
1
, a
2
, ..., a
n
&h hn a
1
< a
2
< ... < a
n
, .h
:hnh.|.. j
1
, j
2
, ..., j
n
, hn,
H(A) = c (a
1
c)

(c a
n
)

n1

=1
_
_
_
h
j

. [(a
1
c)

(a

c)

[
q
j

. [(c a
1
)

(c a

[
_
_
_
= c
n

=1

h
j
1
h
j

_
(a

c)

q
j

q
j
1
_
(c a

(6.2)
h:
h
j

= h
_
1

I=1
j
I
_
nnJ q
j

= q
_

I=1
j
I
_
IrooI. 1lo iooa of llo proof is llo samo as in llo proof of 1loorom 6.2.1.
A oolailoo proof is proviooo in llo apponoix.
In ils gonoral form, H(A) is a piocowiso linoar funclion, so il is nol oior-
onliaLlo. Howovor, wlon a
1
, a
2
, ..., a
n
ano c can Lo orooroo, llon H(A) las a
simplo oioronliaLlo form givon Ly llo following corollary:
6. Asset AIIocatIon In OuaI Tneory 175
CoroIIary 6.3.1 {IosItIon oI c) 1J A . n n&|.nn.n| J.: :nnJn n:.-
nh| n|.nj h n|& (a
1
, a
2
, ..., a
n
) &h hn a
1
< a
2
< ... < a
n
, .h :hnh.|-
.. (j
1
, j
2
, ..., j
n
), hn,
1J c _ a
1
, hn
H(A) = a
1

n1

=1
h
j

[a
1
a

[
=
n

=1

h
j
1
h
j

_
a

1J c _ a
n
, hn
H(A) = a
n

n1

=1
q
j

[a

a
1
[
=
n

=1

q
j

q
j
1
_
a

1J c [a
v
, a
v1
) h: : 1, ..., : 1, hn
H(A) = [1 h
j
v
q
j
v
[ c
v

=1

q
j

q
j
1
_
a

=v1

h
j
1
h
j

_
a

h:
h
j

= h
_
1

I=1
j
I
_
nnJ q
j

= q
_

I=1
j
I
_
1lis corollary illuslralos llo iooa of pricing llo upsioo ano llo oownsioo of
llo risk oioronlly. In oocl, for oulcomos a

`s Lolow llo lovol c, llo proLaLilily

oislriLulion is oislorloo Ly llo funclion q, ano for oulcomos a

`s aLovo llo lovol

c, llo proLaLilily oislriLulion is oislorloo Ly llo funclion h. 1lis is a oxiLlo way
lo prico risk arouno somo Lonclmark c. 1lo cloico of llo oislorlion funclions
q ano h roocls llo risk Lolavior of llo invoslor. Inoooo, h is convox
1
, so
h
_
1
1

I=1
j
I
_
h
_
1

I=1
j
I
_
< h
_
1
2

I=1
j
I
_
h
_
1
1

I=1
j
I
_
1
If k is a convox funclion, llon 5k+s, _ k+s 4, .k+s . 4, wlorovor k is oonnoo.
6. Asset AIIocatIon In OuaI Tneory 176
or
h
j
1
h
j

< h
j
2
h
j
1
So llo proLaLilily assignoo lo llo oulcomo a

is loss llan llo proLaLilily as-

signoo lo a
1
. In ollor lorms, llo invoslor assigns lowor proLaLililios lo liglor
oulcomos. 1lo moro risk avorso llo invoslor, llo moro convox llo oislorlion
funclion h. 1lo samo argumonl applios lo llo concavily of q.
Furllormoro, llo cloico of h will rospocl lo q roocls low llo invoslor con-
sioors llo risk will rospocl lo llo Lonclmark c. For somo cloico of q ano h,
pricing risk ooos nol oopono on c. 1lis is llo iooa of llo following proposilion:
IroosItIon 6.3.2 {Conjugate) 1 A h n :nnJn n:.nh| n|.nj n : J.-
.n n|& A(.
1
), A(.
2
), ..., A(.
n
) .h :hnh.|.. j
1
, j
2
, ..., j
n
. 1n h n
hn h nnJ q n: n]&jn, hn
H(A) = H
I
[A[ (6.8)
h: h rn.n . n|n &nJ: h :hnh.|.j nn&: I
g
j.n hj
I
g
(.) = h(I[A _ A(.)[) h(I[A A(.)[) \. ! (6.4)
IrooI. In llo caso wlon h ano q aro conjugalo, llal is, h(1 a) = 1 q(a),
in llo apponoix wo slow llal
H(A) = H
0,0,I
(A) =
_
o
0
h(I[A t[)dt
1loroforo, llo proposilion follows from 1loorom 6.2.1 (Corlainly oquivalonl).
Henark 6.3.1 1 J n& H(A) .J h :J: A(.
1
) < A(.
2
) < ... <
A(.
n
) hnnj.
1& A = [A(.
1
), A(.
2
), ..., A(.

), ..., A(.

), ..., A(.
n
)[. A . h : J
h :n|..n.n J A .n nn .n:n.nj :J:. 1& I = [j
1
, j
2
, ...., j

, ..., j

, ..., j
n
[
h: I(i) = j

= I[A = A(.

)[. 1]n I
g
= [I
g
(1), I
g
(2), ..., I
g
(:)[ h:
6. Asset AIIocatIon In OuaI Tneory 177
I
g
(i) = q
_

I=1
I(/)
_
q
_

1
I=1
I(/)
_
. 1 hn H(A) = I
g
, A, h .nn:
:J& J h : I
g
nnJ A.
1J n :n&n.n o n|. A, hn:
A := o(A)
I := o(I)
I
g
:= [I
g
(1), I
g
(2), ..., I
g
(:)[, h: I
g
(i) = q
_

I=1
I(/)
_
q
_

1
I=1
I(/)
_
H(A) := I
g
, A,
Il is cloar llal llo oroor of possiLlo valuos (a
1
, a
2
, ..., a
n
) of llo risk A plays
a conlral rolo in llo ovalualion of H(A). 1lis is ouo lo llo facl llal H(A) is
Lasoo on a lransformalion of llo oocumulalivo oislriLulion funclion I[A a[.
In an oplimizalion proLlom, llis is nol an appoaling foaluro, sinco llo possiLlo
valuos of A aro in gonoral llo conlrol variaLlos, llal is, H(A) is oplimizoo Ly
cloosing a
1
, a
2
, ..., a
n
. Sorling lloso valuos al oacl slop of llo oplimizalion is
coslly in limo. In llo following proposilion, wo oo nol gol arouno llis proLlom,
lowovor, llo oroor is implicilly lakon caro of in llo coomcionls of a

`s.
IroosItIon 6.3.3 {^o order assuntIon) 1: n n&|.nn.n| J.: :nn-
Jn n:.nh| A n|.nj : J..n n|& a
1
, a
2
, ..., a
n
, .h :hnh.|.. j
1
, j
2
, ..., j
n
,
hn,
H(A) = (o:t
n

=1
_
q
j,A

1
a
z
c
h
j,A

1
a
z
c
_
a

h:
q
j,A

= q
_
_

a
I
a
z

j
I
_
_
q
_
_

a
I
<a
z

j
I
_
_
h
j,A

=
_
_
h
_
_
1

a
I
<a
z

j
I
_
_
h
_
_
1

a
I
a
z

j
I
_
_
_
_
(o:t =
_
_
1 h
_
_
1

a
I
c
j
I
_
_
q
_
_

a
I
c
j
I
_
_
_
_
c
6. Asset AIIocatIon In OuaI Tneory 178
nnJ h nn.n

a
I
c
j
I
=
n

I=1
j
I
1
a
I
c
h: 1
a
I
c
. h .nJ.n: J&n.n n h a
I
_ c.
1lo aLovo proposilion is usoful wlon solving for llo oplimal consumplion
rulos in mulli-porioos. Inoooo, wlon consumplion ( is a conlrol variaLlo, pos-
siLlo valuos of ( aro unknown ouring llo oplimizalion. Will llis proposilion
il is possiLlo lo compulo H(() willoul any assumplion on llo oroor of possiLlo
valuos of (.
6.4 Asset AIIocatIon vItn HIsk Aeasures
Lased on IroLaLIIIty OIstortIon Func-
tIons
6.4.1 van der Hoek and SnerrIs HIsk Aeasure In SIngIe-
IerIod AodeI
AaxInIzIng OuaI \tIIIty oI TernInaI VeaItn vItn Tvo Assets
1o slarl will, supposo llal lloro aro lwo assols, ono risky socurily will ralo
of rolurn 1
1
ano ono safo assol (casl) will rolurn :. An invoslor will inilial
woalll \
0
facos llo proLlom of oivioing llis amounl Lolwoon casl ano llo risky
socurily. Lol a Lo llo proporlion of woalll invosloo in llo risky assol. Al llo
ono of llo singlo porioo invoslmonl llo woalll is
\
1
= \
0
[1 (1 a): a1
1
[
If llo oocision makor`s proforoncos aro consislonl will Dual 1loory, llon, Ly
1loorom 2.8.1 (Dual Ulilily Ioprosonlalion) lloro oxisls a conlinuous ano non-
oocroasing funclion q, sucl llal llo Losl porlfolio proporlion invosloo in llo
6. Asset AIIocatIon In OuaI Tneory 179
risky assol is llo ono llal maximizos llo corlainly oquivalonl in llo oiscrolo
limo
H(\
1
) =

U
I
g
(.)\
0
[1 (1 a): a1
1
(.)[
wloro I
g
(.) is givon Ly
I
g
(.) = q (I[\
1
_ \
1
(.)[) q (I[\
1
\
1
(.)[) \. !
Using van oor Hook ano Slorris (2001, [106[) risk moasuro, llis corrosponos
lo llo caso wlon q ano h aro conjugalo, soo Iroposilion 6.8.2 (Conjugalo). Now,
q (I[\
1
_ \
1
(.)[) = q (I[\
0
[1 (1 a): a1
1
[ _ \
0
[1 (1 a): a1
1
(.)[[)
= q (I[a1
1
_ a1
1
(.)[)
If no slorl solling is allowoo, llal is, a [0, 1[, llon
q (I[\
1
_ \
1
(.)[) = q ((I[1
1
_ 1
1
(.)[))
lloroforo
I
g
(.) = q ((I[1
1
_ 1
1
(.)[)) q ((I[1
1
1
1
(.)[))
In llis caso, llo corlainly oquivalonl H(\
1
) is oqual lo
H(\
1
) = \
0
_
1 (1 a): a

U
I
g
(.)1
1
(.)
_
= \
0
[1 (1 a): aH(1
1
)[
1lo oplimal proporlion of woalll invosloo in llo risky assol, a
+
, is givon Ly
ar max H(\
1
) = ar max \
0
[1 (1 a): aH(1
1
)[
= ar max a(H(1
1
) :)
Honco
a
+
=
_

_
0 if H(1
1
) < :
1 if H(1
1
) :
[0, 1[ if H(1
1
) = :
6. Asset AIIocatIon In OuaI Tneory 180
Wlon llo corlainly oquivalonl of llo risky assol is loss llan llo risk-froo rolurn
llon a
+
= 0, llal is, llo invoslor puls all llo woalll in llo safo assol. Wlon
corlainly oquivalonl of llo risky assol oxcooos llo risk-froo rolurn, llon a
+
= 1,
llal is, llo invoslor puls llo lolal woalll in llo risky assol. 1lis silualion is
calloo |&nj.nj`.
AaxInIzIng OuaI \tIIIty oI TernInaI VeaItn vItn SeveraI Assets
In llis soclion, wo oraw on llo work of van oor Hook ano Slorris (2001, [106[)
lo oxamino llo assol allocalion using llo proporlional lazaros lransform ano
Gaussian rolurns. If A is normally oislriLuloo A(j, o
2
), llon
H(A) = c o
_
_ 3o
o
o
h(1(n)) dn
_ o3
o
o
q (1(n)) dn
_
wloro 1 is llo slanoaro normal cumulalivo oislriLulion funclion. In llo caso
wlon q ano h aro conjugalo of llo form
q(a) = a
j
h(a) = 1 (1 a)
j
wloro 0 < j _ 1. 1lo paramolor j moasuros llo concavily of llo oislorlion
funclion q. From llo provious analysis of risk avorsion in Dual 1loory (soo
Claplor 1wo), j is a risk avorsion paramolor. Higlor valuos of j roocl liglor
valuos of risk avorsion. 1lo risk moasuro Locomos
H(A) = c o
_
_ 3o
o
o
1 [1 1(n)[
j
dn
_ o3
o
o
(1(n))
j
dn
_
(6.)
Wo roconsioor llo sovon-assol oxamplo wloro llo oLjoclivo was lo maximizo
llo oxpocloo ulilily of lorminal woalll. Wo uso llo samo sol-up Lul loro llo
oLjoclivo is lo maximizo llo corlainly oquivalonl oonnoo Ly (6.). 1lo porlfolio
x = (a
0
, a
1
, ..., a
`
) of posilions in socurilios will corrosponoing rolurns 1
0
= :,
1
1
, ..., 1
`
las a normal oislriLulion will moan
j
W
a
= H[\
0
(1 1
a
)[ = \
0
(1 j

a)
6. Asset AIIocatIon In OuaI Tneory 181
ano varianco
o
2
Wa
= V c: (
0
(1 1
a
)) = \
2
0
a

a
1lon
H(\
1
) = c o
Wa
_
_

V
a
3o
o
V
a
o
1 [1 1(n)[
j
dn
_
o3
V
a
o
V
a
o
(1(n))
j
dn
_
wloro \
1
= \
0
(1 1
a
) ano 1
a
=

