Portfolio optimization in a regime-switching market with derivatives

Jun Fu, Jiaqin Wei, Hailiang Yang*

*Corresponding author for this work

Research output: Contribution to journalArticle

29 Citations (Scopus)

Abstract

We consider the optimal asset allocation problem in a continuous-time regime-switching market. The problem is to maximize the expected utility of the terminal wealth of a portfolio that contains an option, an underlying stock and a risk-free bond. The difficulty that arises in our setting is finding a way to represent the return of the option by the returns of the stock and the risk-free bond in an incomplete regime-switching market. To overcome this difficulty, we introduce a functional operator to generate a sequence of value functions, and then show that the optimal value function is the limit of this sequence. The explicit form of each function in the sequence can be obtained by solving an auxiliary portfolio optimization problem in a single-regime market. And then the original optimal value function can be approximated by taking the limit. Additionally, we can also show that the optimal value function is a solution to a dynamic programming equation, which leads to the explicit forms for the optimal value function and the optimal portfolio process. Furthermore, we demonstrate that, as long as the current state of the Markov chain is given, it is still optimal for an investor in a multiple-regime market to simply allocate his/her wealth in the same way as in a single-regime market.

Original languageEnglish
Pages (from-to)184-192
Number of pages9
JournalEuropean Journal of Operational Research
Volume233
Issue number1
DOIs
Publication statusPublished - 16 Feb 2014

Keywords

  • Dynamic programming principle
  • Elasticity approach
  • Functional operator
  • Portfolio optimization
  • Regime switching

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