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Centre for Mathematical Physics and Stochastics
Department of Mathematical Sciences, University of Aarhus

Funded by The Danish National Research Foundation

MPS-RR 2000-15
April 2000

Portfolio optimization in a Lévy market with intertemporal substitution and transaction costs


Fred Espen Benth, Kenneth Hvistendahl Karlsen, Kristin Reikvam


We investigate an infinite horizon investment-consumption model in which a single agent consumes and distributes her wealth between a risk-free asset (bank account) and several risky assets (stocks) whose prices are governed by Lévy (jump-diffusion) processes. We suppose that transactions between the assets incur a transaction cost proportional to the size of the transaction. The problem is to maximize the total utility of consumption under Hindy-Huang-Kreps intertemporal preferences. This portfolio optimization problem is formulated as a singular stochastic control problem and is solved using dynamic programming and the theory of viscosity solutions. The associated dynamic programming equation is a second order degenerate elliptic integro-differential variational inequality subject to a state constraint boundary condition. The main result is a characterization of the value function as the unique constrained viscosity solution of the dynamic programming equation. Emphasis is put on providing a framework that allows for a general class of Lévy processes. Owing to the complexity of our investment-consumption model, it is not possible to derive closed form solutions for the value function. Hence the optimal policies cannot be obtained in closed form from the first order conditions for the dynamic programming equation. Therefore we have to resort to numerical methods for computing the value function as well as the associated optimal policies. In view of the viscosity solution theory, the analysis found in this paper will ensure the convergence of a large class of numerical methods for the investment-consumption model in question.

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This paper has now been published in Stoch. Stoch. Rep. 74, 517--569 (2002)