IDEAS home Printed from https://ideas.repec.org/a/inm/ormoor/v42y2017i3p599-625.html
   My bibliography  Save this article

Optimal Dynamic Risk Taking

Author

Listed:
  • Ajay Subramanian

    (Department of Risk Management and Insurance and Department of Finance, Georgia State University, Atlanta, Georgia 30303)

  • Baozhong Yang

    (Deparatment of Finance, Georgia State University, Atlanta, Georgia 30303)

Abstract

We analyze a continuous-time stochastic control problem that arises in the study of several important issues in financial economics. An agent controls the drift and volatility of a diffusion output process by dynamically selecting one of an arbitrary (but finite) number of projects and the termination time. The optimal policy depends on the projects’ risk-adjusted drifts that are determined by their drifts, volatilities, and the curvature (or relative risk aversion) of the agent’s payoff function. We prove that the optimal policy only selects projects in the spanning subset . Furthermore, if the projects’ risk-adjusted drifts are consistently ordered for all output values, then the optimal policy is characterized by at most K − 1 switching triggers, where K is the number of projects in the spanning subset. We also characterize the optimal policy when the consistent ordering condition does not hold, and we outline a general and tractable computational algorithm to derive the optimal policies.

Suggested Citation

  • Ajay Subramanian & Baozhong Yang, 2017. "Optimal Dynamic Risk Taking," Mathematics of Operations Research, INFORMS, vol. 42(3), pages 599-625, August.
    • Handle: RePEc:inm:ormoor:v:42:y:2017:i:3:p:599-625
    DOI: 10.1287/moor.2016.0819
    as

    Download full text from publisher

    File URL: https://doi.org/10.1287/moor.2016.0819
    Download Restriction: no
    File URL: https://libkey.io/10.1287/moor.2016.0819?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Philip H. Dybvig & Hong Liu, 2011. "Verification Theorems for Models of Optimal Consumption and Investment with Retirement and Constrained Borrowing," Mathematics of Operations Research, INFORMS, vol. 36(4), pages 620-635, November.
    2. Leland, Hayne E, 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-1252, September.
    3. Cadenillas, Abel & Cvitanic, Jaksa & Zapatero, Fernando, 2007. "Optimal risk-sharing with effort and project choice," Journal of Economic Theory, Elsevier, vol. 133(1), pages 403-440, March.
    4. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    5. Stanley R. Pliska, 1986. "A Stochastic Calculus Model of Continuous Trading: Optimal Portfolios," Mathematics of Operations Research, INFORMS, vol. 11(2), pages 371-382, May.
    6. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers RPF-278, University of California at Berkeley.
    7. Ioannis Karatzas & John P. Lehoczky & Suresh P. Sethi & Steven E. Shreve, 1986. "Explicit Solution of a General Consumption/Investment Problem," Mathematics of Operations Research, INFORMS, vol. 11(2), pages 261-294, May.
    8. Hui Ou-Yang, 2003. "Optimal Contracts in a Continuous-Time Delegated Portfolio Management Problem," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 173-208.
    9. Erhan Bayraktar & Masahiko Egami, 2010. "On the One-Dimensional Optimal Switching Problem," Mathematics of Operations Research, INFORMS, vol. 35(1), pages 140-159, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Ajay Subramanian & Baozhong Yang, 2020. "Dynamic Prudential Regulation," Management Science, INFORMS, vol. 66(7), pages 3183-3210, July.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Agliardi, Elettra & Andergassen, Rainer, 2009. "Last resort gambles, risky debt and liquidation policy," Review of Financial Economics, Elsevier, vol. 18(3), pages 142-155, August.
    2. Alexander Reisz, 1999. "Temporal Resolution of Uncertainty, the Investment Policy of Levered Firms and Corporate Debt Yields," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-044, New York University, Leonard N. Stern School of Business-.
    3. Erwan Morellec & Boris Nikolov & Norman Schürhoff, 2018. "Agency Conflicts around the World," Review of Financial Studies, Society for Financial Studies, vol. 31(11), pages 4232-4287.
    4. Djembissi, Bertrand, 2011. "Excessive risk taking and the maturity structure of debt," Journal of Economic Dynamics and Control, Elsevier, vol. 35(10), pages 1800-1816, October.
    5. Hui Chen, 2010. "Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure," Journal of Finance, American Finance Association, vol. 65(6), pages 2171-2212, December.
    6. Murray Carlson & Ali Lazrak, 2006. "Leverage Choice and Credit Spread Dynamics when Managers Risk Shift," 2006 Meeting Papers 193, Society for Economic Dynamics.
    7. Suresh M. Sundaresan, 2000. "Continuous‐Time Methods in Finance: A Review and an Assessment," Journal of Finance, American Finance Association, vol. 55(4), pages 1569-1622, August.
    8. Decamps, Jean-Paul & Faure-Grimaud, Antoine, 2002. "Excessive continuation and dynamic agency costs of debt," European Economic Review, Elsevier, vol. 46(9), pages 1623-1644, October.
    9. Dan A. Iancu & Nikolaos Trichakis & Gerry Tsoukalas, 2017. "Is Operating Flexibility Harmful Under Debt?," Management Science, INFORMS, vol. 63(6), pages 1730-1761, June.
    10. John D. Schatzberg & David Weeks, 2004. "Security Choice, Information Effects and Firm Characteristics: A Factor Analytic Approach," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 31(9‐10), pages 1483-1503, November.
    11. Duffie, Darrell, 2003. "Intertemporal asset pricing theory," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 11, pages 639-742, Elsevier.
    12. Szydlowski, Martin, 2019. "Incentives, project choice, and dynamic multitasking," Theoretical Economics, Econometric Society, vol. 14(3), July.
    13. Bart Lambrecht & Stewart C. Myers, 2005. "A Theory of Takeovers and Disinvestment," NBER Working Papers 11082, National Bureau of Economic Research, Inc.
    14. repec:dgr:rugsom:01e54 is not listed on IDEAS
    15. Ron Kaniel & Péter Kondor, 2013. "The Delegated Lucas Tree," Review of Financial Studies, Society for Financial Studies, vol. 26(4), pages 929-984.
    16. Tan, Yingxian & Yang, Zhaojun, 2016. "Contingent capital, capital structure and investment," The North American Journal of Economics and Finance, Elsevier, vol. 35(C), pages 56-73.
    17. Mäkinen, Taneli & Sarno, Lucio & Zinna, Gabriele, 2020. "Risky bank guarantees," Journal of Financial Economics, Elsevier, vol. 136(2), pages 490-522.
    18. Hassan Naqvi, 2004. "The Valuation of Corporate Debt with Default Risk," Finance 0410010, University Library of Munich, Germany.
    19. de La Bruslerie, Hubert & Gueguen, Simon, 2021. "Creditors’ holdup, releveraging and the setting of private appropriation in a control contract between shareholders," International Review of Law and Economics, Elsevier, vol. 68(C).
    20. Marco Realdon, 2006. "Valuation of the Firm's Liabilities when Equity Holders are also Creditors," Discussion Papers 06/16, Department of Economics, University of York.
    21. Jean-Paul Décamps & Bertrand Djembissi, 2007. "Switching to a poor business activity: optimal capital structure, agency costs and covenant rules," Annals of Finance, Springer, vol. 3(3), pages 389-409, July.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:inm:ormoor:v:42:y:2017:i:3:p:599-625. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Asher (email available below). General contact details of provider: https://edirc.repec.org/data/inforea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.