`
=0
a

. 1lo proLlom is llon lo maximizo

H(\
1
) suLjocl lo

`
=0
a

= 1. van oor Hook ano Slorris (2001, [106[) slow llal

llo oplimal assol allocalion x
+
salisnos
x
+
= a
)
t
(:)
[)(:) :)
t
(:)[
I
wloro
)(:) =
_
:
o
h(1(n)) dn
_
:
o
q (1(n)) dn
a =

1
1
1

1
1
I =
1

1
1

1
1

2
= x

x
: =
j
Wa
c
o
W
a
1 is an A-oimonsional unil voclor ano ano

aro rospoclivoly llo moan voclor

ano llo covarianco malrix of llo risky rolurns.
A nxoo rolurn of 6/ is usoo as a Lonclmark. 1aLlo (6.1) slows llo cor-
rosponoing assol allocalion. 1lo nrsl column roprosonls llo valuos of llo risk
avorsion paramolor j. 1lo noxl sovon columns roprosonl llo oplimal allocalion
of woalll among llo sovon assols givon a lovol j of risk avorsion. 1lo lasl lwo
columns roprosonl llo moan ano llo slanoaro oovialion of llo oplimal porlfolio.
Figuro (6.8) plols llo omcionl fronlior in llo porlfolio proLlom using llo
oonnoo risk moasuro. Will llis risk moasuro ano proporlional lazaros oislorlion
funclion, llo rosulls aro almosl ioonlical lo lloso for oxpocloo ulilily, al loasl
for llo unconslrainoo assol allocalion.
6. Asset AIIocatIon In OuaI Tneory 182
VHS risk measure
Unconstrained Asset Allocation
Initial Wealth $1,000,000 = $1,060,000
Asset Allocation Mean Standard
(risk aversion) 1 2 3 4 5 6 7 Deviation
0.072640 100.65% -0.72% 0.78% -0.89% 0.18% 0.09% -0.09% 6.01% 0.49%
0.145280 100.52% -0.63% 0.80% -1.01% 0.22% 0.11% 0.00% 6.01% 0.49%
0.217920 100.38% -0.53% 0.82% -1.15% 0.26% 0.13% 0.09% 6.02% 0.49%
0.290560 100.22% -0.42% 0.84% -1.29% 0.30% 0.16% 0.19% 6.03% 0.50%
0.363200 100.03% -0.28% 0.86% -1.47% 0.36% 0.19% 0.32% 6.04% 0.51%
0.435840 99.78% -0.11% 0.90% -1.71% 0.43% 0.22% 0.48% 6.05% 0.52%
0.508480 99.44% 0.14% 0.95% -2.03% 0.53% 0.27% 0.70% 6.06% 0.54%
0.581120 98.90% 0.52% 1.03% -2.54% 0.69% 0.35% 1.05% 6.09% 0.58%
0.653760 97.82% 1.28% 1.18% -3.55% 1.00% 0.51% 1.76% 6.14% 0.69%
0.726400 90.91% 6.17% 2.16% -10.07% 3.00% 1.54% 6.29% 6.46% 1.66%
0.727290 90.41% 6.53% 2.23% -10.54% 3.14% 1.61% 6.61% 6.48% 1.74%
0.728180 89.83% 6.94% 2.32% -11.09% 3.31% 1.70% 7.00% 6.51% 1.83%
0.729070 89.14% 7.43% 2.41% -11.74% 3.51% 1.80% 7.45% 6.54% 1.94%
0.729960 88.31% 8.02% 2.53% -12.52% 3.75% 1.92% 7.99% 6.58% 2.07%
0.730850 87.28% 8.74% 2.68% -13.49% 4.05% 2.08% 8.66% 6.63% 2.23%
0.731740 85.96% 9.68% 2.87% -14.74% 4.43% 2.27% 9.53% 6.69% 2.43%
0.732630 84.17% 10.95% 3.12% -16.43% 4.95% 2.54% 10.70% 6.77% 2.71%
0.733520 81.54% 12.81% 3.49% -18.90% 5.71% 2.93% 12.42% 6.90% 3.13%
0.734410 77.13% 15.93% 4.12% -23.06% 6.98% 3.58% 15.31% 7.10% 3.82%
0.735300 67.12% 23.02% 5.55% -32.50% 9.88% 5.07% 21.87% 7.57% 5.42%
0.735340 66.32% 23.59% 5.66% -33.26% 10.11% 5.19% 22.39% 7.60% 5.54%
0.735380 65.46% 24.20% 5.78% -34.07% 10.36% 5.31% 22.95% 7.64% 5.68%
0.735420 64.53% 24.85% 5.92% -34.94% 10.63% 5.45% 23.56% 7.69% 5.83%
0.735460 63.52% 25.57% 6.06% -35.89% 10.92% 5.60% 24.22% 7.73% 5.99%
0.735500 62.43% 26.34% 6.21% -36.92% 11.24% 5.76% 24.93% 7.78% 6.16%
0.735540 61.24% 27.19% 6.38% -38.05% 11.58% 5.94% 25.72% 7.84% 6.35%
0.735580 59.93% 28.11% 6.57% -39.28% 11.96% 6.13% 26.57% 7.90% 6.56%
0.735620 58.48% 29.14% 6.78% -40.65% 12.38% 6.35% 27.52% 7.97% 6.79%
0.735660 56.86% 30.28% 7.01% -42.17% 12.85% 6.59% 28.58% 8.04% 7.05%
0.735700 55.05% 31.57% 7.26% -43.88% 13.37% 6.86% 29.77% 8.13% 7.34%
0.735740 52.99% 33.03% 7.56% -45.83% 13.97% 7.16% 31.12% 8.22% 7.67%
0.735780 50.62% 34.70% 7.89% -48.06% 14.65% 7.52% 32.67% 8.33% 8.05%
0.735820 47.88% 36.65% 8.29% -50.65% 15.45% 7.92% 34.47% 8.46% 8.48%
0.735860 44.61% 38.96% 8.75% -53.73% 16.39% 8.41% 36.61% 8.61% 9.01%
0.735900 40.67% 41.75% 9.31% -57.44% 17.53% 8.99% 39.19% 8.80% 9.63%
0.735917 38.74% 43.12% 9.58% -59.26% 18.09% 9.28% 40.45% 8.89% 9.94%
0.735934 36.62% 44.62% 9.89% -61.26% 18.71% 9.59% 41.84% 8.98% 10.28%
0.735950 34.26% 46.29% 10.22% -63.48% 19.39% 9.94% 43.38% 9.09% 10.66%
0.735967 31.62% 48.16% 10.60% -65.97% 20.15% 10.33% 45.11% 9.22% 11.08%
0.735984 28.66% 50.25% 11.02% -68.76% 21.01% 10.77% 47.05% 9.35% 11.55%
0.736001 25.27% 52.65% 11.50% -71.96% 21.99% 11.28% 49.27% 9.51% 12.09%
0.736018 21.36% 55.43% 12.06% -75.65% 23.12% 11.86% 51.83% 9.69% 12.72%
0.736034 16.77% 58.68% 12.71% -79.98% 24.45% 12.54% 54.84% 9.91% 13.45%
0.736051 11.25% 62.59% 13.50% -85.18% 26.05% 13.36% 58.45% 10.16% 14.33%
0.736068 4.55% 67.33% 14.45% -91.50% 27.98% 14.35% 62.84% 10.48% 15.40%
0.736085 -3.97% 73.36% 15.66% -99.53% 30.45% 15.61% 68.41% 10.87% 16.76%
0.736102 -15.30% 81.39% 17.27% -110.21% 33.73% 17.30% 75.83% 11.40% 18.57%
0.736118 -31.31% 92.72% 19.55% -125.31% 38.36% 19.67% 86.32% 12.14% 21.13%
0.736135 -56.19% 110.34% 23.09% -148.76% 45.55% 23.36% 102.60% 13.30% 25.11%
0.736152 -104.06% 144.24% 29.90% -193.90% 59.40% 30.47% 133.95% 15.52% 32.76%
1aLlo 6.1: Sovon-Assol Oplimal Iorlfolio Allocalion using llo Iroporlional Haz-
aros Iisk Moauro
6. Asset AIIocatIon In OuaI Tneory 183
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
0.0000 0.0050 0.0100 0.0150 0.0200 0.0250 0.0300
Varianceof Return
E
x
p
e
c
t
e
d

r
e
t
u
r
n
Figuro 6.8: Lmcionl Fronlior in llo Iorlfolio IroLlom using llo Iroporlional
Hazaros Iisk Moasuro
6. Asset AIIocatIon In OuaI Tneory 184
ConsuntIon-Investnent IroLIen vItn Tvo Assets
In llo caso of a ono-porioo moool will ono risky socurily ano ono riskloss assol,
lloro aro unknown variaLlos: (
0
, llo consumplion al limo 0, (
&
1
ano (
J
1
, llo
consumplion al limo 1 for llo up ano oown slalos ano H
0
ano H
1
llo invoslmonl
posilions in llo safo ano llo risky assol rospoclivoly. 1o solvo llis proLlom, wo
slarl from llo Luogol conslrainls llal involvo Loll consumplion ano invoslmonl
slralogios ano oxpross all llo variaLlos in lorms of (
&
1
ano (
J
1
. Wo llon slow
low llis is oquivalonl lo using llo risk-noulral compulalional approacl oiroclly,
wlicl from llo slarl oolorminos llo conslrainls in lorms of (
&
1
ano (
J
1
.
1lo consumplion-invoslmonl proLlom is
max
(C,1)
H((
0
) ,H((
1
)
suLjocl lo (
0
, (
1
_ 0
ano Luogol conslrainls
(6.6)
wloro llo Luogol conslrainls aro
\
0
(
0
= H
0
1
0
H
1
o
0
(6.7)
\
1
= (
1
= H
0
1
1
H
1
o
1
(6.8)
Wo can rowrilo all llo variaLlos in lorms of (
&
1
ano (
J
1
, wlicl Locomo llo conlrol
variaLlos in proLlom (6.6).
p C
1
u
C
0
q C
1
d
Figuro 6.4: Consumplion Nooos in Singlo-Iorioo Linomial Moool
Lqualion (6.8) yiolos lwo oqualions
(
&
1
= H
0
1
1
H
1
o
&
1
(
J
1
= H
0
1
1
H
1
o
J
1
6. Asset AIIocatIon In OuaI Tneory 185
Solving llon for H
0
ano H
1
:
H
0
=
S
u
1
1
1
(S
u
1
S
u
1
)
(
&
1

S
u
1
1
1
(S
u
1
S
u
1
)
(
J
1
H
1
=
1
S
u
1
S
u
1
(
&
1

1
S
u
1
S
u
1
(
J
1
(6.0)
Using oqualions (6.7) ano (6.0), (
0
can Lo oxprossoo in lorms of (
&
1
ano (
J
1
:
(
0
= \
0
/
1
(
&
1
/
2
(
J
1
(6.10)
wloro
/
1
=
1
1
o
0
o
J
1
1
1
(o
&
1
o
J
1
)
ano /
2
=
o
&
1
1
1
o
0
1
1
(o
&
1
o
J
1
)
InterretatIon oI /
1
and /
2
:
For llo cloico of o
J
1
< 1
1
o
0
< o
&
1
, il is oasy lo clock llal Q(.
1
) =
_
1
1
o
0
o
J
1
_
,(o
&
1
o
J
1
) ano Q(.
2
) = (o
&
1
1
1
o
0
) ,(o
&
1
o
J
1
) oonno a marlingalo
moasuro for llo oiscounloo prico o
1
,1
1
. 1loroforo.
/
1
(
&
1
/
2
(
J
1
= H
"
_
(
1
1
1
_
Ano oqualion (6.10) can Lo wrillon as
\
0
= (
0
H
"
_
(
1
1
1
_
1lo aLsonco of arLilrago conoilion is oquivalonl lo Q(.

) (0, 1) for i
1, 2. Iroviooo llal 1
1
= (1 :) _ 1, wo also lavo /

= Q(.

