Optimal investment and consumption when regime transitions cause price shocks
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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- Jun Liu & Francis A. Longstaff & Jun Pan, 2003.
"Dynamic Asset Allocation with Event Risk,"
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- Jun Liu & Francis A. Longstaff & Jun Pan, 2002. "Dynamic Asset Allocation With Event Risk," NBER Working Papers 9103, National Bureau of Economic Research, Inc.
- Liu, Jun & Longstaff, Francis & Pan, Jun, 2001. "Dynamic Asset Allocation with Event Risk," University of California at Los Angeles, Anderson Graduate School of Management qt9fm6t5nb, Anderson Graduate School of Management, UCLA.
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- 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, 02.
- 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, 06.
- 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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