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Optimal investment and consumption when regime transitions cause price shocks

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  • Lim, Andrew E.B.
  • Watewai, Thaisiri
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    Abstract

    This paper concerns optimal investment and consumption with CRRA utility when there is event risk. Events are modeled by transitions in a finite state Markov chain, but unlike traditional regime switching models, transitions not only change the instantaneous return statistics but are accompanied by jumps in the price at the instant of transition. Optimal investment and consumption policies are characterized using stochastic control methods and computed by solving a system of ordinary differential equations and a convex optimization problem. We show that optimal policies are significantly different from those of traditional regime switching or jump-diffusion problems and that the cost of ignoring transition price shocks can be substantial.

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    Bibliographic Info

    Article provided by Elsevier in its journal Insurance: Mathematics and Economics.

    Volume (Year): 51 (2012)
    Issue (Month): 3 ()
    Pages: 551-566

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    Handle: RePEc:eee:insuma:v:51:y:2012:i:3:p:551-566

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    Web page: http://www.elsevier.com/locate/inca/505554

    Related research

    Keywords: Event risk; Regime switching; Defaultable bonds; Jump processes; Optimal investment and consumption; Stochastic control;

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    1. Robert A. Jarrow, 2001. "Counterparty Risk and the Pricing of Defaultable Securities," Journal of Finance, American Finance Association, American Finance Association, vol. 56(5), pages 1765-1799, October.
    2. Das, Sanjiv Ranjan & Uppal, Raman, 2002. "Systemic Risk and International Portfolio Choice," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3305, C.E.P.R. Discussion Papers.
    3. Jun Liu & Francis A. Longstaff & Jun Pan, 2002. "Dynamic Asset Allocation With Event Risk," NBER Working Papers 9103, National Bureau of Economic Research, Inc.
    4. Bjørn Eraker & Michael Johannes & Nicholas Polson, 2003. "The Impact of Jumps in Volatility and Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 58(3), pages 1269-1300, 06.
    5. Yihong Xia, 2001. "Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 205-246, 02.
    6. Kyriakos Chourdakis, 2002. "Continuous Time Regime Switching Models and Applications in Estimating Processes with Stochastic Volatility and Jumps," Working Papers, Queen Mary, University of London, School of Economics and Finance 464, Queen Mary, University of London, School of Economics and Finance.
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