),1
1
(0, 1).
1lo proLlom (6.6) is llon oquivalonl lo
max
(C,1)
H((
0
) ,H((
1
)
suLjocl lo (
0
, (
1
_ 0
\
0
= (
0
H
"
[(
1
,(1 :)[
(6.11)
1lis woulo Lo llo slarling poinl if llo oplimal porlfolio proLlom (6.6) was
formulaloo willin llo risk-noulral compulalional approacl.
1lo conslrainls of IroLlom (6.6) aro:
1. (
&
1
_ 0 ano (
J
1
_ 0
2. \
0
(
0
_ 0 = /
1
(
&
1
/
2
(
J
1
_ 0 (using (6.10))
8. (
0
_ 0 = /
1
(
&
1
/
2
(
J
1
_ \
0
(using (6.10))
6. Asset AIIocatIon In OuaI Tneory 186
SoIvIng tne IroLIen - FeasILIe HegIon In llis paragrapl, wo consioor llo
spocial caso wlon llo oislorlion funclions q ano h aro conjugalo, ano wo solvo
llo proLlom analylically. 1lo gonoral caso of non-conjugalo oislorlion funclions
is lofl lo llo noxl paragrapl ooaling will llo caso of 2 risky assols ano 1 riskloss
socurily.
Lol us wrilo all llo variaLlos in lorms of (
&
1
ano (
J
1
:
H((
0
) = (
0
= \
0
/
1
(
&
1
/
2
(
J
1
H((
1
) =
_
_
_
h(j)(
&
1
[1 h(j)[(
J
1
if (
&
1
_ (
J
1
h()(
J
1
[1 h()[(
&
1
if (
&
1
_ (
J
1
1loroforo, llo oLjoclivo funclion in llo proLlom (6.11) is oqual lo
H((
0
) ,H((
1
) =
_
_
_
\
0
,h(j) /
1
(
&
1
,(1 h(j)) /
2
(
J
1
if (
&
1
_ (
J
1
\
0
,(1 h()) /
1
(
&
1
,h() /
2
(
J
1
if (
&
1
_ (
J
1
Wo consioor llon llo lwo maximizalion proLloms
1
1
=
_

_
max
C
u
1
,C
u
1
,h(j) /
1
(
&
1
,(1 h(j)) /
2
(
J
1
suLjocl lo (
&
1
_ 0, (
J
1
_ 0
(
&
1
_ (
J
1
/
1
(
&
1
/
2
(
J
1
_ \
0
(6.12)
ano
1
2
=
_

_
max
C
u
1
,C
u
1
,(1 h()) /
1
(
&
1
,h() /
2
(
J
1
suLjocl lo (
&
1
_ 0, (
J
1
_ 0
(
&
1
_ (
J
1
/
1
(
&
1
/
2
(
J
1
_ \
0
(6.18)
Maximizing (6.6) is oquivalonl lo solving 1
1
ano 1
2
ano cloosing llo solulion
llal corrosponos lo llo liglor oLjoclivo valuo funclion. 1lo lwo maximizalion
proLloms aro linoar programs llal can Lo solvoo numorically using any opli-
mizalion soflwaro packago. Howovor, sinco lloro aro only lwo cloico variaLlos,
an analylical solulion can Lo givon oxplicilly.
6. Asset AIIocatIon In OuaI Tneory 187
Henark 6.4.1 1J h :hnh.|.j J.:.h&.n . &h hn I.
1
= I.
2
=
1
2
,
hn 1
1
nnJ 1
2
hn h nn |&.n nnJ h:J:, . &] | .h:
h :h|n 1
1
: 1
2
.
Givon llo conslrainls, foasiLlo sols of llo solulion lo 1
1
ano 1
2
aro illuslraloo
in Figuro (6.).
C1d
C1u
b
1
.C
1
u
+
b
2
.C
1
d
=
W
o
Feasible set of (C1u,C1d) in P2
Feasible set of (C1u,C1d) in P1
C
1
u


-

C
1
d

=

0
b
1
.C
1
u
+
b
2
.C
1
d
=
0
Figuro 6.: FoasiLlo Iogions for Consumplion in Singlo-Iorioo Moool
1lo oLjoclivo funclion in llo proLlom (6.12) is linoar in (
&
1
ano (
J
1
. 1lo
oqualion of llo lino roprosonling llo lovol curvo of llo oLjoclivo funclion al a
possiLlo valuo :
1
is givon Ly
(
J
1
=
:
1
,(1 h(j)) /
2

,h(j) /
1
,(1 h(j)) /
2
(
&
1
(6.14)
1loro aro four possiLlo solulions of llo proLlom corrosponoing lo llo summils
6. Asset AIIocatIon In OuaI Tneory 188
of llo foasiLlo rogion
(0, 0),
_
0,
\
0
/
2
_
,
_
\
0
/
1
/
2
,
\
0
/
1
/
2
_
ano
_
\
0
/
1
, 0
_
. (6.1)
HeIatIon Letveen tne SoIutIon and tne HIsk-AversIon Index {j) 1lo
solulion lakos ono of llo four possiLlo valuos givon in (6.1). For llo cloico
of llo funclion h(j) = 1 (1 j)
j
, wloro j is a risk avorsion paramolor, llo
inlorcopl ano llo slopo of (6.14) oopono on j. 1lo lovol curvo oqualion (6.14)
can Lo wrillon as
(
J
1
=
:
1
(j)

1(j)
(j)
(
&
1
(6.16)
wloro (j) = ,(1 h(j)) /
2
ano 1(j) = ,h(j) /
1
(j) _ 0 = j _
ln(/
2
,,)
ln(1 j)
ano 1(j) _ 0 = j _
ln(1 /
1
,,)
ln(1 j)
Iul j
1
= ln(1/
1
,,), ln(1j) ano j
2
= ln(/
2
,,), ln(1j), wo lavo: j
1
< j
2
if ano only if , /
1
/
2
= 1,(1 :).
Case 6.4.1 , 1, (1 :), hn j
1
< j
2
, h J||.nj nh| &nnn:.. h
.jn J (j) nnJ 1(j), j.n h ..n J j .n :|n.n j
1
nnJ j
2
:
j u j
1
j
2

(j) u -
1(j) - u
1(j)
(j)
0 -
On (0, j
1
) h | . .. nnJ (j) . ... `nr.n...nj :
1
.
j&.n|n .n:n.nj h .n: .n ;.1) ;h.J.nj h &: &). Jh
|&.n . hn (\
0
(1 :), \
0
(1 :))
2
.
2
Sinco llo slopo
E+,
D+,
_ 4> llon llo solulion +3> 3, is oliminaloo
6. Asset AIIocatIon In OuaI Tneory 189
On (j
1
, j
2
) h | . njn. nnJ (j) . ... `nr.n...nj :
1
.
j&.n|n .n:n.nj h .n: .n ;.1) ;h.J.nj h &: &). Jh
|&.n . hn
_
_
_
(
W
u
b
1
, 0) .J j (j
1
, j
S
)
(\
0
(1 :), \
0
(1 :)) .J j (j
S
, j
2
)
h: j
S
=
ln(1 /
1
(1 :))
ln(1 j)
On (j
2
, ) h | . .. nnJ (j) . njn.. `nr.n...nj :
1
.
j&.n|n :J&.nj h .n: .n ;.1) ;h.J.nj h &: Jn).
Jh |&.n . hn (\
0
,/
1
, 0).
Case 6.4.2 , < 1, (1 :), hn j
1
j
2
, h J||.nj nh| &nnn:.. h
.jn J (j) nnJ 1(j), j.n h ..n J j .n :|n.n j
1
nnJ j
2
:
j u j
2
j
1

(j) u - - -
1(j) - - - u
1(j)
(j)
- 0
On (0, j
2
) h | . .. nnJ (j) . ... `nr.n...nj :
1
.
j&.n|n .n:n.nj h .n: .n ;.1) ;h.J.nj h &: &). Jh
|&.n . hn (0, 0)
8
.
On (j
2
, j
1
) h | . njn. nnJ (j) . njn.. `nr.n...nj :
1
.
j&.n|n :J&.nj h .n: .n ;.1) ;h.J.nj h &: Jn).
Jh |&.n . hn (0, 0).
On (j
1
, ) h | . .. nnJ (j) . njn.. `nr.n...nj :
1
.
j&.n|n :J&.nj h .n: .n ;.1) ;h.J.nj h &: Jn).
Jh |&.n . hn (
W
u
b
1
, 0).
8
Sinco llo slopo
E+,
D+,
_ 4> llon llo solulion +Z
3
+4 .u,> Z
3
+4 .u,, is oliminaloo
6. Asset AIIocatIon In OuaI Tneory 190
In sum, llo possiLlo valuos for oplimal consumplion ((
&
1
, (
J
1
) aro (0, 0),
(\
0
,/
1
, 0) ano (\
0
, (/
1
/
2
) , \
0
, (/
1
/
2
)). 1lo solulion ooponos on llo risky
socurily oislriLulion (valuos of (j
1
, j
2
)) ano llo sign of , 1, (1 :) .
1lo samo analysis applios lo llo proLlom 1
2
(6.18). Iul j
t
1
= ln(/
1
,,), ln(j)
ano j
t
2
= ln(1/
2
,,), ln(j), wo lavo: j
t
1
< j
t
2
if ano only if , < /
1
/
2
= 1,(1:).
Case 6.4.1 , 1, (1 :), hn j
t
1
j
t
2
,
On (0, j
t
2
) h |&.n . (0, 0)
On (j
t
2
, j
t
1
) h |&.n .
_
_
_
(\
0
(1 :), \
0
(1 :)) .J j (j
t
2
, j
t
S
)
(0,
W
u
b
2
) .J j (j
t
S
, j
t
1
)
h: j
t
S
=
ln(/
1
(1 :))
ln(j)
On (j
2
, ) h | . .. nnJ (j) . njn.. `nr.n...nj :
1
.
j&.n|n :J&.nj h .n: .n ;.1) ;h.J.nj h &: Jn).
Jh |&.n . hn (0,
W
u
b
2
).
Case 6.4.2 , <
1
1v
, hn j
t
1
< j
t
2
,
On (0, j
t
1
) h |&.n . (\
0
(1 :), \
0
(1 :)).
On (j
t
1
, j
t
2
) h |&.n . (0, 0).
On (j
t
2
, ) h |&.n . (0,
W
u
b
2
).
Figuro 6.6 plols llo solulion for llo caso wloro , = 0.0, : = 10/ ano
j = 0.8.
OtInaI Investnent StrategIes Onco llo oplimal consumplion rulos aro
oLlainoo, llo oplimal invoslmonl slralogios follow from llo Luogol oqualions
(6.0).
6. Asset AIIocatIon In OuaI Tneory 191
0 50 100 150 200 250 300 350
-500
-400
-300
-200
-100
0
100
200
300
400
500
** Hvhs** maximizing H(C0)+ 0.95*H(C1)
C1d: consumption in down state
C
1
u
:

c
o
n
s
u
m
p
t
i
o
n

i
n

u
p

s
t
a
t
e
constraints max
constraints min
level curve (OF) = 104.5
level curve (OOF) = 118.61
risk aversion = 0.8
interest rate = 10%
solution
Figuro 6.6: Solulion lo llo Singlo-Iorioo Iorlfolio IroLlom in llo Dual 1loory
6. Asset AIIocatIon In OuaI Tneory 192
Wlon ((
&
1
, (
J
1
) = (0, 0), llon (H
0
, H
1
) = (0, 0)
Wlon ((
&
1
, (
J
1
) = (
W
u
b
1
, 0), llon (H
0
, H
1
) = (\
0
S
u
1
1
1
S
u
S
u
1
, \
0
1
1
1
1
S
u
S
u
1
).
Wlon ((
&
1
, (
J
1
) = (
W
u
b
1
b
2
,
W
u
b
1
b
2
), llon (H
0
, H
1
) = (\
0
, 0). 1lis silualion is
roforroo lo as plunging".
Wlon ((
&
1
, (
J
1
) = (0,
W
u
b
2
), llon (H
0
, H
1
) = (\
0
S
u
1
S
u
1
1
1
S
u
, \
0
1
1
S
u
1
1
1
S
u
).
ConsuntIon-Investnent IroLIen vItn Tnree Assets
In llis soclion wo sluoy llo consumplion-invoslmonl proLlomwill lwo corrolaloo
risky socurilios ano ono riskloss assol.
OIscretIzIng tne Irocess Consioor lwo risky socurilios, wlicl aro log-normally
oislriLuloo ano ono riskloss assol. In oroor lo oLlain complolonoss of llo mar-
kol, wo consioor a lrinomial lallico, wloro llo Livarialo log-normal procoss is
ooscriLoo Ly
do
|,1
= j
1
o
|,1
dt o
1
o
|,1
d\
|,1
do
|,2
= j
2
o
|,2
dt o
2
o
|,2
_
jd\
|,1

_
1 j
2
d\
|,2
_
wloro \
1
ano \
2
aro lwo inooponoonl Lrownian molions, o

is llo volalilily of
llo inslanlanoous rolurn on slock i, ano j is llo corrolalion coomcionl Lolwoon
llo inslanlanoous rolurns of llo lwo slocks. Following Ho (1000, [8[), wo ap-
proximalo llo incromonls of (\
|,1
,\
|,2
) Ly lwo ranoom variaLlos (
1
,
2
) sucl
llal
Ir
_

1
=
_
3
_
2
,
2
=
1
_
2
_
=
1
3
Ir
_

1
= 0,
2
=
2
_
2
_
=
1
3
Ir
_

1
=

_
3
_
2
,
2
=
1
_
2
_
=
1
3
6. Asset AIIocatIon In OuaI Tneory 193
So,
o
I1,1
=
_

_
o
I,1
_
1
j
1
n
o
1
_
S
_
2n
_
o
I,1
_
1
j
1
n
_
o
I,1
_
1
j
1
n
o
1
_
S
_
2n
_
o
I1,2
=
_

