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Optimal investment and consumption when regime transitions cause price shocks


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


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.

Suggested Citation

  • Lim, Andrew E.B. & Watewai, Thaisiri, 2012. "Optimal investment and consumption when regime transitions cause price shocks," Insurance: Mathematics and Economics, Elsevier, vol. 51(3), pages 551-566.
  • Handle: RePEc:eee:insuma:v:51:y:2012:i:3:p:551-566 DOI: 10.1016/j.insmatheco.2012.07.011

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    References listed on IDEAS

    1. Bjørn Eraker & Michael Johannes & Nicholas Polson, 2003. "The Impact of Jumps in Volatility and Returns," Journal of Finance, American Finance Association, vol. 58(3), pages 1269-1300, June.
    2. Jun Liu & Francis A. Longstaff & Jun Pan, 2003. "Dynamic Asset Allocation with Event Risk," Journal of Finance, American Finance Association, vol. 58(1), pages 231-259, February.
    3. Sanjiv Ranjan Das & Raman Uppal, 2004. "Systemic Risk and International Portfolio Choice," Journal of Finance, American Finance Association, vol. 59(6), pages 2809-2834, December.
    4. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515 World Scientific Publishing Co. Pte. Ltd..
    5. Yihong Xia, 2001. "Learning about Predictability: The Effects of Parameter Uncertainty on Dynamic Asset Allocation," Journal of Finance, American Finance Association, vol. 56(1), pages 205-246, February.
    6. Kyriakos Chourdakis, 2002. "Continuous Time Regime Switching Models and Applications in Estimating Processes with Stochastic Volatility and Jumps," Working Papers 464, Queen Mary University of London, School of Economics and Finance.
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    More about this item


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

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions


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