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Optimal investment with S-shaped utility and trading and Value at Risk constraints: An application to defined contribution pension plan

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  • Dong, Yinghui
  • Zheng, Harry

Abstract

In this paper we investigate an optimal investment problem under loss aversion (S-shaped utility) and with trading and Value-at-Risk (VaR) constraints faced by a defined contribution (DC) pension fund manager. We apply the concavification and dual control method to solve the problem and derive the closed-form representation of the optimal terminal wealth in terms of a controlled dual state variable. We propose a simple and effective algorithm for computing the initial dual state value, the Lagrange multiplier and the optimal terminal wealth. Theoretical and numerical results show that the VaR constraint can significantly impact the distribution of the optimal terminal wealth and may greatly reduce the risk of losses in bad economic states due to loss aversion.

Suggested Citation

  • Dong, Yinghui & Zheng, Harry, 2020. "Optimal investment with S-shaped utility and trading and Value at Risk constraints: An application to defined contribution pension plan," European Journal of Operational Research, Elsevier, vol. 281(2), pages 341-356.
    • Handle: RePEc:eee:ejores:v:281:y:2020:i:2:p:341-356
    DOI: 10.1016/j.ejor.2019.08.034
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