_
o
I,2
_
1
j
2
n
o
2
j
_
S
_
2n
o
2
_
1 j
2
1
_
2n
_
o
I,2
_
1
j
2
n
o
2
_
1 j
2
2
_
2n
_
o
I,2
_
1
j
2
n
o
2
j
_
S
_
2n
o
2
_
1 j
2
1
_
2n
_
wloro : is llo numLor of limo slops. Nolo llal llo cloico of (
1
,
2
) approxi-
maling llo incromonls of (\
|,1
,\
|,2
) is nol uniquo.
1lo lrinomial lallico will lwo socurilios is a complolo markol moool. Il is
arLilrago-froo if ano only if lloro oxisls a uniquo risk-noulral moasuro Q. 1lal
is,
H
"
[^o
+
1
[ = 0 (6.17)
H
"
[^o
+
2
[ = 0
1lo moool las oogroos of froooom (j
1
, j
2
, o
1
, o
2
, j). Will llo conoilions
(6.17), lloro romains 3 oogroos of froooom. Wo can lol (o
1
, o
2
, j) Lo froo ano
clooso (j
1
, j
2
) so llal llo syslom (6.17) las a solulion (Q(.
1
), Q(.
2
), Q(.
S
))
(0, 1)
S
.
j
1
= :(1
1
1 o
1
_
3
2:
(Q(.
1
) Q(.
S
))
j
2
= :(1
1
1 o
2
j
_
3
2:
(Q(.
1
) Q(.
S
))
o
2
_
1 j
2
_
1
2:
(Q(.
1
) 2Q(.
2
) Q(.
S
))
For Q(.
1
) = Q(.
2
) = Q(.
S
) =
1
S
, wo oLlain j
1
= j
2
= (1
1
1) = :.
Ono can clooso suilaLlo valuos for (Q(.
1
), Q(.
2
), Q(.
S
)) so as lo oLlain
sonsiLlo valuos for (j
1
, j
2
, o
1
, o
2
). For oxamplo, (j
1
, o
1
) = (10/, 20/) for a slaro
ano (j
2
, o
2
) = (/, 8/) for a 1roasury Lill.
6. Asset AIIocatIon In OuaI Tneory 194
Wlon llo lallico is rocomLining, wo loso 2 oogroos of froooom Locauso of llo
conoilions
n
1
d
1
= :
2
1
n
2
d
2
= :
2
2
lowovor, llo oxislonco of llo risk-noulral moasuro Q slill lolos.
SoIvIng tne IroLIen 1loro is nol a groal ooal of oioronco Lolwoon llo caso
of ono risky ano ono riskloss assol ano llo caso of lwo risky ano ono riskloss assol.
In oocl, llo mallomalical form of llo oplimizalion proLlom is oxaclly llo samo,
lowovor, llo numLor of slalos incroasos Ly ono lo onsuro llo complolonoss of llo
markol moool. 1lis aoooo oimonsion is lranslaloo Ly llo aooilion of a now
conlrol variaLlo (
n
1
wlicl roprosonls llo valuo of llo consumplion al limo 1 in
llo mioolo slalo. 1lo proLlom is
max
C
u
,C
1
H((
0
) ,H((
1
)
suLjocl lo = (
0

1
1 :
H
"
[(
1
[
ano (
0
, (
1
_ 0
Il can Lo slown llal for llo cloico of llo risk-noulral proLaLililios
&
_
n
_

J
, llo oroor (
&
1
_ (
n
1
_ (
J
1
is oplimal. An applicalion of Iroposilion 6.8.1
(Oroor assumplion) in llo caso of a lrinomial ranoom variaLlo givos
H((
1
) = c ((
&
1
c)

((
n
1
c)

((
&
1
c)

_
h(1 j
&
)

((
J
1
c)

((
n
1
c)

_
h(1 j
&
j
n
)
(c (
J
1
)

(c (
n
1
)

(c (
J
1
)

_
q(1 j
J
)

(c (
&
1
)

(c (
n
1
)

_
q(1 j
J
j
n
)
1lis is a piocowiso linoar funclion will conlrol variaLlos (
&
1
, (
n
1
ano (
J
1
.
Using Corollary 6.2.2 (Iosilion of c), wo lransform il lo four linoar funclions
6. Asset AIIocatIon In OuaI Tneory 195
ooponoing on llo valuo of c will rospocl lo llo conlrol variaLlos.
H((
1
) =
_

_
(h
0
h
1
)(
&
1
(h
1
h
2
)(
n
1
(h
2
h
S
)(
J
1
if c < (
J
1
c(1 h
1
q
1
) (q
1
q
0)
(
&
1
(h
1
h
2
)(
n
1
(h
2
h
S
)(
J
1
if (
J
1
_ c < (
n
1
c(1 h
2
q
2
) (q
1
q
0)
(
&
1
(q
2
q
1
)(
n
1
(h
2
h
S
)(
J
1
if (
n
1
_ c < (
&
1
(q
1
q
0)
(
&
1
(q
2
q
1
)(
n
1
(q
S
q
2
)(
J
1
if (
&
1
_ c
wloro
h

= h
_
1

I=1
j
I
_
ano q

= q
_

I=1
j
I
_
Wo llon solvo four linoar programs (1

) for i = 1, ..., 4.
(1

) =
_

_
max
C=(C
u
1
,C
n
1
,C
u
1
)

1
1v
H
"
[(
1
[ ,H((
1
)
suLjocl lo H
"
[(
1
[ _ (1 :)
0 _ (

1
_ (1 :),

i = d, :, n
(
J
1
_ (
n
1
_ (
&
1
c [(

1
, (
1
1
)
(6.18)
1lo oplimal consumplion is llo ono llal corrosponos lo llo maximum of llo
four oplimal oLjoclivos rosulling from solving llo four linoar programs oonnoo
aLovo.
6.4.2 Vang`s TransIorn In SIngIe-IerIod AodeI
Now consioor anollor class of oislorlion oporalors inlrooucoo Ly Wang (2000,
[118[). Wang slows llal applying llis oislorlion oporalor lo a slock prico oislri-
Lulion, llo risk-noulral valualion of slock pricos can Lo rocovoroo in llo normal
ano llo lognormal casos. Furllor invosligalions, lowovor, sloulo Lo carrioo oul
lo clock wlollor llis slalomonl is lruo for any conlingonl claim, ano also wlon
lloro is no normalily assumplion on llo unoorlying assol pricos. Hamaoa ano
Slorris (2001, [40[) provioo somo insigll inlo llis quoslion.
6. Asset AIIocatIon In OuaI Tneory 196
Tne ConsuntIon-Investnent IroLIen
In assol allocalion, al oacl limo porioo, llo consumplion (
|
is a posilivo ranoom
variaLlo. 1lo invoslor sooks lo maximizo llo oiscounloo sum of llo corlainly
oquivalonls of consumplion llrougl limo, as ooscriLoo Ly llo proLlom
_

_
max
C

T
|=0
,
|
H[(
|
, c[
suLjocl lo

T
|=0
1
1
|
H
"
[(
|
[ =
ano ( is an aoaploo procoss
(6.10)
wloro
H[(
|
, c[ =
_
o
0
q
c
(I[(
|
a[) da
If llo moool consisls of a nnilo numLor of slalos al oacl limo porioo, llon (
|
lakos
:
|
possiLlo valuos c
|,1
, c
|,2
, ..., c
|,n
I
will rospoclivo proLaLililios j
|,1
, j
|,2
, ..., j
|,n
I
,
wloro :
|
is llo numLor of slalos al limo t. Using Corollary 6.2.1,
H[(
|
, c[ =
n
I

=1
[q
c
(I[(
|
_ c
|,
[) q (I[(
|
c
|,
[)[
,c
|,
: c
|,
= c
|,

c
|,
1lo proLaLilily llal (
|
_ c
|,
is oqual lo llo sum of llo proLaLilily woiglls
j
I
, sucl llal c
|,I
_ c
|,
, llal is,
I[(
|
_ c
|,
[ =

I:c
I,I
c
I,z

j
|,I
Honco,
H[(
|
, c[ =
n
I

=1
_
q
c
_

I:c
I,I
c
I,z

j
|,I
_
q
_

I:c
I,I
c
I,z

j
|,I
__
,c
|,
: c
|,
= c
|,

c
|,
Ly oonning llo risk-noulral proLaLilily ano using llo oxprossion aLovo, llo
ooscriplion of llo proLlom is complolo. 1lis is nol a linoar program, lowovor il
can Lo solvoo using an oplimizalion packago. 1lo noxl paragrapl slows low lo
solvo il on a lrinomial lallico ano provioos somo rosulls in lwo porioos.
6. Asset AIIocatIon In OuaI Tneory 197
2
3
4
t = 0 t = 1
1
-4
-3
-2
-1
0
t = 2
(0,0)
(3,-1)
(3,-3)
(1,1)
(1,0)
(1,-1)
(3,0)
t = 3 t = 4
(2,2)
(2,0)
(2,-1)
(3,2)
Figuro 6.7: Cooing IocomLining 1rinomial Lallico Nooos
6. Asset AIIocatIon In OuaI Tneory 198
Hov to Conute H[(, c[ over a LattIce?
Fix a limo t, ano consioor llo oislriLulion of llo consumplion roprosonloo Ly
llo vorlical nooos (t, i)
||
. Al limo t, llo consumplion (
|
lakos 2t1 possiLlo
valuos c
|,
will proLaLililios j
|,
= I[o = o
|,
[. Honco,
H[(
|
, c[ =
|

=|
_
q
c
_

I:c
I,I
c
I,z

j
|,I
_
q
c
_

I:c
I,I
c
I,z

j
|,I
__
,c
|,
: c
|,
= c
|,

c
|,
1lo proLaLililios j
|,
, t 1, ..., 1, i t, ..., 0, ..., t can Lo spocinoo as
follows
j
|,
= I[o = o
|,
[
=

nnx(0,)I[
Iz
2
[
_
t
/
__
t /
/ i
_
j
I
&
j
I
J
(1 j
&
j
J
)
|2I
(6.20)
wloro j
&
ano j
J
aro rospoclivoly llo proLaLililios of up ano oown jumps ano [a[ is
llo inlogor parl of a. 1lo oxprossion (6.20) is a gonoralizalion of llo proLaLililios
in a Linomial moool. Likowiso, llo oxprossion H
"
[(
|
[ in llo conslrainls can Lo
compuloo. In oocl,
H
"
[(
|
[ =
|

=|
Q
|,
c
|,
wloro
Q
|,
= Q[o = o
|,
[
=

nnx(0,)I
[
Iz
2
[
_
t
/
__
t /
/ i
_

I
&

I
J
(1
&

J
)
|2I
wloro
&
ano
J
aro rospoclivoly llo risk-noulral proLaLililios of up ano oown
jumps. Claplor Four givos moro oolails ano oiscussion of llo implomonlalion.
6.4.3 ConsuntIon-Investnent IroLIen In AuItI-IerIod
AodeI
In Dual 1loory, invoslors ovalualo a risk A Ly calculaling ils corlainly oquivalonl
H(A) as oonnoo in oqualion (6.1), using llo oislorlion funclions q ano h rop-
6. Asset AIIocatIon In OuaI Tneory 199
rosonling lloir proforonco oroor. Givon a cloico among many risks, an invoslor
woulo llon pick llo ono laving llo groalosl corlainly oquivalonl.
In mulli-porioo assol allocalion, invoslors aro facoo will a sorios of oocisions
wloro al llo Loginning of oacl invoslmonl porioo, lloy lavo lo clooso llo opli-
mal amounl of consumplion, ano llo rosl is invosloo in llo markol. 1lo oplimal
consumplion lovol (
|
al limo t is a risky prospocl. Formally, (
|
, t = 0, ..., 1 is a
non-nogalivo ano Lounooo ranoom variaLlo oonnoo on somo proLaLilily spaco.
Ly virluo of 1loorom 2 in Yaari (1086, [117[), llo sclomo ((
0
, (
1
, ..., (
T
) is
proforroo lo ((
t
0
, (
t
1
, ..., (
t
T
) if ano only if lloro oxisls an incroasing conlinuous
funclion l : 1
n

sucl llal
l(H((
0
), H((
1
), ..., H((
T
)) _ l(H((
t
0
), H((
t
1
), ..., H((
t
T
))
In woros, llo invoslor cloosos llo consumplion slroam llal maximizos an in-
croasing funclion of llo corlainly oquivalonls of consumplion al oacl porioo. In
wlal follows, wo clooso
l : 1
n

(a
1
, a
2
, ..., a
n
)

wloro 0 < , _ 1 is llo limo proforonco faclor. 1lo consumplion-invoslmonl

proLlom (8.20) Locomos
_

_
max
C
u
,C
1
,...,C
T

T
|=0
,
|
H((
|
)
suLjocl lo =

T
|=0
H
"
_
(
|
(1 :)
|
_
ano (
|
_ 0 \t [0, 1[
(6.21)
Wloro is llo inilial woalll ano : is a conslanl inlorosl ralo.
IroLlom (6.21) is sol up in llo oiscrolo-limo caso. Howovor, il can Lo solvoo
numorically oillor will a nnilo numLor or a conlinuum rango of slalos al oacl
limo porioo.
Lol us consioor llo caso wlon al oacl limo t, (
|
lakos (2t 1) possiLlo valuos
(rocomLining lrinomial lroo), llon (
|
is a voclor of 2t 1 conlrol variaLlos, llal
6. Asset AIIocatIon In OuaI Tneory 200
is,
(
|
= [(
|,|
, ..., (
|,0
, ..., (
|,|
[ U
2|1

For oacl voclor (

|
, lloro oxisls a corrosponoing voclor
j
|
= [j
|,|
, ..., j
|,0
, ..., j
|,|
[ [0, 1[
2|1
wloro j
|,
= I[(
|
= (
|,
[.
From Iroposilion 6.8.8 (No oroor assumplion), ono way lo wrilo llo lorm
H((
|
) in llo oLjoclivo funclion is
H((
|
) =
|

=|
1
C
I,z
(j
|
).(
|,
wloro llo funclion
1
C
I,z
: [0, 1[
2|1
U

j
|
= [j
|,|
, ..., j
|,0
, ..., j
|,|
[
_

_
_
q
_

C
I,I
C
I,z

j
I
_
q
_

C
I,I
<C|,
z

j
I
__
1
C
I,z
c

_
h
_
1

C
I,I
<C
I,z

j
I
_
h
_
1

C
I,I
C
I,z

j
I
__
1
C
I,z
c
_

_
(6.22)
Henark 6.4.2 nh: J:n&|n.n . n| .h| &.nj 1:..n ..1 ;O:-
J: n&n.n), h: h n:| n:.nh| n: :J:J r|..|j.
1lo gonoral oxprossion (6.22) can Lo signincanlly simplinoo in llo caso wlon
q ano h aro conjugalo funclions ano llo consumplion al oacl limo is oislriLuloo
will llo samo proLaLilily ovor llo slalos, llal is,
q(a) = 1 h(1 a) \a [0, 1[
ano
I[(
|
= (
|,
[ =
|
=
1
2t 1
\t [1, 1[, \i [t, t[
6. Asset AIIocatIon In OuaI Tneory 201
1lon, using Iroposilion 6.8.2 (Conjugalo), wo lavo
1
C
I,z
(j
|
) = q
_
1
2t 1
,(
|,I
_ (
|,

