Solving the Non-Linear Dynamic Asset Allocation Problem: Effects of Arbitrary Stochastic Processes and Unsystematic Risk on the Super Efficient Portfolio Space
AbstractIn this paper we propose a methodology that we believe improves the effectiveness of several common assumptions underlying Modern Portfolio Theory's dynamic optimization framework. The paper derives a general outline of a stochastic nonlinear-quadratic control for analyzing and solving a non-linear mean-variance optimization problem. The study first develops and then investigates the role of unsystematic (credit) risk in this continuous time stochastic asset allocation model where the wealth generating process has a non-negative constraint. The paper finds that given unsystematic risk, wealth constraints and higher order moments the market price of risk is non-constant and the investor's optimal terminal return may be lower than previously indicated by a number of classical models. This result provides a convenient solution to practitioners seeking to evaluate competing investment strategies.
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Bibliographic InfoPaper provided by University of Connecticut, Department of Economics in its series Working papers with number 2009-04.
Length: 38 pages
Date of creation: Jan 2009
Date of revision:
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Postal: University of Connecticut 341 Mansfield Road, Unit 1063 Storrs, CT 06269-1063
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Web page: http://www.econ.uconn.edu/
More information through EDIRC
Dynamic Optimization; Credit Risk; Mean-Variance Analysis; Linear Quadratic Control; Credit Default Swaps; Capital Market Line; Gram-Charlier expansion; unsystematic risks;
Find related papers by JEL classification:
- G0 - Financial Economics - - General
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
- C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-01-24 (All new papers)
- NEP-CFN-2009-01-24 (Corporate Finance)
- NEP-ORE-2009-01-24 (Operations Research)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005.
"Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market,"
Journal of Finance,
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- Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2004. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default Swap Market," NBER Working Papers 10418, National Bureau of Economic Research, Inc.
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- Jondeau, Eric & Rockinger, Michael, 2001. "Gram-Charlier densities," Journal of Economic Dynamics and Control, Elsevier, vol. 25(10), pages 1457-1483, October.
- Kwamie Dunbar, 2009. "The Effects of Credit Risk on Dynamic Portfolio Management: A New Computational Approach," Working papers 2009-03, University of Connecticut, Department of Economics, revised Feb 2009.
- Bawa, Vijay S. & Lindenberg, Eric B., 1977. "Capital market equilibrium in a mean-lower partial moment framework," Journal of Financial Economics, Elsevier, vol. 5(2), pages 189-200, November.
- Longstaff, Francis A, 1995. "Option Pricing and the Martingale Restriction," Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 1091-1124.
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