Inconsistent Investment and Consumption Problems

Inconsistent Investment and Consumption Problems In a traditional Black–Scholes market we develop a verification theorem for a general class of investment and consumption problems where the standard dynamic programming principle does not hold. The theorem is an extension of the standard Hamilton–Jacobi–Bellman equation in the form of a system of non-linear differential equations. We derive the optimal investment and consumption strategy for a mean-variance investor without pre-commitment endowed with labor income. In the case of constant risk aversion it turns out that the optimal amount of money to invest in stocks is independent of wealth. The optimal consumption strategy is given as a deterministic bang-bang strategy. In order to have a more realistic model we allow the risk aversion to be time and state dependent. Of special interest is the case were the risk aversion is inversely proportional to present wealth plus the financial value of future labor income net of consumption. Using the verification theorem we give a detailed analysis of this problem. It turns out that the optimal amount of money to invest in stocks is given by a linear function of wealth plus the financial value of future labor income net of consumption. The optimal consumption strategy is again given as a deterministic bang-bang strategy. We also calculate, for a general time and state dependent risk aversion function, the optimal investment and consumption strategy for a mean-standard deviation investor without pre-commitment. In that case, it turns out that it is optimal to take no risk at all. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Applied Mathematics and Optimization Springer Journals

Inconsistent Investment and Consumption Problems

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Publisher
Springer US
Copyright
Copyright © 2015 by Springer Science+Business Media New York
Subject
Mathematics; Calculus of Variations and Optimal Control; Optimization; Systems Theory, Control; Theoretical, Mathematical and Computational Physics; Mathematical Methods in Physics; Numerical and Computational Physics
ISSN
0095-4616
eISSN
1432-0606
D.O.I.
10.1007/s00245-014-9267-z
Publisher site
See Article on Publisher Site

Abstract

In a traditional Black–Scholes market we develop a verification theorem for a general class of investment and consumption problems where the standard dynamic programming principle does not hold. The theorem is an extension of the standard Hamilton–Jacobi–Bellman equation in the form of a system of non-linear differential equations. We derive the optimal investment and consumption strategy for a mean-variance investor without pre-commitment endowed with labor income. In the case of constant risk aversion it turns out that the optimal amount of money to invest in stocks is independent of wealth. The optimal consumption strategy is given as a deterministic bang-bang strategy. In order to have a more realistic model we allow the risk aversion to be time and state dependent. Of special interest is the case were the risk aversion is inversely proportional to present wealth plus the financial value of future labor income net of consumption. Using the verification theorem we give a detailed analysis of this problem. It turns out that the optimal amount of money to invest in stocks is given by a linear function of wealth plus the financial value of future labor income net of consumption. The optimal consumption strategy is again given as a deterministic bang-bang strategy. We also calculate, for a general time and state dependent risk aversion function, the optimal investment and consumption strategy for a mean-standard deviation investor without pre-commitment. In that case, it turns out that it is optimal to take no risk at all.

Journal

Applied Mathematics and OptimizationSpringer Journals

Published: Jun 1, 2015

References

  • Dynamic mean-variance asset allocation
    Basak, S; Chabakauri, G

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