_
q
_
1
2t 1
,(
|,I
< (
|,

_
wloro ,(
|,I
_ (
|,
oonolos llo numLor of variaLlos (
|,I
, / t, ..., t, sucl
llal (
|,I
_ (
|,
.
In llis caso, IroLlom (6.21) can Lo solvoo using ono of llo simplicial algo-
rillms usoo in rank rogrossion proLloms. OsLorno (2001, [88[) is an oxcollonl
roforonco for solving sucl lypos of proLloms.
6.4.4 ^unerIcaI ExanIes
1lis paragrapl provioos lwo numorical oxamplos of porlfolio allocalion using
llo classos of oislorlion oporalors inlrooucoo oarlior.
1lo nrsl oxamplo consioors Wang`s oislorlion oporalor. Supposo llal lloro
aro llroo oalos t = 0, 1, 2 ano nvo slalos of llo worlo. 1lis corrosponos lo
a rocomLining lrinomial lallico. Wo numorically solvo llo proLlom (6.10) for
1 = 2. For a loaoing paramolor c = 0., Figuro (6.8) slows llo consumplion
ano invoslmonl slralogios as woll as llo woalll procoss for a lwo porioo oxamplo.
1lo oiscounl faclor , = 0.0, llo risk-froo inlorosl ralo : = 10/ ano inilial woalll
= $10.
1lo jump proLaLililios aro j
&
= j
n
= j
J
=
1
S
ano
&
=
2
1
,
n
=
1
S
ano

J
=
S
1
. For llis cloico of risk-noulral proLaLililios, ano a corrolalion coomcionl
j = 0.7, llo moans ano volalililios of llo lwo risky socurilios aro rospoclivoly
moan
1
= 13.46/, volalilily
1
= 07.07/, ano moan
2
= 1.20/, volalilily
2
=
10.61/.
1lo inlormooialo consumplion ( is null ano llo consumplion is slriclly pos-
ilivo al llo liglosl slalo of llo worlo. Howovor, inlormooialo posilions :, :1 ano
:2 in llo riskloss assol, llo nrsl socurily ano llo socono socurily rospoclivoly aro
nonzoro.
1o soo llo impacl of llo loaoing paramolor c on llo consumplion slroam,
Figuro (6.0) plols llo oplimal consumplion for oioronl valuos of c.
6. Asset AIIocatIon In OuaI Tneory 202
a l p h a = 0 . 5
c o r r e l a t i o n = 0 . 7 5
b e t a = 0 . 9
r = 0 . 1
C = 0
W = 1 0
n r = 7 , 8 9 6
r 1 = - 2 , 4 6 1
r 2 = 1 , 1 1 4 . 9 0
C = 0
W = 0
n r = 0
r 1 = 0
r 2 = 0
C = 0
W = 0
C = 0
W = 8 2 . 5 0
n r = 5 9 , 2 1 8
r 1 = - 1 , 6 6 1
r 2 = 7 , 1 6 2
C = 0
W = 0
n r = 0
r 1 = 0
r 2 = 0
C = 0
W = 0
C = 0
W = 0
C = 0
W = 0
C = 6 8 0 . 6 2 5 0
W = 6 8 0 . 6 2 5 0
Figuro 6.8: Oplimal Consumplion ano Invoslmonl Slralogios using Wang`s Dis-
lorlion Oporalor
6. Asset AIIocatIon In OuaI Tneory 203
Arouno llo valuo c = 0.8, lloro is a swilcl in consumplion from llo lowosl
slalo, wloro il is nonzoro ano null olsowloro, lo llo liglosl slalo.
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
0
100
200
300
400
500
600
700
** 2 period consumption in a trinomial lattice using wangs distortion operator
alpha: loading parameter
C
:

c
o
n
s
u
m
p
t
i
o
n

a
t

t
=

2
C2,2: highest state
C2,1
C2,0
C2,-1
C2,-2: lowest state
Figuro 6.0: Oplimal Consumplion Irocoss as a Funclion of llo Loaoing Iaram-
olor c
A closor look al llo consumplion procoss arouno c = 0.8, is roprosonloo in
Figuro (6.10). 1lis nguro slows llal in llo lransilory passago across llo lovol
c = 0.8, llo inlormooialo consumplion Locomos nonzoro.
From llo oxamplos aLovo, il is cloar llal llo linoarily of llo oual ulilily in
consumplion rosulls in a cornor solulion in llo oplimizalion proLlom. 1lis is
nol a oosiraLlo foaluro in porlfolio soloclion, alllougl, as slown in llo oxamplo,
will 8 assols, oivorsincalion is possiLlo. On llo ollor lano, willin llo oxpocloo
ulilily framowork, a risk avorso invoslor is always oivorsifying proviooo llal llo
oxpocloo rolurn of llo risky assol is posilivo.
1lo socono oxamplo is a numorical solulion lo llo proLlom (6.18) wloro llo
risk moasuro is llo ono inlrooucoo Ly van oor Hook ano Slorris. Figuro (6.11)
6. Asset AIIocatIon In OuaI Tneory 204
-0.9 -0.85 -0.8 -0.75 -0.7 -0.65
0
100
200
300
400
500
600
700
** 2 period consumption in a trinomial lattice using wangs distortion operator
alpha: loading parameter
C
:

c
o
n
s
u
m
p
t
i
o
n

a
t

t
=

2
C2,2: highest state
C2,-1
C2,-2: lowest state
C1,1: highest state
C1,-1: lowest state
Figuro 6.10: Consumplion Irocoss as a Funclion of llo Loaoing Iaramolor c
(Zoom inlo -0.8)
slows llo oplimal consumplion ano lraoing slralogios for llo paramolors valuos
inoicaloo in llo nguro.
1lis numorical oxamplo slows llal consumplion al llo ono of llo invoslmonl
porioo is posilivo in all llo slalos. 1lis is ouo lo llo asymmolry rosulling
from pricing llo oownsioo of llo risk using llo oislorlion funclion q(a) = a
0.2
ano llo upsioo of llo risk using h(a) = 1 (1 a)
0.u
. Il is worll noling
llal llo consumplion in llo mioolo ano llo oown slalo oquals llo Lonclmark
consumplion c = . 1lis is consoquonco of llo linoarily in IroLlom (6.18) wloro
( = c is a cornor solulion.
6.5 ConcIusIon
In llis claplor wo lavo proviooo a formal lroalmonl of risk moasuros Lasoo on
oislorlion funclions in oiscrolo-limo solling. Wo lavo also slown llal llo risk-
6. Asset AIIocatIon In OuaI Tneory 205
r = 0.1; interest rate
alpha = 5; benchm ark consumption
rh = 0.9; distortion coefficient in h function
rg = 0.2; distortion coefficient in g function
v = 10; initial wealth
beta = 0.9; discount factor
qd = 0.4; qm = 0.35; qu = 0.25; risk neutral probabilities
Pd = 1/3; Pm = 1/3; Pu = 1/3; real world probabilities
correlation = 0.9 ;
C = 0
W = 10
nr = 88.3
r1 = -9.5
r2 = 6.5
C = 5
W = 5
C = 5
W = 5
C = 29
W = 29
Figuro 6.11: Oplimal Consumplion ano 1raoing Slralogios using llo Iropor-
lional Hazaros Iisk Moasuro
6. Asset AIIocatIon In OuaI Tneory 206
noulral compulalional approacl is woll aoaploo lo porlfolio oplimizalion will
sucl moasuros llal oo nol lio willin llo oxpocloo ulilily framowork.
1lo applicalion lo lwo oioronl oislorlion oporalors slows llal llo porlfolio
consumplion ano invoslmonl rulos aro oioronl from llo oxpocloo ulilily rosulls
sinco llo oplimizalion loaos lo cornor solulions rosulling from llo linoarily of
llo oLjoclivo in llo conlrol variaLlos. 1lis is an unoosiraLlo foaluro ano an
imporlanl aroa llal nooos lo Lo aoorossoo Loforo lloso non-oxpocloo ulilily risk
moasuros can Lo connoonlly applioo lo assol allocalion.
lLaplci +
ConcIuuIon
1lis oissorlalion las covoroo llroo lopics in assol allocalion ano pricing. 1lo
nrsl parl concorning oynamic porlfolio oplimizalion aimoo lo Lring oul a com-
parison Lolwoon llo risk-noulral compulalional approacl ano sloclaslic oynamic
programming in a oiscrolo-limo solling. Wo proviooo somo now lloorolical ro-
sulls for assol allocalion wlon llo invoslor las HyporLolic ALsolulo Iisk Avor-
sion ulilily funclion. Wo also proposoo an implomonlalion of 1A(/ in Linomial
ano lrinomial lallicos. Numorical oxamplos using MallaL aro incluooo lo illus-
lralo llo procoouro oovolopoo. Il lurns oul llal 1A(/ las Lollor porformanco
llan oynamic programming in lorms of compulalion. Moroovor, insloao of ois-
crolizing llo Hamillon-JacoLi-Lollman oqualion will possiLly moro llan ono
slalo variaLlo, wo usoo symLolic algorillms lo implomonl sloclaslic oynamic
programming. 1lis now approacl provioos a simplor procoouro for compuling
oplimal consumplion-invoslmonl policios. 1lis parl can Lo oxlonooo lo incluoo
roal oxamplos will assol ano liaLilily managomonl as woll as a sluoy of llo
comploxily of llo algorillms implomonling 1A(/ ano oTT.
1lo socono parl consiooroo llo pricing of conlingonl claims using llo proLa-
Lilily oislorlion funclions approacl wlicl las roconlly Loon oovolopoo ano usoo
in insuranco. Will llo convorgonco of nnancial ano insuranco markols, oomon-
slraloo Ly issuing woallor oorivalivos, onorgy risk socurilios ano moro gonorally
llo socurilizalion of insuranco risks, lloro is a major concorn aLoul consisloncy
in llo pricing molloos usoo in Loll markols. In llo socono parl of llis rosoarcl
wo oslaLlisloo llo consisloncy wlon llo unoorlying assol pricos follow a goomol-
ric Lrownian molion, wlicl is a slanoaro assumplion in llo nnancial markol.
Wo also invosligaloo casos wlon llo insuranco-Lasoo approacl fails lo proouco
arLilrago-froo pricos ano oolorminoo llo approprialo oislorlion oporalor unoor
207
7. ConcIusIon 208
moro gonoral assumplions llan lloso usoo in Llack-Sclolos oplion pricing. Wo
lavo nol covoroo casos of sloclaslic volalilily ano jumps, Lul slarloo invosli-
galing oquiliLrium pricing using proLaLilily oislorlion funclions ano llis can Lo
carrioo oul furllor.
In llo lliro parl wo inlrooucoo oynamic porlfolio oplimizalion will risk moa-
suros Lasoo on proLaLilily oislorlion funclions ano proviooo a formal lroalmonl
of llis class of risk moasuros. As an applicalion, wo consiooroo risk moasuros
Lasoo on llo Iroporlional Hazaro 1ransform ano risk moasuros Lasoo on Wang`s
lransform. Assol allocalion lurnoo oul lo Lo inconsislonl will oxpocloo ulilily
lloory wlon llo assumplions aro oioronl from lloso of llo Capilal Assol Iric-
ing Moool. 1lis is oomonslraloo Ly a plunging" Lolavior, wloro llo invoslor
puls ovorylling is llo risky assol. Furllor oovolopmonl consisls of comLining
proLaLilily oislorlion funclions will ulilily of woalll as a crilorium of cloico
unoor uncorlainly as in rank-ooponoonl moool proposoo Ly Quiggin (1082, [00[).
HILIIograny
[1[ Doodlv/ P1 Lo comporlomonl oo l`lommo ralionnol oovanl lo risquo.
1nn:.n .1 (108), 0846.
[2[ Dplq/ N1 O1/ dqg Ergxuwkd/ M1 Q1 Discrolo-limo valualion of amorican
oplions will sloclaslic inlorosl ralos. 1. J 1.nnn.n| 5&J. , 1
(Spring 100), 108284.
[8[ Dqghuvrq/ M1/ Gloorq/ M1/ dqg Kdugdnhu/ E1 j:.&|&:n| 1..n
nn|j.. Iowa Slalo Univorsily Iross, 1077.
[4[ Dqj/ D1/ Ehndhuw/ J1/ dqg Olx/ M1 Wly slocks may oisappoinl.
|&nh.n 1n.:.j :|.nj n: (2000).
[[ Duurz/ N1 M1 J h Jh:j J 1.|-1n:.nj. Yrjo Jalnsson
Locluro, Holsinki, 106.
[6[ Duw}qhu/ S1/ Ghoedhq/ I1/ Hehu/ M10P1/ dqg Khdwk/ G1 Coloronl
moasuros of risk. `nhnn.n| 1.nnn , 8 (1000), 20828.
[7[ Edvdn/ V1 On llo uclualions in consumplion ano markol rolurns in llo
prosonco of laLor ano luman capilal: An oquiliLrium analysis. J&:nn| J
1nn. 1jnnn. nnJ n:| . (1000), 10201064.
[8[ Edwwdolr/ U1/ N1 M1/ dqg Nrpdlq/ M1 1osling Lolwoon allornalivo
moools of cloico unoor uncorlainly: Somo inilial rosulls. J&:nn| J 1.|
nnJ 1n:n.nj , 1 (1000), 20.
200
HIHLIOCHAIHY 210
[0[ Ehfnhuv/ V1 1lo conslanl olaslicily of varianco moool ano ils implicalions
for oplion pricing. J&:nn| J 1.nnn (1080).
[10[ Ehoopdq/ U1 1jnnn. 1:j:nnn.nj. Irincolon, Irincolon Univorsily
Iross, 107.
[11[ Ehqwk/ I1 H1/ Nduovhq/ N1 K1/ dqg Uhlnydp/ N1 Oplimal porlfolio so-
loclion will consumplion ano nonlinoar inlogro-oioronlial oqualions will
graoionl conslrainl: A viscosily solulion approacl. 1.nnn nnJ 5hn-
. , 8 (July 2001), 27808.
[12[ Ehuwvhndv/ G1 S1 1jnnn. 1:j:nnn.nj nnJ 5hn. n:|. Now
York: Acaoomic Iross, 1076.
[18[ Ehuwvhndv/ G1 S1 1jnnn. 1:j:nnn.nj nnJ O.nn| n:|. Lolmonl,
MA: Allona Scionlinc, 100.
[14[ Ehuwvhndv/ G1 S1 Nocossary ano sumcionl conoilions for oxislonco of an
oplimal porlfolio. J&:nn| J 1nn. Jh:j (Juno, 1074), 2847.
[1[ Ehuwvhndv/ G1 S1/ dqg Vkuhyh/ V1 H1 5hn. n:|: Jh 1.:
J.n n. Now York: Acaoomic Iross, 1078.
[16[ Ehuwvlpdv/ G1/ Nrjdq/ O1/ dqg Or/ D1 Z1 Wlon is limo conlinuous
J&:nn| J 1.nnn.n| 1nn. , 2 (FoLruary 2000), 178204.
[17[ Elqjkdp/ Q1/ dqg Nlhvho/ U1 1.| A&:n| 1n|&n.n : 1:..nj nnJ
1Jj.nj J 1.nnn.n| 1:.n.. Lonoon, Now York : Springor, 1008.
[18[ Erkq/ M1 A survoy of conlingonl-claims approaclos lo risky ooLl valua-
lion. 1`1 1:|.nj 1n: (1000).
[10[ Euhhghq/ G1 W1 An inlorlomporal capilal assol pricing moool will
sloclaslic consumplion ano invoslmonl opporlunilios. J&:nn| J 1.nnn-
.n| 1nn. 7 (1070), 26206.
HIHLIOCHAIHY 211
[20[ Euhqqdq/ P1 M1/ Vfkzduw}/ H1 V1/ dqg Odjqdgr/ U1 Slralogic assol
allocalion. J&:nn| J 1nn. 1jnnn. nnJ n:| .1 (Juno 1007),
18771408.
[21[ Exipdq/ J1/ dqg Ohlghupdq/ O1 Consumplion ano assol rolurns unoor
non-oxpocloo ulilily, somo now ovioonco. 1nn. |: (1000),
28128.
[22[ Fdphuhu/ F1 I1 An oxporimonlal losl of sovoral gonoralizoo ulilily llo-
orios. J&:nn| J 1.| nnJ 1n:n.nj, ., n. 1 (April 1080), 61104.
[28[ Fdpsehoo/ M1 \1/ dqg Ylfhlud/ O1 P1 Consumplion ano porlfolio
oocisions wlon oxpocloo rolurns aro limo varying. &n::|j J&:nn| J
1nn., |. 11 (May, 1000), 4880.
[24[ Fkrz/ J1 F1 Oplimal conlrol willoul solving llo Lollman oqualion.
J&:nn| J 1nn. 1jnnn. nnJ n:| 17 (1008), 621680.
[2[ Fkrz/ J1 F1 1lo lagrango molloo of oplimizalion will applicalions
lo porlfolio ano invoslmonl oocision. J&:nn| J 1nn. 1jnnn. nnJ
n:| .u (1006), 118.
[26[ Fkrz/ J1 F1 1jnnn. 1nn.. O.n..n.n hj h 1nj:nnj `hJ.
Oxforo Univorsily Iross, 1007.
[27[ Frfkudqh/ M1 K1 1:..nj. Irincolon Univorsily Iross, 2001.
[28[ Fr{/ M1/ dqg Urvv/ V1 1lo valualion of oplions for allornalivo sloclaslic
procossos. J&:nn| J 1.nnn.n| 1nn. (1076).
[20[ Fr{/ M1 F1/ dqg Kxdqj/ F10I1 Oplimal consumplion ano porlfolio
policios wlon assol pricos follow a oiusion procoss. J. 1nn. Jh:j
(1080), 8888.
HIHLIOCHAIHY 212
[80[ Fr{/ M1 F1/ dqg Kxdqj/ F10I1 A varialional proLlom arising in nnancial
oconomics. J&:nn| J `nhnn.n| 1nn., |. .u, n. (1001),
4687.
[81[ Fr{/ M1 F1/ Lqjhuvroo/ M1 H1/ dqg Urvv/ V1 D1 An inlorlomporal
gonoral oquiliLrium moool of assol pricos. 1nn:.n (108), 868
884.
[82[ Fr{/ M1 F1/ Urvv/ V1 D1/ dqg Uxelqvwhlq/ P1 Oplion pricing: A
simplinoo approacl. J&:nn| J 1.nnn.n| 1nn., |. 7, n. (Sopl.
1070), 22068.
[88[ Fudqgdoo/ P1/ dqg Olrqv/ S1 Viscosily solulions of lamillon-jacoLi
oqualions. J:nnn.n J h n:.nn `nhnn.n| 5.j .77 (1088),
142.
[84[ Ghoedhq/ I1/ dqg Vfkdfkhupd|hu/ Z1 A gonoral vorsion of llo fun-
oamonlal lloorom of assol pricing. `nhnn.h nnn|n uu, 8 (1004),
46820.
[8[ Ghwhpsoh/ M1/ Jdufld/ U1/ dqg Ulqglvedfkhu/ P1 A monlo carlo
molloo for oplimal porlfolios. 1:|.nj n:, 5.n.] 5:., 11AO
(January 2000).
[86[ Grvv/ K1 Lions onlro cqualions oicronliollos sloclasliquos ol oroinairos.
nnn| J |`1n.& 1n:. 1.nn:. 5.n 1. n|&| J 1:hnh.|.
5n..j&. A&|| 5:. 1 (1077), 0012.
[87[ Guh|ixv/ V1 H1 Dynamic programming ano llo calculus of varialion.
218210.
[88[ Gxiilh/ G1 1jnnn. 1:..nj Jh:j. Irincolon Univorsily Iross,
1002.
[80[ Gxiilh/ G1/ dqg Ndq/ U1 A yiolo-faclor moool of inlorosl ralos. `nh-
nn.n| 1.nnn , 4 (OcloLor 1006), 870406.
HIHLIOCHAIHY 213
[40[ Hoovehuj/ G1 Iisk, amLiguily ano savago axioms. &n:|j J&:nn| J
1nn. 7 (1061), 648660.
[41[ Hsvwhlq/ O1 J1/ dqg ]lq/ V1 H1 SuLslilulion, risk avorsion, ano llo lom-
poral Lolavior of consumplion ano assol rolurns: An ompirical analysis.
n:nj.-`||n 1n.:.j, 1.:h&:j, 1 (1080).
[42[ Hsvwhlq/ O1 J1/ dqg ]lq/ V1 H1 SuLslilulion, risk avorsion, ano llo lom-
poral Lolavior of consumplion ano assol rolurns: A lloorolical framowork.
1nn:.n, |. 7, n. (July 1080), 08760.
[48[ Idpd/ H1 I1/ dqg Iuhqfk/ N1 U1 Divioono yiolos ano oxpocloo slock
rolurns. J&:nn| J 1.nnn.n| 1nn. .. (OcloLor 1088), 82.
[44[ Ilvkexuq/ S1 F1 Nonlinoar proforonco ano ulilily lloory. Jhn 1|.n
5:. .n h `nhnn.n| 5.n, n . 1n|.n: nnJ 1nJn (1088),
xiv, 20.
[4[ Ilw}sdwulfn/ E1 J1/ dqg Iohplqj/ Z1 K1 Numorical molloos for
an oplimal invoslmonl-consumplion moool. `nhnn. J O:n.n
1n:h 1, 4 (1001), 828841.
[46[ Jloerd/ L1 Lxpocloo ulilily will puroly suLjoclivo non-aooilivo proLaLil-
ilios. J&:nn| J `nhnn.n| 1nn. 1 (1087), 688.
[47[ Jlrydqqlql/ D1/ dqg Mrulrq/ S1 1imo-sorios losls of a non-oxpocloo
ulilily moool of assol pricing. |&nh.n 1n.:.j, A `:| (1080).
[48[ Jxo/ I1 A lloory of oisappoinlmonl avorsion. 1nn:.n , 8 (May
1001), 66786.
[40[ Kdpdgd/ P1/ dqg Vkhuulv/ P1 Conlingonl claim pricing using proLa-
Lilily oislorlion oporalors: Molloos from insuranco risk pricing ano lloir
rolalionslip lo nnancial lloory. 1:|.nj n: (Juno 2001).
HIHLIOCHAIHY 214
[0[ Kdpdgd/ P1/ Vkhuulv/ P1/ dqg ydq ghu Krhn/ M1 Marlingalo moll-
oos in porlfolio allocalion will oislorlion oporalors. 1:|.nj n: (April
2001).
[1[ Kduulvrq/ M1 P1/ dqg Solvnd/ V1 U1 Marlingalos ano sloclaslic inlo-
grals in llo lloory of conlinuous lraoing. 5hn. 1: nnJ h.:
|.n.n 11 (1081), 21260.
[2[ Kduulvrq/ P1 M1/ dqg Nuhsv/ G1 P1 Marlingalos ano arLilrago in
mulliporioo socurilios markols. J&:nn| J 1nn. Jh:j .u (Juno
1070), 881408.
[8[ Kh/ K1 Convorgonco from oiscrolo lo conlinuous-limo conlingonl claims
pricos. Jh 1. J 1.nnn.n| 5&J., |. , n. (1000), 2846.
[4[ Kxdqj/ F10I1/ dqg Olw}hqehujhu/ U1 K1 1&nJn.n J: 1.nnn.n|
1nn.. Norll-Hollano, 1088.
[[ Kxqw/ S1 M1/ dqg Nhqqhg|/ M1 H1 1.nnn.n| 1:.n. .n Jh:j nnJ
1:n.. Wiloy, 2000.
[6[ Lqjhuvroo/ M1 H1 Jh:j J 1.nnn.n| 1..n `n|.nj. 1olowa, N.J. :
Iowman ano Lilllonolo, 1087.
[7[ Ndkqhpdq/ G1/ dqg Wyhuvn|/ D1 Irospocl lloory: An analysis of
oocision unoor risk. 1nn:.n 7 (1070), 268201.
[8[ Ndoovhq/ M1 Oplimal porlfolios for oxpononlial Lcvy procossos. `nh-
nn.n| `hJ J O:n.n 1n:h 1, 8 (Augusl 2000), 8774.
[0[ Ndudw}dv/ L1/ Ohkrf}n|/ M1 S1/ Vhwkl/ V1 S1/ dqg Vkuhyh/ V1 H1 Lx-
plicil solulion of a gonoral consumplioninvoslmonl proLlom. `nhnn.
J O:n.n 1n:h 11 (1086), 261204.
HIHLIOCHAIHY 215
[60[ Ndudw}dv/ L1/ Ohkrf}n|/ M1 S1/ dqg Vkuhyh/ V1 H1 Oplimal porlfolio
ano consumplion oocisions for a "small invoslor" on a nnilo lorizon. 51`
J&:nn| n n:| nnJ O.n..n.n . (1087), 17186.
[61[ Ndudw}dv/ L1/ dqg Vkuhyh/ V1 H1 `hJ J `nhnn.n| 1.nnn.
Now York, Lonoon : Springor, 1008.
[62[ Nlp/ W1 V1/ dqg Rpehuj/ H1 Dynamic nonmyopic porlfolio Lolavior.
1. J 1.nnn.n| 5&J. (Spring 1006), 14161.
[68[ Nrvnlhylf/ M10P1 An inlorlomporal consumplion-loisuro moool will non-
oxpocloo ulilily. 1nn. 1: (1000), 28280.
[64[ Nuhsv/ G1 P1/ dqg Sruwhxv/ H1 O1 1omporal rosolulion of uncorlainly
ano oynamic cloico lloory. 1nn:.n, |. , n. 1 (Jan. 1078),
18200.
[6[ Nxkq/ K1/ dqg Wxfnhu/ D1 An|.nn: 1:j:nnn.nj. Irocoooings of
llo socono Lorkloy Symposium of Mallomalical Slalislics ano IroLaLilily,
101.
[66[ Nxvkqhu/ K1 M1 1:hnh.|.j `hJ J: :r.nn.n .n 5hn.
n:| nnJ J: 1||.. 1j&n.n. Now York : Acaoomic Iross, 1077.
[67[ Nxvkqhu/ K1 M1/ dqg Gxsxlv/ S1 J1 A&n:.n| `hJ J: 5hn.
n:| 1:h|n .n n.n&& J.n. Now York : Springor-Vorlag, 1002.
[68[ Nzdq/ \1 N1/ dqg Fkrz/ J1 F1 Clow`s molloo of oplimal conlrol: A
numorical solulion. J&:nn| J 1nn. 1jnnn. nnJ n:| .1 (1007),
78072.
[60[ Odqgvpdq/ ]1/ dqg Vkhuulv/ P1 Iisk moasuros ano insuranco promium
principlos. 1n&:nn: `nhnn. nnJ 1nn. ., 1 (2001), 10811.
[70[ Ohodqg/ K1 H1 On llo oxislonco of oplimal policios unoor uncorlainly.
J&:nn| J 1nn. Jh:j (1072), 844.
HIHLIOCHAIHY 216
[71[ Or/ D1 Z1/ dqg PdfNlqod|/ F1 D1 Slock markol pricos oo nol follow
ranoom walks: Lvioonco from a simplo spocincalion losl. 1n.:.j J
1nnj|nn.n 1nn:. 1.&.n 1n: , 18 (Marcl 1087), 47.
[72[ Oxfdv/ U1 Assol pricos in an oxclango oconomy. 1nn:.n (1078),
14261446.
[78[ Pdfklqd/ P1 M1 "oxpocloo ulilily" analysis willoul llo inooponoonco
axiom. 1nn:.n, |. u (Marcl 1082), 277828.
[74[ Pdunrzlw}/ K1 P1 `nn-1n:.nn nn|j. .n 1:J|. h. nnJ
n.n| `n:|. Now York : L. Llackwoll, 1087.
[7[ Pdunrzlw}/ K1 P1 Iorlfolio soloclion. J&:nn| J 1.nnn (Marcl,
102).
[76[ Pdvrq/ V1 S1 Consumplion ano invoslmonl inconlivo associaloo will
wolfaro programs. :|.nj n: A. 7-, G:nJ&n h| J h&.n
nJn.n.:n.n, 1n:n:J &n.:.j (DocomLor, 1081).
[77[ Phuwrq/ U1 F1 n.n&&-J.n 1.nnn. Oxforo, U.K.: Lasil Llack-
woll, 1002.
[78[ Phuwrq/ U1 F1 Lifolimo porlfolio soloclion unoor uncorlainly: 1lo
conlinuous-limo caso. 1. J 1nn. nnJ 5n.. 1 (Augusl
1060).
[70[ Phuwrq/ U1 F1 Oplimum consumplion ano porlfolio rulos in a
conlinuous-limo moool. J&:nn| J 1nn. Jh:j (DocomLor 1071).
[80[ Phuwrq/ U1 F1 An analylical oorivalion of llo omcionl porlfolio fronlior.
J&:nn| J 1.nnn.n| nnJ &nn.n. nn|j., 1u (SoplomLor 1072).
[81[ Qhlovrq/ Z1 V1 An oxpocloo ulilily-usor`s guioo lo nonoxpocloo ulilily
oxporimonls. 1n:n 1nn. J&:nn| 1, n. (Summor 1008), 2774.
HIHLIOCHAIHY 217
[82[ Rfrqh/ G1 O1/ dqg Ndudw}dv/ L1 A gonoralizoo clark roprosonlalion
formula, will applicalion lo oplimal porlfolios. 5hn. nnJ 5hn.
1: (1001), 187220.
[88[ Rveruqh/ P1 5.n|..n| |j:.hn J: `.n.n...nj 1|jhJ:n| 1&n.n.
CamLriogo Univorsily Iross, 2001.
[84[ Sdqmhu/ K1 K1, Lo. 1.nnn.n| 1nn. .h |.n.n 1nnn,
1n&:nn nnJ 1n.n. 1lo Acluarial Founoalion, 1008.
[8[ Solvnd/ V1 U1 A sloclaslic calculus moool of conlinuous lraoing: Oplimal
porlfolios. `nhnn. J O:n.n 1n:h 11 (1086), 870882.
[86[ Solvnd/ V1 U1 1n:J&.n `nhnn.n| 1.nnn: 1.: J.n `J-
|. Llackwoll IuLlislors, 1007.
[87[ Sudww/ M1 Z1 Iisk avorsion in llo small ano in llo largo. 1nn:.n
., 1-2 (January-April 1064).
[88[ Sxufdo/ V1/ dqg Sljjrww/ M1 Lifolimo nnancial planning will rogimo-
swilcling: 1lo caso of porsislonco ano moan rovorsion. 1ocl. rop., Facully
of Commorco ano Lconomics Iosoarcl Iapors, SoplomLor 2001.
[80[ Sxwhupdq/ P1 O1 `n:| 1..n 1:. Now York: Wiloy, 1004.
[00[ Txljjlq/ M1 A lloory of anlicipaloo ulilily. J&:nn| J 1nn. 1hn.:
nnJ O:jnn..n.n (1082), 828848.
[01[ Txljjlq/ M1 Gn:n|..J 1rJ 1.|.j Jh:j, Jh 1nn|-1nJn
`J|. Kluwor Acaoomic IuLlislors, 1008.
[02[ Uhoo/ D1 Iisk avorsion in Quiggin ano Yaari`s rank-oroor moool of cloico
unoor uncorlainly. 1nn. J&:nn| 7, 0 supplomonl (1087), 1480.
[08[ Urjhuv/ O1 1lo rolaxoo invoslor ano paramolor uncorlainly. 1.nnn nnJ
5hn. (2001), 18114.
HIHLIOCHAIHY 218
[04[ Urvv/ V1 D1 Somo slrongor moasuros of risk avorsion in llo small ano in
llo largo will applicalions. 1nn:.n (1081), 621688.
[0[ Uxvw/ M1 A&n:.n| 1jnnn. 1:j:nnn.nj .n 1nn.. 1n 1nnJh|
J n&n.nn| 1nn.. Amsloroam: Llsovior, 1006.
[06[ Vdpxhovrq/ S1 D1 Lifolimo porlfolio soloclion Ly oynamic sloclaslic
programming. 1. J 1nn. nnJ 5n.. 1, 8 (Augusl 1060),
28046.
[07[ Vdpxhovrq/ S1 D1 Sl. polorsLourg paraoox: Dofangoo, oissocloo, ano
lislorically ooscriLoo. J&:nn| J 1nn. 1.:n&: 1 (Marcl, 1077),
24.
[08[ Vfkplgohu/ G1 SuLjoclivo proLaLilily ano oxpocloo ulilily willoul ao-
oilivily. 1nn:.n 7 (1080), 7187.
[00[ Vfkurghu/ P1 Compuling llo conslanl olaslicily of varianco oplion pric-
ing formula. Jh J&:nn| J 1.nnn (1080).
[100[ Vklu|dhy/ D1 Q1 1n.n| J 5hn. 1.nnn : 1n, `J|, Jh-
:j. Worlo Scionlinc, 1000.
[101[ Vwduphu/ F1/ dqg Vxjghq/ U1 IroLaLilily ano juxlaposilion oocls:
An oxporimonlal invosligalion of llo common ralio oocl. J&:nn| J 1.|
nnJ 1n:n.nj ., 2 (Juno 1080), 1078.
[102[ Vwrnh|/ Q1/ dqg Oxfdv/ U1 1&:. `hJ .n 1nn. 1jnnn..
CamLriogo: Harvaro Univorsily Iross, 1080.
[108[ Wdttx/ P1 V1 Laclolior ano lis limos: A convorsalion will Lornaro Lru.
1.nnn 5hn. , 1 (2001), 882.
[104[ Wdttx/ P1 V1/ dqg Zloolqjhu/ Z1 1lo analysis of nnilo socurily
markols using marlingalos. J. |.J 1:hnh.|.j 1 (1087), 12.
HIHLIOCHAIHY 219
[10[ Wrelq/ M1 Jh Jh:j J 1:J|. 5|.n. Lonoon: Macmillan, 106.
[106[ ydq ghu Krhn/ M1/ dqg Vkhuulv/ P1 A class of non-oxpocloo ulilily risk
moasuros ano implicalions for assol allocalions. 1n&:nn: `nhnn.
nnJ 1nn. . (2001), 6082.
[107[ Yduldq/ K1 U1 1n:nJ.n `.:nn. : `J:n :nh. Nor-
lon, Now York : W.W., 1087.
[108[ yrq Qhxpdqq/ M1/ dqg Prujhqvwhuq/ R1 Jh:j J Gnn nnJ 1-
nn. 1hn.:, 8ro oo. Now York : Wiloy, 1064.
[100[ Zdfkwhu/ M1 Oplimal porlfolio allocalion for an invoslor will ulilily ovor
consumplion. 1:|.nj n:, 1n:n:J &n.:.j (SoplomLor, 1000).
[110[ Zdqj/ V1 AmLiguily avorsion ano llo oconomics of insuranco. 1n.:.j
J 1n:|, :n:h :: -u (1006).
[111[ Zdqj/ V1 Iromium calculalion Ly lransforming llo layor promium oon-
sily. .n 1&||.n . (1006), 7102.
[112[ Zdqj/ V1 Implomonlalion of proporlional lazaros lrans-
forms in ralomaking. 1:J.nj J h n&n|j &-
n:.n| 5.j 1AAA1 (1008). AvailaLlo for oownloao on
lllp:www.casacl.orgpuLsprocoooprocooo08inoox.llm.
[118[ Zdqj/ V1 V1 A class of oislorlion oporalors for pricing nnancial ano
insuranco risks. Jh J&:nn| J 1.| nnJ 1n&:nn, |. , n. 1 (2000),
186.
[114[ Zlooldpv/ G1 1:hnh.|.j .h `n:.njn|. CamLriogo Univorsily Iross,
1001.
[11[ Zlufk/ M1 O1/ dqg Kdug|/ P1 U1 A synllosis of risk moasuros for
capilal aooquacy. 1ocl. rop., Univorsily of Walorloo, 1000.
HIHLIOCHAIHY 220
[116[ \ddul/ P1 H1 Iisk avorsion willoul oiminisling marginal ulilily. 1nJn
5h| J 1nn. (1084).
[117[ \ddul/ P1 H1 1n.n:.n nnJ `&|.n:.n nn:.n J 1.| :.n:
A :nh. CamLriogo Univorsily Iross, 1086.
[118[ \ddul/ P1 H1 1lo oual lloory of cloico unoor risk. 1nn:.n, |.
(January 1087), 011.
[110[ \dq/ M10d1/ ]kdqj/ T1/ dqg ]kdqj/ V1 Growll oplimal porlfolio in a
markol orivon Ly a jump-oiusion-liko procoss or a Lcvy procoss. nnn|
J 1nn. nnJ 1.nnn 1, 1 (May 2000), 10116.
[120[ ]dulskrsrxorx/ W1 Oplimal invoslmonl ano consumplion moools will
non-linoar slock oynamics. `nhnn.n| `hJ J O:n.n 1n:h,
|. u (OcloLor, 1000), 27106.
[121[ ]kdqj/ M1 SuLjoclivo amLiguily, oxpocloo ulilily ano cloquol oxpocloo
ulilily. 1:|.nj n:, n:|n 1n.:.j (1000).
ppcnoix
1tooIu
A.1 Asset IrIcIng usIng IroLaLIIIty OIs-
tortIon FunctIons
Iroof of llo Lxpoclalion ioonlily in Soclion .4:
if A _ 0, llon A =
_
o
0
1
A&
dn. Using FuLinni lloorom,
H[A[ = H[
_
o
0
1
A&
dn[
=
_
o
0
11
A&
[dn
=
_
o
0
I[A n[dn
if A _ 0, llon A =
_
0
o
1
A<&
[dn. 1loroforo
H[A[ = H[
_
0
o
1
A<&
dn[
=
_
0
o
H[1
A<&
[dn
=
_
0
o
I[A < n[dn
=
_
0
o
I[A n[ 1dn
So in llo gonoral caso wo lavo
H[A[ =
_
0
o
I[A n[ 1dn
_
o
0
I[A n[dn
Iroof of Wang`s prico ioonlily for llo log-normal caso (Soclion .4):
221
A. IrooIs 222
Lol 1 = lnA q A(j, o
2
), llon
o
A
(t) = I[A t[
= I[lnA ln t[
= 1 1
j,o
2(ln t)
= 1 1
0,1
_
lnt j
o
_
1lo oislorloo oocumulalivo oislriLulion funclion is
q
c
[o
A
(t)[ = 1
0,1

1
1
0,1
(o
A
(t)) c
_
= 1
0,1
_
1
1
0,1
_
1 1
0,1
_
ln t j
o
__
c
_
(A.1)
1lo aLovo oqualily is oLlainoo Ly roplacing o
A
(t) Ly ils valuo 11
0,1
_
ln|j
o
_
in llo caso of a lognormally oislriLuloo ranoom variaLlo.
Lol n = 1
0,1
(a), llon 1
1
0,1
(n) = a, applying 1
0,1
lo Loll sioos of llo
aLovo oqualily givos
1
0,1
(1
1
0,1
(n)) = 1
0,1
(a)
Sinco 1
0,1
is symmolric arouno llo origin, llon for any roal numLor a,
1
0,1
(a) = 1 1
0,1
(a)
So
1
0,1
(1
1
0,1
(n)) = 1 1
0,1
(a) = 1 n
ano lloroforo
1
1
0,1
(n) = 1
1
0,1
(1 n)
Going Lack lo (A.1),
q
c
[o
A
(t)[ = 1
0,1
_
1
1
0,1
_
1 1
0,1
_
lnt j
o
__
c
_
= 1
0,1
_
1
1
0,1
_
1
0,1
_
ln t j
o
__
c
_
= 1
0,1
_

_
lnt j
o
_
c
_
= 1 1
0,1
_
ln t (j co)
o
_
= 1 1
(jco),o
2(lnt)
= o
Z
(ln t)
A. IrooIs 223
wloro
7 q A
_
j co, o
2
_
Finally,
H[A, c[ =
_
o
0
q
c
[o
A
(t)[dt
=
_
o
0
o
Z
(ln t)dt
=
_
o
0
o
Z
(t)dt
wloro ln7
t
q A (j co, o
2
) . 1loroforo,
H[A, c[ = H[7
t
[
= c
jco
o
2
2
A.2 Asset AIIocatIon In OuaI Tneory
A.2.1 IrooI oI IroosItIon 6.3.1 {Order assuntIon)
IrooI. For a
1
< a
2
< ... < a
n
wo lavo
(a
1
c)

_ (a
2
c)

_ ... _ (a
n
c)

ano (c a
1
)

_ (c a
2
)

_ ... _
(c a
n
)

, so
Ir

(A c)

t
_
=
_

_
1 i) (a
1
c)

n
I=2
j
I
i) (a
2
c)

t _ (a
1
c)

n
I=S
j
I
i) (a
S
c)

t _ (a
2
c)

.... .....
j
n
i) (a
n
c)

t _ (a
n1
c)

0 i) t _ (a
n
c)

ano
Ir

(c A)

t
_
=
_

_
1 i) (c a
n
)

n1
I=1
j
I
i) (c a
n1
)

t _ (c a
n
)

n2
I=1
j
I
i) (c a
n2
)

t _ (c a
n1
)

.... .....
j
1
i) (c a
1
)

t _ (c a
2
)

0 i) t _ (c a
1
)

A. IrooIs 224
1loroforo,
H(A) = c
_
(a
1
c)

0
h(1)dt
_
(a
2
c)

(a
1
c)

h(

n
I=2
j
I
)dt

_
(a
3
c)

(a
2
c)

h(

n
I=S
j
I
)dt ...
_
(a
r
c)

(a
r31
c)

h(j
n
)dt
_
(a
r
c)

0
q(1)dt

_
(ca
r31
)

(ca
r
)

q(

n1
I=1
j
I
)dt
_
(ca
r32
)

(ca
r31
)

q(

n2
I=1
j
I
)dt ...
_
(ca
1
)

(ca
2
)

q(j
1
)dt
Ly using
_
(a
z1
c)

(a
z
c)

h(
n

I=1
j
I
)dt = h
_
1

I=1
j
I
_

(a
1
c)

(a

c)

_
ano
_
(ca
z
)

(ca
z1
)

q(

I=1
j
I
)dt = q
_

I=1
j
I
_

(c a
1
)

(c a

_
wo gol llo oosiroo rosull.
A.2.2 Tne case vnen q and h are conjugate
Wo proposo lo slow llal
H(A) = H
0,0,I
(A) =
_
o
0
h(I[A t[)dt
Firsl, il is oasy lo clock llal, for t _ 0,
o
(Ac)
(t) = o
A
(c t)
o
(cA)
(t) = 1 o
A
(c t)
ano sinco h ano q aro conjugalo, wo lavo
h
t
(a) = q
t
(1 a)
K+[, @ .
_
o
0
k
_
V
(Ac)
+w,
_
gw
_
o
0
j
_
V
(cA)
+w,
_
gw
@ .
_
o
0
k+V
A
+ .w,, gw .
_
o
0
j +4 V
A
+ w,, gw
@
_
o
0
wk
t
+V
A
+ .w,, gV
A
+ .w,
_
o
0
wj
t
+4 V
A
+ w,, gV
A
+ w,
@
_
o
c
+x ,k
t
+V
A
+x,, gV
A
+x,
_
o
c
+ y,j
t
+4 V
A
+y,, gV
A
+y,
A. IrooIs 225
@ .
_
o
c
k
t
+V
A
+x,, gV
A
+x,
_
o
c
xk
t
+V
A
+x,, gV
A
+x,

_
o
c
k
t
+V
A
+y,, gV
A
+y, .
_
o
c
yk
t
+V
A
+y,, gV
A
+y,
@ .
_
o
o
k
t
+V
A
+x,, gV
A
+x,
_
o
o
yk
t
+V
A
+y,, gV
A
+y,
@
_
o
o
k
t
+V
A
+x,, gI
A
+x,
. .
=1

_
o
o
yk
t
+V
A
+y,, gV
A
+y,
@
_
o
o
yk
t
+V
A
+y,, gI
A
+y,
@
_
o
0
k+V
A
+y,, gy
ppcnoix L
OIInIzaIIon Codc
H.1 SynLoIIc OynanIc IrogrannIng
(( Wklv lv Edfnzdug G|qdplf Surjudpplqj vroylqj iru wkh rswlpdo
(( frqvxpswlrq dqg lqyhvwphqw vwudwhjlhv dqg wkh ydoxh ixqfwlrq
(( v|perolfdoo|1 Lw vwruhv wkh h{suhvvlrqv lq **Odwwlfh** zklfk lv
(( d wzr0glphqvlrqdo vwuxfwxuh duud| zlwk urzv uhsuhvhqwlqj qrghv
(( dqg froxpqv uhsuhvhqwlqj wlph1 Wklv lv d elqrpldo uhfrpelqlqj
(( odwwlfh1 Odwwlfh+pdwxulw|.w.405-q/w.4, uhwxuqv d vwuxfwxuh dw
(( wlph w dqg qrgh q +hqfrglqj, zlwk ilhogv = frqvxpswlrq/
(( lqyhvwphqw/ zhdowk dqg wkh remhfwlyh ydoxh ixqfwlrq1
ixqfwlrq Odwwlfh @ EdfnzdugGS+Lqsxw,>
irupdw vkruw
gljlwv+4,>
W @ Lqsxw+</4,>
ehwd @ Lqsxw+6/4,>
u @ Lqsxw+7/4,>
Sx @ Lqsxw+:/4,>
( j @ Lqsxw+4/4,>
sulqw @ Lqsxw+43/4,>
( { xvhg iru frqvxpswlrq dqg | iru lqyhvwphqw/ z iru zhdowk
v|pv { | z
( lqlwldol}dwlrq ri zhdowk dw d ilqdo qrgh
Odwwlfh+5-W.4/W.4,1Z @ v|p+*3*,>
( lqlwldo zhdowk
Odwwlfh+W.4/4,1Z @ z>
iru q @ 3=W/
( Ydoxh ixqfwlrq dw wkh whuplqdo qrghv htxdov xwlolw| ri zhdowk
Odwwlfh+5-+W0q,.4/W.4,1Y @ xwlolw|+z,>
( lqlwldol}dwlrq ri lqyhvwphqw vwudwhjlhv
Odwwlfh+5-+W0q,.4/W.4,1K4 @ v|p+*3*,>
226
H. OtInIzatIon Code 227
( lqlwldol}dwlrq ri frqvxpswlrq kdupohvv exw frqyhqlhqw
Odwwlfh+5-+W0q,.4/W.4,1F @ z>
hqg
(( w lv wkh uhdo wlph
iru w @ W04=04=3/
(( q lv wkh qrgh qxpehu
iru q @ 3=w/
{ @ v|p+*{*,> | @ v|p+*|*,>
( fkdqjh lq wkh ulvn| sulfh ehwzhhq wlph w dqg w.4
ghowdVxs @ V+w.4/q.4/Lqsxw,2E+w.4/Lqsxw, 0 V+w/q/Lqsxw,2E+w/Lqsxw,>
ghowdVgq @ V+w.4/q/Lqsxw,2E+w.4/Lqsxw, 0 V+w/q/Lqsxw,2E+w/Lqsxw,>
( wkh zhdowk lq wkh xs dqg grzq vwdwhv dw wlph w.4
zhdowkxs @ +z0{, - +4.u, . E+w.4/Lqsxw, - ghowdVxs - |>
zhdowkgq @ +z0{, - +4.u, . E+w.4/Lqsxw, - ghowdVgq- |>
( wkh remhfwlyh wr eh pd{lpl}hg1 Qrwh wkdw { lv v|perolf
( zkhuhdv zhdowkxs dqg zhdowkgq frpelqh qxphulfdo ydoxhv
( +ydoxhv ri wkh vhfxulwlhv/ lqwhuhvw udwh, dqg v|perolf
( h{suhvvlrqv ri { / z dqg z
remhfwlyh @ xwlolw|+{, . ehwd-+ 111
Sx - vxev+Odwwlfh+W.w.505-+q.4,/w.5,1Y/zhdowkxs, . 111
+40Sx, - vxev+Odwwlfh+W.w.505-q/ w.5,1Y/zhdowkgq,,>
( gliihuhqwldwh wkh remhfwlyh zlwk uhvshfw wr frqvxpswlrq
( { dqg lqyhvwphqw |
v|pbfrqv @ glii+remhfwlyh/{,>
v|pbdoor @ glii+remhfwlyh/|,>
( vroyh wkh iluvw rughu frqglwlrqv
^{ / |` @ vroyh+v|pbfrqv/ v|pbdoor,>
( v|perolf rswlpdo frqvxpswlrq dqg lqyhvwphqw
Odwwlfh+W.w.405-q/w.4,1F @ {>
Odwwlfh+W.w.405-q/w.4,1K4 @ |>
( uhsodfh wkh rswlpdo vroxwlrqv wr ilqg wkh rswlpdo zhdowk
( lq xs dqg grzq vwdwhv
zhdowkxs @ +z0{, - +4.u, . E+w.4/Lqsxw, - ghowdVxs - |>
zhdowkgq @ +z0{, - +4.u, . E+w.4/Lqsxw, - ghowdVgq- |>
H. OtInIzatIon Code 228
( soxjjlqj wkh rswlpdo ydoxhv lq wkh remhfwlyh wr rewdlq
( wkh rswlpdo remhfwlyh ydoxh ixqfwlrq
Odwwlfh+W.w.405-q/w.4,1Y @ xwlolw|+{, . ehwd-+ 111
Sx - vxev+Odwwlfh+W.w.505-+q.4,/w.5,1Y/zhdowkxs, . 111
+40Sx, - vxev+Odwwlfh+W.w.505-q/ w.5,1Y/zhdowkgq,,>
hqg
hqg
H.2 HIsk-^eutraI ConutatIonaI Aroacn
(( Wklv ixqfwlrq uhwxuqv d pdwul{ ri rswlpdo frqvxpswlrq zkhuh
(( F+l/m, lv wkh frqvxpswlrq dw wlph l04/ dqg qrgh m04
(( Wkh frqvxpswlrq lv iurp wlph 3 wr 5aW/ dqg iru hdfk wlph w/
(( qrghv udqjh iurp 3 wr 5aw 04/ lq pdwul{/ 4?@l?@W.4 dqg 4?@m?@5aW
(( Wklv dfuredwlf lv wr flufxpyhqw wkh idfw wkdw pdwulfhv lq Pdwode
(( vwduw dw +4/4,
ixqfwlrq F @ frqvxpswlrq+Lqsxw,>
( lqlwldo zhdowk
z @ Lqsxw+5/4,>
( wlph suhihuhqfh glvfrxqw idfwru
ehwd @ Lqsxw+6/4,>
( pdwxulw|
W @ Lqsxw+</4,>
F @ }hurv+W.4/5aW,>
( Fdvh ri orj xwlolw| x+f, @ oq+f,
li +ehwd @@ 4,
iru w@4=+W.4,/
iru m@4=5a+w04,/
F+w/m, @ z 2 +W . 4, 2 Q+w04/m04/Lqsxw,>
hqg
hqg
hovh
iru w@4=+W.4,/
iru m@4=5a+w04,/
F+w/m, @ z - +40ehwd,-ehwda+w04,2 +40ehwda+W.4,, 111
2 Q+w04/m04/Lqsxw,>
hqg
hqg
H. OtInIzatIon Code 229
hqg
(( Wklv ixqfwlrqv uhwxuqv wkh pdwul{ ri lqyhvwphqwv lq ulvn|
(( dqg ulvnohvv vhfxulwlhv dv zhoo dv wkh zhdowk dw hdfk qrgh
(( ri wkh odwwlfh
ixqfwlrq L @ lqyhvwphqw+Frqvxpswlrq/Lqsxw,>
F @ Frqvxpswlrq>
( qxpehu ri urzv 04 lv htxdo wr wkh qxpehu ri shulrgv lq wkh prgho
Qe @ vl}h+F/4,04>
Z @ }hurv+Qe.4/5aQe,>
( Lqlwldol}h wkh odvw froxpq ri wkh zhdowk pdwul{ e|
( ilqdo frqvxpswlrq
Z+Qe.4/=, @ F+Qe.4/=,>
( pdwul{ ri ulvn| vhfxulw| srvlwlrqv
u @ }hurv+Qe/5a+Qe04,,>
( pdwul{ ri vdih dvvhw srvlwlrqv
qu @ }hurv+Qe/5a+Qe04,,>
( qhvwhg orrs wr frpsxwh lqyhvwphqw vwudwhjlhv wkdw ilqdqfhv
( rswlpdo frqvxpswlrq
iru urz @ Qe=04=4/
iru fro @ 4=5a+urz04,/
ghowd @ V+urz/5-fro04/Lqsxw, 0 V+urz/5-fro05/Lqsxw,>
u+urz/fro, @ +Z+urz.4/5-fro, 0 Z+urz.4/5-fro04,, 2 ghowd>
qu+urz/fro, @ +Z+urz.4/5-fro, 0 V+urz/5-fro 04/Lqsxw, 111
- u+urz/fro,, 2 E+urz/Lqsxw,>
Z+urz/fro, @ F+urz/fro, . E+urz04/Lqsxw, - qu+urz/fro, 111
. V+urz04/fro04/Lqsxw, - u+urz/fro,>
hqg
hqg
L @ vwuxfw+*Zhdowk*/Z/*Ulvn|*/u/*Vdih*/qu,>